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How can ratios reveal a business's profitability, liquidity and efficiency?

Calculate and interpret profitability, liquidity and efficiency ratios.

Calculate key profitability, liquidity and efficiency ratios and interpret what they mean for decision-makers, with worked figures.

Generated by Claude Opus 4.88 min answerUpdated 2026-06-02

Reviewed by: AI editorial process; not yet individually human-reviewed

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What this dot point is asking

Raw dollar figures are hard to compare, so ratios express one figure as a relationship to another. This lets a decision-maker judge performance and position, and compare across time and between businesses of different sizes. Ratios fall into three main groups for this course.

Profitability ratios

These measure how well the business generates profit from its sales and resources.

Gross\ Profit\ Margin = \frac{Gross\ Profit}{Sales} \times 100

Net\ Profit\ Margin = \frac{Net\ Profit}{Sales} \times 100

Return\ on\ Owner's\ Equity = \frac{Net\ Profit}{Average\ Owner's\ Equity} \times 100

A higher margin means more profit is kept from each dollar of sales. Return on owner's equity shows the reward earned on the funds the owner has invested.

Liquidity ratios

These measure whether the business can pay its short-term debts.

Current\ Ratio = \frac{Current\ Assets}{Current\ Liabilities}

Quick\ Ratio = \frac{Current\ Assets - Inventory}{Current\ Liabilities}

A current ratio around $2:1$ is often regarded as comfortable, though the right level depends on the industry. The quick (or acid-test) ratio is stricter because it removes inventory, which can be slow to convert to cash.

Efficiency ratios

These measure how well assets and working capital are managed.

Inventory\ Turnover = \frac{Cost\ of\ Goods\ Sold}{Average\ Inventory}

Debtors\ Collection\ Period = \frac{Average\ Debtors}{Credit\ Sales} \times 365

Faster inventory turnover and a shorter collection period generally mean cash is freed up sooner.

Worked example

Profitability and liquidity

Given information

Sales $200\,000$ ; Gross profit $80\,000$ ; Net profit $24\,000$ . Current assets $60\,000$ (including inventory $25\,000$ ); Current liabilities $30\,000$ .

Profitability

Gross profit margin $= \frac{80\,000}{200\,000} \times 100 = 40\%$
Net profit margin $= \frac{24\,000}{200\,000} \times 100 = 12\%$

So $40$ cents of every sales dollar is gross profit, but expenses reduce this to $12$ cents of net profit per dollar.

Liquidity

Current ratio $= \frac{60\,000}{30\,000} = 2:1$
Quick ratio $= \frac{60\,000 - 25\,000}{30\,000} = \frac{35\,000}{30\,000} = 1.17:1$

The business holds twice the current assets needed to cover current liabilities, and even excluding inventory it can still cover its short-term debts. This suggests sound short-term liquidity.

How to write a full interpretation

A high-scoring interpretation follows a simple structure: state the ratio and what it is, compare it (to last year, to budget, or to an industry benchmark), explain the likely cause, and state the consequence or decision it supports. For example: "The current ratio fell from $2.2:1$ to $1.4:1$ , so short-term cover has weakened, probably because debtors and cash have dropped while creditors rose; the business may struggle to pay suppliers on time, so it should tighten debtor collection before taking on more credit." The calculation earns one or two marks; the comparison, cause and consequence earn the rest.

Linking ratios to the cash story

Ratios from the income statement and balance sheet are most powerful when read alongside the cash flow statement. Strong profitability with a falling current ratio and slow debtor collection often explains a negative operating cash flow: profit is being earned but tied up in debtors and inventory rather than turned into cash. Joining the ratio picture to the cash picture is exactly the kind of integrated analysis the decision-making strand rewards, and it connects this topic to the cash flow statement and budgeting.

Limitations to acknowledge

A thorough answer notes the limits of ratios. They are historical, depend on the accounting policies each business chose, can be distorted by one-off events or year-end timing, and ignore non-financial factors such as competition, staff and the economy. A single ratio in isolation can mislead, which is why comparison and context are essential. Acknowledging these limitations shows the marker you understand that ratios inform a decision rather than make it.

Why this matters

Owners, lenders and potential investors all rely on ratios to make decisions about lending, investing or changing how the business operates. Marks in this topic come from correct formulae, correct calculation, and a clear interpretation linked to a decision.

Exam-style practice questions

Practice questions written in the style of TASC exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.

TCE 20228 marksUsing the figures below, calculate the gross profit margin, net profit margin, current ratio and quick ratio, and comment on the business's profitability and liquidity. Sales

300\,000; Gross profit

135\,000; Net profit

45\,000; Current assets

90\,000 (including inventory

40\,000); Current liabilities

50\,000.

Show worked answer →

Calculate each ratio, then interpret.

Gross profit margin $= \frac{135\,000}{300\,000} \times 100 = 45\%$ .
Net profit margin $= \frac{45\,000}{300\,000} \times 100 = 15\%$ .
Current ratio $= \frac{90\,000}{50\,000} = 1.8:1$ .
Quick ratio $= \frac{90\,000 - 40\,000}{50\,000} = \frac{50\,000}{50\,000} = 1:1$ .

Interpretation: profitability looks sound, with 45 cents of gross profit per sales dollar and 15 cents of net profit, though the gap shows expenses absorb a large share. Liquidity is adequate but not strong: the current ratio of $1.8:1$ is a little below the often-cited $2:1$ guide, and the quick ratio of exactly $1:1$ shows the business can just cover current liabilities without relying on selling inventory. Markers reward correct formulae and figures plus interpretation that compares to a benchmark and links to a decision.

TCE 20235 marksExplain three limitations of ratio analysis that a user should keep in mind when interpreting a business's ratios.

Show worked answer →

A full 5 mark answer gives three valid limitations with brief explanation.

Valid limitations include: ratios are based on historical figures, so they describe the past and may not predict the future; a single ratio means little without a comparison to a trend, budget or industry benchmark; different businesses use different accounting policies (for example, depreciation method or inventory valuation), so ratios may not be truly comparable; ratios use end-of-period figures that may not represent the whole year (seasonality); they ignore non-financial factors such as staff quality, competition and economic conditions; and they can be distorted by one-off events or window dressing.

Any three, each explained, earn the marks. Markers reward genuine limitations with a sentence showing why each one weakens the conclusions a user might draw, not just a bare list.