How do financial ratios help users assess the profitability, liquidity and stability of a business?
Calculate and interpret profitability, liquidity, efficiency and financial stability ratios, and evaluate business performance and its limitations using ratio analysis
WACE Year 12 Accounting and Finance Unit 4 on ratio analysis: calculating and interpreting profitability, liquidity, efficiency and stability ratios, comparing performance over time and against benchmarks, and recognising the limitations of ratios for decision-making.
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What this dot point is asking
SCSA wants you to calculate ratios from company statements, interpret what each says about performance, compare across periods or against benchmarks, and discuss the limitations of ratio analysis.
Profitability ratios
A rising gross profit margin suggests better pricing or lower cost of sales. Return on equity measures the return generated for shareholders on their funds.
Liquidity ratios
A current ratio of 2 to 1 means 1 of current liabilities. Too low signals difficulty paying short-term debts; very high may signal idle assets.
Efficiency ratios
The accounts receivable turnover (or collection period) shows how quickly the business converts credit sales into cash.
Financial stability ratios
A high debt ratio means heavy reliance on borrowed funds, raising financial risk because interest must be paid regardless of profit.
Interpreting ratios
Ratios are only meaningful in context. Compare them over time (trend analysis) and against industry benchmarks or competitors. A single number in isolation tells you little.