Analysis Of Accounts: How To Interpret The Financial Performance Of A Business By Calculating And Analysing Profitability Ratios And Liquidity Ratios (Copy)
Cheat Sheet: 5.5.3 Interpreting Profitability and Liquidity Ratios
Profitability Ratios
| Ratio | Formula | Interpretation | Example |
|---|---|---|---|
| Gross Profit Margin | (Gross Profit ÷ Revenue) × 100 | Measures profit from sales before expenses. Higher = better cost control on production. | Revenue = $100,000, GP = $40,000 → 40% margin |
| Profit Margin (Net Profit Margin) | (Profit for Year ÷ Revenue) × 100 | Profit after all expenses. Shows efficiency of overall operations. | Profit = $15,000, Revenue = $100,000 → 15% margin |
| Return on Capital Employed (ROCE) | (Profit ÷ Capital Employed) × 100 | Efficiency of using long-term capital. Higher = more attractive to investors. | Profit = $20,000, Capital = $100,000 → 20% ROCE |
Written and Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change O Level And IGCSE Business Studies Full Scale Course
Liquidity Ratios
| Ratio | Formula | Interpretation | Example |
|---|---|---|---|
| Current Ratio | Current Assets ÷ Current Liabilities | Ideal = 1.5–2:1. Too low = liquidity risk; too high = inefficient use of funds. | CA = $30,000, CL = $15,000 → 2:1 |
| Acid Test Ratio | (Current Assets – Inventory) ÷ Current Liabilities | Stricter test (excludes inventory). Ideal = at least 1:1. | (30,000 – 10,000) ÷ 15,000 = 1.33:1 |
How to Analyse Results
| Situation | Interpretation | Action |
|---|---|---|
| High Gross Margin, Low Net Margin | Expenses too high | Cut overheads |
| Low Gross Margin | Cost of sales too high | Negotiate cheaper suppliers |
| ROCE below competitors | Capital used inefficiently | Invest in profitable projects |
| Current Ratio < 1 | Cannot cover short-term debts | Raise cash, reduce liabilities |
| Acid Test < 1 | Over-reliance on inventory | Improve cash collections |
Written and Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change O Level And IGCSE Business Studies Full Scale Course
Quick Revision Bullets
- Gross Margin = profit before expenses → check production cost efficiency.
- Net Margin = profit after all costs → shows full efficiency.
- ROCE = how well capital is used. Higher % = more efficient.
- Current Ratio → liquidity test, 1.5–2:1 ideal.
- Acid Test stricter liquidity check (excludes inventory).
- Ratios help compare performance over time and against competitors.
Written and Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change O Level And IGCSE Business Studies Full Scale Course