PROFITABILITY AND LIQUIDITY
Analysis of Accounts is about using the information contained in the accounts (financial
statements) to make some useful observations about the performance and financial strength
of the business organization.
Ratio analysis is a financial tool used to interpret and assess an organization's financial
statements.
A ratio is simply a mathematical relationship between one figure (number) and another.
Ratio allows a business to look at its financial performance.
NOTE: Comparison can be done within the business and with other businesses.
Profitability and Liquidity are the ways to measuring business performance.
Way 1 Profitability - It is the ability of a business to make profit.
Key ratios include Gross profit margin, Net profit margin and Return on capital employed.
➢ Gross profit margin
It is the ratio between gross profit and revenue.
𝑔𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡
X 100
𝑟𝑒𝑣𝑒𝑛𝑢𝑒
(It means that for every $100 revenue how much gross profit is the business making)
➢ Net profit margin
It is the ratio between net profit and revenue.
𝑛𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡
X 100
𝑟𝑒𝑣𝑒𝑛𝑢𝑒
(It means that for every $100 revenue how much net profit is the business making)
➢ Return on capital employed
It is the ratio between net profit and capital employed.
𝑛𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡
X 100
𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑
(It means that for every $100 invested how much profit is the business making)
Way 2 Liquidity – It is the ability of a business to pay its short-term debts.
Key ratios include current ratio and quick ratio (Acid test ratio).
➢ Current ratio
It is the ratio between current assets and current liabilities.
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
NOTE: The current ratio must be no less than 1.5:1 and should be no more than 2:1.
(It means that the business has 1.5 to 2 times more current assets than liabilities to covers its debts)
➢ Quick ratio (acid test ratio)
It is the ratio between liquid assets and current liabilities.
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠−𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
NOTE: The quick ratio must be 1:1.
(It means the business has the same amount of liquid assets as current liabilities)
