Analysing financial statements helps stakeholders assess a business’s performance. Ratio analysis compares figures within and between financial statements to evaluate profitability, liquidity and efficiency.
Profitability ratios
These ratios measure how effectively a business generates profit:
- Gross profit margin = (Gross profit ÷ Revenue) × 100. Indicates how efficiently a business turns revenue into gross profit.
- Profit margin = (Profit for the year ÷ Revenue) × 100. Shows the proportion of revenue that is kept as profit after all expenses.
- Return on capital employed (ROCE) = (Profit from operations ÷ Capital employed) × 100. Measures the return generated on the resources invested in the business.
Liquidity ratios
These ratios indicate a firm’s ability to meet short‑term obligations:
- Current ratio = Current assets ÷ Current liabilities. A ratio of around 1.5–2 is often considered healthy.
- Acid test (quick) ratio = (Current assets – Inventory) ÷ Current liabilities. Excludes inventory because it may not be quickly converted to cash.
Limitations of ratio analysis
Ratios are useful but have limitations:
- They are based on historical data and may not reflect current conditions.
- Different accounting policies between firms can distort comparisons.
- They do not consider qualitative factors such as workforce skills, customer loyalty or brand reputation.
- External factors (economic conditions, industry trends) can influence performance.
Stakeholders should therefore use ratios alongside other information and consider the broader context.
| Ratio | Formula | What it shows |
|---|---|---|
| Gross profit margin | Gross profit ÷ Revenue × 100 | Ability to generate profit from sales before overheads. |
| Profit margin | Profit for the year ÷ Revenue × 100 | How much of revenue is retained as profit after all expenses. |
| Return on capital employed (ROCE) | Operating profit ÷ Capital employed × 100 | Efficiency in using capital to generate profit. |
| Current ratio | Current assets ÷ Current liabilities | Ability to pay short‑term debts. |
| Acid test ratio | (Current assets – Inventory) ÷ Current liabilities | Liquidity excluding stock. |
Example calculations
The following simple figures illustrate how each ratio is computed. Suppose a business reports:
- Revenue: $100,000
- Cost of sales: $60,000
- Operating profit (profit before interest and tax): $20,000
- Capital employed: $120,000
- Current assets: $50,000, of which inventory (stock) is $10,000
- Current liabilities: $30,000
Using these numbers:
- Gross profit margin = (Revenue − Cost of sales) ÷ Revenue × 100 = (100,000 − 60,000) ÷ 100,000 × 100 = 40%. This means the business earns 40 cents of gross profit on every $1 of sales.
- Profit margin = Profit for the year ÷ Revenue × 100. If the business makes a profit of $20,000, the margin is 20,000 ÷ 100,000 × 100 = 20%.
- Return on capital employed (ROCE) = Operating profit ÷ Capital employed × 100 = 20,000 ÷ 120,000 × 100 ≈ 16.7%. This shows how efficiently long‑term funds are being used to generate profit.
- Current ratio = Current assets ÷ Current liabilities = 50,000 ÷ 30,000 ≈ 1.67 : 1. A current ratio above 1 indicates the business should be able to pay its short‑term debts.
- Acid test (quick) ratio = (Current assets − Inventory) ÷ Current liabilities = (50,000 − 10,000) ÷ 30,000 ≈ 1.33 : 1. This excludes inventory to focus on the most liquid assets.
Examples and applications
Ratio analysis turns raw financial data into meaningful comparisons. Suppose a business reports revenue of $500,000, cost of sales of $300,000 and profit for the year of $50,000. Its gross profit margin is \((500,000-300,000)/500,000\times100=40%\), meaning it retains 40 per cent of sales after paying for materials and direct labour. The profit margin is \(50,000/500,000\times100=10%\), so 10 per cent of revenue becomes profit after all expenses.
If current assets are $60,000 and current liabilities are $30,000, the current ratio is 2:1, suggesting the business has twice as much in near‑cash assets as it owes in the short term. A current ratio below 1 may indicate liquidity problems. An inventory turnover of 5 means that the business sells and replaces its average stock five times a year; higher turnover implies efficient stock management. Stakeholders compare these ratios with previous years and industry averages to judge performance. For example, a declining profit margin could signal rising costs or falling prices, prompting managers to investigate.
