Profitability and liquidity ratio analysis

How effectively a business turns revenue into profit — expressed as a percentage of revenue.

NPM = (Net profit ÷ Sales revenue) × 100

GPM = (GP ÷ Revenue) × 100. NPM = (NP ÷ Revenue) × 100.

GP=$200k, GPM=40%. NP=$50k, NPM=10%. Gap suggests high overheads.

Overheads eating into gross profit — trading is fine but the business has an expense problem.

GPM = (Gross profit ÷ Sales revenue) × 100

Reduce COGS (cheaper suppliers, bulk buying) or raise selling prices.

($80k ÷ $200k) × 100 = 40%. Means 40 cents of every dollar covers expenses and profit.

($20k ÷ $200k) × 100 = 10%. The business keeps 10 cents profit per dollar.

Serious concern — less profitable at both trading and overall level.

Calculate → State → Interpret → Suggest improvements. Earns top marks.

They allow meaningful comparisons between years and businesses of different sizes.

NPM deducts ALL costs (overheads, interest, tax), not just COGS. It's the 'bottom line'.

GPM = TRADING efficiency. NPM = OVERALL efficiency.

30% of revenue consumed by expenses — overheads are high relative to revenue.

No — only 1% margin. Raw profit needs context; ratios reveal the real picture.

Cut overheads (rent, waste) and increase sales volume to spread fixed costs.

The business earns well on each sale after direct costs — efficient at buying/selling.

Reduce overheads (renegotiate rent, cut waste) and increase sales volume to spread fixed costs.

Increase selling prices (if demand allows) or reduce COGS (cheaper suppliers, bulk buying).

Interpretation is worth more marks than the calculation — always explain what the number means.

Gross Profit Margin (GPM) and Net Profit Margin (NPM).

Previous years (trends) and competitors (benchmarks). A ratio alone is meaningless.

Reveals whether problems are in trading (COGS) or overheads — pinpoints where to fix.

Overhead/expense problem — trades well but spends too much on running costs.

Net profit appears at the bottom of the income statement — after ALL costs deducted.

A pricing or COGS problem — not enough made on core sales.

After paying for COGS, 40 cents from each dollar of revenue remains for expenses and profit.

Percentages make size irrelevant — both can be compared on efficiency.

Trading efficiency — how much is left from each sale after paying direct costs (COGS).

The ability of a business to meet its short-term debts as they fall due — can it pay bills on time?

Collect debts faster, negotiate longer supplier terms, sell excess stock, inject capital, arrange overdraft.

Acid test = (Current assets − Stock) ÷ Current liabilities

CR = 45/30 = 1.5:1 ✓. AT = (45-25)/30 = 0.67:1 ⚠️ below ideal.

CR = CA ÷ CL (1.5–2:1). AT = (CA − Stock) ÷ CL (~1:1).

Current ratio = Current assets ÷ Current liabilities (expressed as ratio e.g. 2:1)

$60k ÷ $30k = 2:1. Business has $2 of current assets per $1 of short-term debt.

Acid test excludes stock — it's stricter because stock may not sell quickly.

False — it can be profitable but illiquid if cash is tied up in stock or receivables. Liquidity ≠ profitability.

Reduces receivables and brings cash in sooner — increasing liquid current assets.

Without selling stock, can't cover debts. Heavily reliant on inventory — risky if stock doesn't sell.

Stock may be hard to sell quickly and isn't truly liquid — tests if debts can be paid WITHOUT selling stock.

A healthy CR can hide a weak AT if the business holds lots of stock.

Cash or near-cash items that can quickly pay debts — cash in bank, receivables (NOT stock).

1.5:1 to 2:1 — enough to pay debts with a buffer but not too much idle cash.

($60k − $20k) ÷ $30k = 1.33:1

Delays cash outflows — more time to collect income before paying bills.

Short-term

Around 1:1 — can pay debts without relying on selling stock.

Danger — the business cannot cover short-term debts with current assets.

If it lacks enough liquid assets to pay suppliers, staff and short-term obligations on time.

Lots of stock relative to other current assets — depends on selling inventory to pay bills.

Different industries have different norms — supermarkets safely run low acid tests due to fast turnover.

Get cash IN faster and push cash OUT slower — it's all about timing.

Just calculating without interpreting — always state ideal, compare, and recommend.

Converts illiquid stock into immediate cash — solves short-term crisis even at reduced prices.

Too much cash/stock sitting idle — the business is inefficient with its resources.

State the ideal range, explain if above/below/within it, say what the business should DO.

Yes — e.g. if it received a large loan or sold assets. Cash ≠ profit.

They sell stock quickly for cash every day — their stock IS liquid in practice. Industry context matters.

Comparing the same ratio across multiple years to spot if performance is improving or declining.

Only useful when compared — with previous years, competitors, or benchmarks.

Historical data, window dressing (accounts manipulated), non-financial factors ignored.

Direction (up/down), Magnitude (by how much), Possible causes (why), Recommended actions.

Interpretation and comparison — don't stop at the number, explain what it means.

Calculate → State → Explain → Compare → Recommend

Fell 7pp — COGS likely increased (e.g. rising material prices). Should renegotiate with suppliers.

Comparing ratios with similar businesses in the same industry for relative performance.

Trend = direction over time. Inter-firm = relative performance vs competitors.

Based on historical data — past performance doesn't guarantee future results.

At least 3 years — shows a meaningful pattern, not just year-to-year fluctuation.

Explain: '35 cents per dollar after COGS', then compare with previous years or competitors.

Recessions, regulations, pandemics affect results but aren't captured in ratios.

The size of the change — measured in percentage points (e.g. 'fell by 7 percentage points').

Calculate → State → Explain → Compare → Recommend

Shows analytical thinking — explaining WHY it happened, not just describing the change.

Recommend action — what should the business DO to improve or maintain?

One-off events can distort — need multiple years to see the real trend.

Historical bias, window dressing, non-financial factors missed.

Different industries, sizes, and methods distort comparisons — compare similar businesses.

2-3 shows excellent critical thinking and earns top mark bands.

Direction + Magnitude + Causes + Actions

Depends on industry! Excellent in supermarkets (thin margins), poor in luxury fashion (high margins).

Not necessarily — both trend AND benchmark matter. Improving is positive but below average shows room for growth.

A recommendation — what should the business DO about it?