What profitability ratios tell us

Ratio analysis is a financial analysis method that compares figures from final accounts as proportions. This allows business performance to be judged more meaningfully than raw numbers alone. A profit of 200 000 may sound impressive, but it has a very different meaning for a corner bakery than for a supermarket chain.

Profitability ratios are financial ratios that measure how effectively a business converts sales revenue, costs and capital into profit. Most are calculated from the profit and loss account. ROCE also uses capital employed from the balance sheet.

The three profitability ratios in this topic can be learned as a ladder. Gross profit margin measures profit after direct costs, while profit margin looks at profit after more expenses. ROCE then asks whether the business is using the owners’ and long-term lenders’ money productively.

Comparison of the three profitability ratios and what each one shows.

Gross profit margin

Write the answer as a percentage. A rise in gross profit margin shows that the business keeps more gross profit from each unit of sales revenue. If the ratio falls, direct costs may be increasing faster than selling prices. The business may instead have cut its selling prices, or its sales mix may have moved towards lower-margin products.

The word “may” matters here. A ratio signals what might be happening; it doesn’t tell the whole story. For example, a falling gross profit margin doesn’t automatically indicate poor management if a business has deliberately reduced prices to enter a new market.

Profit margin

This ratio goes beyond gross profit margin because it includes expenses such as rent, salaries, advertising and administration costs. A business may have a healthy gross profit margin yet still record a weak profit margin when its overheads are too high.

To interpret profit margin, compare the figure with previous years and similar businesses in the same industry. A 7 percent profit margin could be strong in one industry but weak in another. Ratio analysis becomes useful when it reveals change, trend and comparison.

Return on capital employed

ROCE asks a tougher question than “Did the business make profit?” Instead, it asks, “Was the profit good enough compared with the amount of long-term finance tied up in the business?” A business may earn a high profit but have a huge capital base. As a result, its ROCE could be weaker than that of a smaller business that uses its capital more efficiently.

Interpreting profitability ratios properly

Don’t stop once you have calculated gross profit margin, profit margin or ROCE. The calculation is AO4; business judgement begins with the interpretation. A useful interpretation usually connects the ratio to both a cause and a consequence. For example, higher direct costs may reduce gross profit margin, putting pressure on the business to raise prices or renegotiate supplier terms.

Keep the three profitability ratios separate. Gross profit margin compares gross profit with sales revenue. Profit margin compares profit before interest and tax with sales revenue, whereas ROCE compares profit before interest and tax with capital employed.

Improving gross profit margin

A business improves its gross profit margin by increasing gross profit relative to sales revenue. In practice, it can raise selling prices, cut direct costs or adjust its product mix.

Possible strategies include:

• increasing prices if customers are not too price sensitive
• negotiating lower prices with suppliers
• finding alternative suppliers with lower input costs
• reducing production wastage
• improving productivity so that direct labour cost per unit falls
• focusing promotion on higher-margin products

Each option involves a trade-off. A price increase may raise the margin on every sale, but total profit could still decline if sales volume falls sharply. Switching to cheaper suppliers can reduce costs, though it may harm quality, reliability or brand reputation.

Improving profit margin

To improve profit margin, a business needs to increase profit before interest and tax relative to sales revenue. The strategies used to raise gross profit can help, alongside tighter control of expenses.

A business might cut unnecessary overheads, renegotiate rent, reduce energy usage or improve workforce productivity. It could also use more cost-effective promotion or remove unprofitable product lines. However, managers should take care with cuts that produce short-term gains but weaken the business later. Reducing training, for example, may lower expenses now while damaging service quality and productivity in the future.

Improving ROCE

A business can improve ROCE by increasing profit before interest and tax, reducing capital employed or using its existing capital more productively. ROCE is therefore a favourite ratio for judging management efficiency because it links profit to the resources used to generate it.

Possible strategies include selling underused non-current assets, improving capacity utilisation or investing in more efficient equipment if it genuinely raises profit. The business could close poorly performing branches or reduce unnecessary retained funds. Paying higher dividends would reduce retained profit and therefore capital employed, but it wouldn’t automatically improve the business. If funds needed for future growth are starved, the higher ROCE may be cosmetic rather than healthy.

The judgement point

A strategy is only “good” when it fits the business context. A luxury hotel won’t improve profitability in the same way as a discount retailer. In ratio questions, the strongest answers link the chosen strategy directly to the specific ratio: reduce cost of goods sold to improve gross profit margin; reduce overheads to improve profit margin; improve profit relative to capital employed to improve ROCE.

What liquidity ratios tell us

Liquidity ratios measure whether a business can use its current assets to meet short-term debts. These financial ratios are calculated from the balance sheet.

Liquidity describes how quickly an asset can be converted into cash without a significant loss in value. Cash is already liquid. Inventory is less liquid: it has to be sold first and may need to be discounted before it becomes cash.

Liquidity and profitability aren’t the same. A business may be profitable on paper yet still struggle to pay suppliers, wages or short-term loans because its cash is tied up in inventory or unpaid customer debts.

Comparison of the current ratio and acid test ratio.

Current ratio

Current ratio is a liquidity ratio that compares current assets with current liabilities to assess short-term financial security.

When the current ratio is 1, current assets equal current liabilities. A ratio below 1 suggests that the business may struggle to meet its short-term obligations. However, a very high ratio can also be a warning sign. It may point to idle cash, excessive inventory or customers taking too long to pay.

As a rough guide, a current ratio around 1.5 is often considered comfortable. It isn’t a universal rule, though; industry context matters. A supermarket may operate safely with a lower ratio because it sells inventory quickly for cash. By contrast, a manufacturer with slower inventory turnover may need a stronger cushion.

Acid test ratio

The acid test is stricter than the current ratio because it leaves out inventory. Inventory may sell slowly, become obsolete or have to be sold at a discount. For some businesses, it is the least reliable current asset.

A ratio below 1 may signal liquidity pressure: the business might not have enough cash and receivables to cover its short-term liabilities. At the other extreme, a very high acid test ratio may show that the business holds too much cash or has too many trade receivables. This could indicate weak credit control.

Interpreting liquidity ratios properly

Current ratio and acid test ratio are usually shown as numbers rather than percentages. A result of 1.4, for example, means that current assets are 1.4 times current liabilities.

The gap between the two ratios can be revealing. If the current ratio is healthy but the acid test ratio is weak, the business may depend heavily on inventory. That could be acceptable for a fast-moving retailer, but it would be risky for a business selling slow-moving or perishable goods.

Improving liquidity by increasing current assets

A business can improve its liquidity ratios by increasing current assets, reducing current liabilities, or combining the two. Which approach works best depends on the cause of the weak liquidity.

When a business doesn’t have enough cash, it could encourage customers to pay sooner or offer small early-payment discounts. Other options include tightening credit terms for new customers and improving invoicing procedures. The business might also sell unused current assets or dispose of excess inventory. However, selling inventory at a discount can support cash flow while reducing the profit margin.

Sometimes, too much money is tied up in inventory. Better inventory control can help, as can reducing over-ordering, using sales promotions to clear slow-moving goods, or matching purchases more closely to demand. But inventory shouldn’t be cut too far. Doing so can lead to stockouts, lost sales and unhappy customers.

Improving liquidity by reducing current liabilities

Reducing short-term obligations can also improve liquidity. For example, a business might use longer-term finance to repay short-term debt, negotiate extra time to pay suppliers, or rely less on overdrafts. These steps may ease immediate pressure, but sound cash management is still necessary.

Longer supplier credit can improve the current position. If suppliers lose trust, though, they may offer worse terms later. In the same way, converting short-term borrowing into long-term borrowing can improve liquidity ratios, although total interest paid over time may rise.

Avoiding the “higher is always better” trap

Better liquidity doesn’t mean pushing the ratios as high as possible. A very high current ratio or acid test ratio may show that resources are sitting idle rather than being invested productively. Keeping plenty of cash in the bank may be safe, but the business could miss opportunities for growth, marketing, staff training or new equipment.

The aim should be adequate liquidity: enough short-term security to pay debts when they fall due, without trapping excessive funds in low-return current assets. As with profitability ratios, liquidity needs to be interpreted over time and compared with similar businesses in the same sector.