What You Need to Know
- Profitability ratios measure how successfully a business converts sales into profit
- Liquidity ratios measure whether a business can pay its short-term debts
- Gross profit margin shows what % of revenue becomes gross profit
- Net profit margin shows what % of revenue becomes profit after all costs
- Return on Capital Employed (RoCE) shows how efficiently capital is converted to profit
- Current ratio compares all current assets to current liabilities
- Acid test ratio compares only liquid assets to current liabilities
- Different stakeholders use different ratios for different purposes
1. Understanding Profitability & Liquidity
Why Profitability Matters
Profitability is a measure of how successful a business is. Think of it like asking:
"What percentage of every pound of sales does the business keep as profit?" This tells you how efficiently
the business converts sales revenue into actual profit.
There are two ways to think about profitability:
- As a percentage: How effectively does the business convert sales revenue into profit?
- As efficiency: How well does the capital (money) invested in the business generate profit?
Why This Matters
Investors look at profitability to decide which business to invest in.
The higher the profitability, the higher their rewards are likely to be.
Directors and managers use profitability to assess whether the business is successful
and decide what to do next.
Employees might use profitability to argue for higher wages —
"The business is making good profit, so I should be paid more."
Why Liquidity Matters
Liquidity is the ability of a business to pay back its short-term debts —
things like what it owes to suppliers, overdrafts, or short-term loans.
This is different from profitability. A business can be very profitable but still go bust
if it can't pay its bills right now.
Here's why this is critical:
- If a business can't pay its suppliers, they won't deliver raw materials or components. Production stops.
- If it can't repay an overdraft, the bank might withdraw the facility and damage its credit rating.
- If it continues to fail, creditors (people it owes money to) can force it to stop trading and sell its assets.
Real-World Example
Imagine a restaurant that's booked solid and profitable, but the owner spent all available cash
on renovations. When suppliers demand payment or staff need wages paid, there's no cash in the bank.
The restaurant is profitable but illiquid — and it goes under. This is why liquidity matters.
Who Cares About Liquidity?
Suppliers want to know if they'll get paid.
Banks and lenders want evidence the business can repay loans or overdrafts.
Customers want to be sure the supplier can produce and deliver goods they've ordered.
2. Profitability Ratios — Understanding the Numbers
The Gross Profit Margin
gross profit margin