Understanding Financial Performance (Years 10–11) — Business Studies

Profitability and liquidity ratios turn raw figures into percentages and comparisons that help judge how well a business performs.

Raw profit figures alone can mislead. Ratios turn the numbers from the financial statements into percentages and comparisons, so a business can be judged fairly and over time.

Why this matters A £10,000 profit sounds good, but on £1 million of sales it is thin. Ratios reveal the real quality of performance and help spot problems early.

Profitability: profit margins

These show how much of each pound of sales becomes profit.

Gross profit margin = (gross profit ÷ revenue) × 100.
Net profit margin = (net profit ÷ revenue) × 100.

For example, with revenue £50,000, gross profit £20,000 and net profit £8,000: gross margin = (20,000 ÷ 50,000) × 100 = 40%; net margin = (8,000 ÷ 50,000) × 100 = 16%. A higher margin means the business keeps more of each sale as profit.

Liquidity: can bills be paid?

Liquidity is about having enough short-term resources to pay short-term debts as they fall due. A business can be profitable and still fail if it cannot find the cash to pay suppliers or wages on time, so liquidity is watched closely. A common measure is the current ratio:

Current ratio = current assets ÷ current liabilities

A result of about 1.5 to 2 is often seen as healthy. Below 1 the business may struggle to pay its short-term bills; far above 2 may mean cash is sitting idle rather than being used.

A current ratio below 1 signals real danger paying bills; 1.5 to 2 is usually seen as healthy; well above 2 can mean cash is sitting idle instead of being put to use.

Notice that the net profit margin (16%) is lower than the gross profit margin (40%). This is normal: the gap is caused by the other expenses, such as rent, wages and marketing, that are taken off after gross profit. If the two margins move apart over time, it can signal that everyday running costs are rising and need attention.

Using ratios well

Compare over time (this year against last year) to spot trends.
Compare with similar businesses to judge relative performance.
Remember ratios show what happened, not why — further investigation is always needed.

A rising net profit margin with a healthy current ratio suggests a business that is both profitable and able to pay its way — a strong combination for owners and lenders alike.

Put these steps in order to calculate a profit margin:

Find the relevant profit figure (gross or net) from the income statement
Find the revenue figure
Divide the profit by the revenue
Multiply by 100 to express it as a percentage

Common exam mistake: forgetting the final ×100 step and leaving a margin as a decimal (e.g. writing "0.4" instead of "40%"). A profit margin is always expressed as a percentage — always finish the calculation with ×100.

Exam technique: when comparing two years of ratios, do not assume "higher is always better" — say specifically whether the change is an improvement for that ratio (a rising net margin is good, but a current ratio climbing from 1.8 to 3.5 suggests cash sitting idle rather than being used well).