Key definitions
Profitability — measuring how successful a business is.
Liquidity — the ability for a business to pay back current liabilities (the more liquid the business, the more likely debts can be paid back).
Formulas
1. Profitability ratios
The higher the %, the more successful.
Gross profit margin = Gross profit ÷ Sales revenue × 100
Net profit margin = Net profit before tax ÷ Sales revenue × 100
Return on capital employed = Operating profit ÷ Capital employed × 100
2. Liquidity ratios
A ratio greater than 1 indicates good liquidity.
Current ratio = Current assets ÷ Current liabilities
Acid test ratio = (Current assets − Inventory) ÷ Current liabilities
Why are accounts used?
- Shareholders — to recognise the value of the profits made and how large the return on investment is.
- Employees — to recognise if they are working for a profitable business, and if they can push for higher wages.
- Banks — to recognise if they should loan money to a business and if the money will be paid back.
- Suppliers — to recognise if a business has enough money to continue funding them.
- Potential investors — to recognise if they should invest in a business, and if so, how high the return on investment may be.
- The government — to recognise if the business is doing well, as a successful business pays more taxes to the government and reduces unemployment.