Large figures in the statements are sometimes hard to understand directly. Financial ratios help by turning those figures into simple measures that can be compared across years or across businesses. Two basic groups are profitability ratios and liquidity ratios.
Profitability ratios
- Gross profit margin = (Gross profit ÷ Sales) × 100. It shows how much profit is earned from sales before deducting expenses.
- Net profit margin = (Net profit ÷ Sales) × 100. It shows profit after all expenses are deducted.
Liquidity ratios
- Current ratio = Current assets ÷ Current liabilities. It measures the business's ability to pay short-term debts.
Key idea
Gross profit margin = (Gross profit ÷ Sales) × 100. Current ratio = Current assets ÷ Current liabilities. A current ratio of about 2:1 is often considered healthy.
Example
Deen's business records sales of RM100,000 and gross profit of RM40,000. Its gross profit margin is (40,000 ÷ 100,000) × 100 = 40%. Its current assets are RM30,000 and current liabilities RM15,000, so the current ratio = 30,000 ÷ 15,000 = 2:1.
Interpreting the results
A ratio is meaningful only when compared — with the previous year, with competitors or with a target. A rising margin shows improving profitability, while a current ratio that is too low signals that the business may struggle to pay short-term debts.
However, a ratio that is too high is not automatically good either. A current ratio well above 2:1, for instance, may mean too much money is tied up in stock or idle cash that is not being used to earn income. Ratios must therefore be interpreted with judgement rather than viewed in isolation. Combining several ratios gives a fuller picture of performance than relying on a single figure.
Remember
A single ratio tells you little on its own. Compare over time to see the true trend in the business's performance.