How do organisations use ratios to measure profitability and liquidity, and what are the limits of doing so?
Ratio analysis: the main profitability ratios (gross profit percentage, profit for the year percentage) and liquidity ratios (current ratio, acid test), how to interpret them, and the limitations of ratio analysis.
An SQA Higher Business Management answer on ratio analysis, covering the main profitability ratios (gross profit percentage and profit for the year percentage) and liquidity ratios (current ratio and acid test), how to interpret them, and the limitations of relying on ratios.
Reviewed by: AI editorial process; not yet individually human-reviewed
Have a quick question? Jump to the Q&A page
Jump to a section
What this key area is asking
Ratio analysis turns the raw figures in the financial statements into measures that can be compared and interpreted. The SQA wants you to know the main profitability ratios (gross profit percentage, profit for the year percentage) and liquidity ratios (current ratio, acid test), how to interpret them, and the limitations of relying on ratios. Higher rewards you for interpreting a ratio and for a balanced discussion of usefulness.
Profitability ratios
The two profitability ratios are read together: a healthy gross profit percentage but a much lower net profit percentage shows the firm buys and sells well but has high running costs (wages, rent, advertising) eating its profit. Comparing the ratios over time or with rivals shows whether profitability is improving or weak.
Liquidity ratios
- The current ratio shows whether the firm has enough current assets (stock, debtors, cash) to cover its current liabilities (what it owes soon). Too low risks not paying debts; far too high may mean too much idle cash or stock.
- The acid test is stricter, leaving out stock because stock may not sell quickly, so it tests whether the firm could pay its short-term debts from near-cash assets alone.
Interpreting ratios
A ratio means little on its own; it is interpreted by comparison: with the previous year (is it improving or worsening?), with a competitor, or with an industry standard. The trend and the comparison reveal strengths and weaknesses in profitability and liquidity and guide decisions.
The limitations of ratio analysis
Examples in context
Example 1. A firm profitable but illiquid. A firm reports a healthy net profit percentage but a current ratio of 0.8:1, below 1:1. It is making profit but cannot easily pay its short-term debts, perhaps because cash is tied up in stock or owed by debtors. This shows why profitability and liquidity are different: a profitable firm can still fail if it runs out of cash, the classic SQA distinction that ratios reveal.
Example 2. Comparing two firms with ratios. Two shops have the same sales, but Shop A has a net profit percentage of and a current ratio of , while Shop B has and . The ratios show Shop A is more profitable and more liquid, so it is performing better. But a fair judgement also notes the limitations: the figures are from the past, ignore non-financial factors, and assume the shops use the same methods, the balanced point a "discuss" question rewards.
Try this
Q1. State the formula for the gross profit percentage. [2 marks]
- Cue. Gross profit percentage = (gross profit divided by sales revenue) multiplied by 100. It measures the profit from buying and selling before running expenses are deducted.
Q2. Explain two limitations of ratio analysis. [4 marks]
- Cue. Ratios use past figures, so they may not predict the future; they ignore non-financial factors such as staff morale, the economy and competition; comparisons are only fair between similar firms using the same methods; and a single ratio in isolation can mislead, so several should be used together (any two, developed).
Exam-style practice questions
Practice questions written in the style of SQA exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.
SQA Higher style4 marksDistinguish between profitability ratios and liquidity ratios.Show worked answer →
Worth 4 marks. "Distinguish between" means show clearly how the two types differ.
Profitability ratios (about 2 marks). Measure how good the business is at making a profit from its sales and resources, for example the gross profit percentage and the profit for the year (net profit) percentage. They show whether the firm is profitable and how this compares over time or with rivals.
Liquidity ratios (about 2 marks). Measure whether the business can pay its short-term debts as they fall due, for example the current ratio and the acid test (quick) ratio. They show whether the firm has enough current assets, or near-cash assets, to meet its current liabilities and avoid running out of cash.
SQA Higher style6 marksDiscuss the use of ratio analysis to judge the performance of a business.Show worked answer →
Worth 6 marks. "Discuss" means give the benefits and the limitations of ratio analysis.
Benefits (about 3 marks). Ratios turn the figures in the financial statements into useful measures that can be compared over time, with competitors or with industry standards. They highlight strengths and weaknesses in profitability and liquidity, help managers make decisions and inform lenders and investors.
Limitations (about 3 marks). Ratios are based on past figures, so they may not predict the future; they ignore non-financial factors such as staff morale, market conditions and the economy; comparisons are only fair between similar firms using the same methods; and a single ratio in isolation can mislead, so several should be used together with other information.
Related dot points
- The purpose and content of the main financial statements (the income statement and the statement of financial position), the figures they show, and the users of financial information.
An SQA Higher Business Management answer on financial statements, covering the purpose and content of the income statement (profit and loss) and the statement of financial position (balance sheet), the key figures they show such as gross and net profit, and the users of financial information.
- Cash budgeting: the purpose of a cash budget, interpreting receipts, payments, net cash flow and closing balance, identifying cash flow problems, and the solutions to a shortfall.
An SQA Higher Business Management answer on cash budgeting, covering the purpose of a cash budget, how to interpret receipts, payments, net cash flow and the closing balance, how to identify cash flow problems, and the solutions a firm can use to improve cash flow.
- The sources of finance available to large organisations (share issue, bank loan, debenture, retained profit, government grant, leasing, trade credit) and the factors affecting the choice of source.
An SQA Higher Business Management answer on sources of finance for large organisations, covering share issues, bank loans, debentures, retained profit, government grants, leasing and trade credit, and the factors that affect the choice of source.
- The objectives organisations pursue (profit maximisation, growth, survival, market share, satisfying customers, managerial objectives, social responsibility) and how objectives differ across the private, public and third sectors.
An SQA Higher Business Management answer on business objectives, covering profit maximisation, growth, survival, increasing market share, customer satisfaction, managerial objectives and corporate social responsibility, and how objectives differ across the private, public and third sectors.
- Types of decision (strategic, tactical, operational), the role of the manager, the structured decision-making process (such as POGADSCIE) and the use of SWOT analysis, with the factors that affect the quality of a decision.
An SQA Higher Business Management answer on decision-making, covering strategic, tactical and operational decisions, the role of the manager, the structured decision-making process such as POGADSCIE, the use of SWOT analysis, and the factors that affect the quality of a decision.
Sources & how we know this
- Higher Business Management Course Specification — SQA (2026)
- Higher Business Management Course Code C810 76 — SQA (2026)