- 5 Marks
Question
Accounting ratios cover a wide array of ratios that are used by accountants and act as different indicators that measure profitability, liquidity, and potential financial distress in a company’s financials.
Required:
Differentiate between profitability ratios and liquidity ratios and give TWO examples each.
Answer
Difference Between Profitability and Liquidity Ratios:
| Profitability Ratios | Liquidity Ratios |
|---|---|
| Profitability ratios assess a company’s ability to generate earnings relative to its revenue, assets, or shareholders’ equity. | Liquidity ratios measure a company’s ability to meet short-term financial obligations as they fall due. |
| These ratios indicate how well a company is utilizing its resources to generate profits. | These ratios assess whether the company has sufficient cash or assets that can be quickly converted into cash to cover its short-term liabilities. |
Examples of Profitability Ratios:
- Return on Capital Employed (ROCE) = (Operating Profit ÷ Capital Employed) × 100
- Net Profit Margin = (Net Profit ÷ Revenue) × 100
Examples of Liquidity Ratios:
- Current Ratio = (Current Assets ÷ Current Liabilities)
- Quick Ratio (Acid Test Ratio) = (Current Assets – Inventory) ÷ Current Liabilities
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