U2.18 — Characteristics of Financial Indicators
Overview
Dotpoint 18: characteristics of the following financial indicators.
Financial indicators are measures used to judge the financial performance and financial position of a business. In this dotpoint, the focus is on profitability, liquidity and stability.
These indicators are often measured using financial ratios. Ratios help turn raw financial data into something easier to compare, interpret and evaluate.
- profitability — ability to make profit
- liquidity — ability to meet short-term debts
- stability — long-term financial strength
💰 Profitability
Profitability shows how successful a business is at turning sales into profit. It helps answer the question: is the business making enough profit from what it sells?
Why profitability matters
- shows whether the business is making a worthwhile return from its sales
- helps managers judge whether pricing, cost control and efficiency are strong enough
- is important to owners, shareholders, investors and lenders because profit helps support growth and survival
- can reveal whether the business is improving or weakening over time
- helps the business decide whether changes are needed to price, costs, promotion or operations
Financial ratios
Financial ratios are calculations that use figures from financial statements to help measure performance more clearly.
There are many different ratios, but in this course the main ones are:
- profitability ratios — gross profit ratio and net profit ratio
- liquidity ratio — current ratio
- stability ratio — debt to equity ratio
Profitability ratios
Profitability ratios help show how well a business turns sales into profit. In this course, the two main profitability ratios are the gross profit ratio and the net profit ratio.
The main financial statement needed for profitability ratios is the profit and loss statement.
Gross Profit Ratio
Net Profit Ratio
Gross profit ratio
This measures how much gross profit the business earns from each dollar of sales.
It is usually expressed as a percentage.
A higher gross profit ratio usually suggests the business is controlling the direct cost of goods sold well.
Net profit ratio
This measures how much final profit the business keeps from each dollar of sales after all expenses are paid.
It is usually expressed as a percentage.
A higher net profit ratio usually suggests the business is managing its overall costs more effectively.
How to interpret gross profit ratio
- usually, higher is better because it suggests the business is keeping more gross profit from sales
- there is no exact universal number because industries differ
- best interpreted by comparing with previous years, competitors or the industry average
- if the gross profit ratio falls, this may suggest higher cost of goods sold or weaker pricing power
How to interpret net profit ratio
- usually, higher is better because it suggests the business is keeping more final profit after expenses
- there is no exact universal number because industries differ
- best interpreted by comparing with previous years, competitors or the industry average
- if the net profit ratio falls, this may suggest lower sales, higher expenses or weaker cost control
Strategies to improve gross profit ratio
- increase the selling price if customers will still buy
- reduce cost of goods sold by negotiating better supplier prices
- improve stock buying and reduce wastage
- focus promotion on higher-margin products
- reduce discounting if it is cutting margins too much
Strategies to improve net profit ratio
- increase sales revenue through stronger promotion or better customer retention
- reduce unnecessary operating expenses
- improve labour efficiency and control overheads
- reduce returns, complaints and defects that create extra costs
- keep tighter control over rent, wages, utilities and marketing spend
How to comment on a profitability ratio
- start by defining profitability as the ability of the business to make profit
- state the ratio result clearly
- compare it with a previous year, competitor or industry average
- comment on the figures behind the ratio if relevant, such as lower sales or higher expenses
- finish with a judgment and suggest how the business could improve it if needed
Worked example — profitability ratio response
A sports clothing business wants to measure its profitability.
This year:
Sales Revenue = $120,000
Net Profit = $14,400
Industry average net profit ratio = 9%
Last year’s net profit ratio = 10%
Net Profit Ratio
= Net Profit ÷ Sales Revenue × 100
= 14,400 ÷ 120,000 × 100
= 0.12 × 100
= 12%
Comment:
Profitability refers to the ability of a business to make profit from its sales.
The business has a net profit ratio of 12%, meaning it keeps 12 cents of net profit
for every $1 of sales revenue.
This is stronger than last year’s 10% and also above the industry average of 9%.
This suggests the business has improved its profitability and is performing better
than many firms in the industry.
Possible reasons may include stronger sales, better pricing, or improved control
over expenses.
💧 Liquidity
Liquidity shows whether a business can meet its short-term debts when they fall due. It focuses on the short-term financial position of the business.
Why liquidity matters
- a business can be profitable but still run into trouble if it cannot pay short-term obligations
- good liquidity helps the business pay suppliers, wages and other current liabilities on time
- poor liquidity may cause cash flow stress, missed payments and damage to supplier relationships
- owners and lenders will often watch liquidity closely because it affects day-to-day survival
Liquidity ratios
The main liquidity ratio in this course is the current ratio. It uses figures from the balance sheet, especially current assets and current liabilities.
The current ratio is usually expressed as a ratio, such as 1.5:1.
Current Ratio
Current ratio
This shows how many dollars of current assets the business has for every $1 of current liabilities.
A higher current ratio usually suggests a stronger ability to cover short-term debts.
How to interpret current ratio
- a ratio above 1:1 usually suggests the business has enough current assets to cover current liabilities
- around 1.5:1 to 2:1 is often seen as reasonably healthy, but industries differ
- below 1:1 may suggest a liquidity problem
- best interpreted by comparing with previous years, competitors or the industry average
Strategies to improve liquidity
- increase cash sales or collect debts faster
- reduce current liabilities by paying off short-term debts
- sell an unwanted non-current asset for cash
- obtain a long-term loan to replace short-term liabilities
- improve stock control so less cash is tied up in inventory
How to comment on a liquidity ratio
- define liquidity as the ability to meet short-term debts
- state the ratio clearly, such as 1.4:1 or 0.9:1
- explain what that means in simple terms
- compare it with last year, a competitor or the industry average
- say whether the business appears to have a liquidity problem and suggest an improvement strategy if needed
Worked example — liquidity ratio response
A café wants to measure its liquidity.
This year:
Current Assets = $45,000
Current Liabilities = $30,000
Industry average current ratio = 1.8:1
Last year’s current ratio = 1.2:1
Current Ratio
= Current Assets ÷ Current Liabilities
= 45,000 ÷ 30,000
= 1.5
Current Ratio = 1.5:1
Comment:
Liquidity refers to the ability of a business to meet its short-term debts.
The business has a current ratio of 1.5:1, meaning it has $1.50 of current assets
for every $1 of current liabilities.
This is stronger than last year’s 1.2:1, so liquidity has improved.
However, it is still slightly below the industry average of 1.8:1, suggesting the
business is sound but not as strong as many rivals in the industry.
🏦 Stability
Stability shows the long-term financial strength of a business. It helps show whether the business is relying too heavily on debt and whether its financial structure looks safe over time.
Why stability matters
- shows whether the business can handle long-term debt
- helps assess overall financial risk
- is important for lenders, investors and owners
- a business with weak stability may be more vulnerable during hard times or rising interest rates
Stability ratios
The main stability ratio in this course is the debt to equity ratio.
It uses figures from the balance sheet, especially total liabilities and equity.
Debt to Equity Ratio
Debt to equity ratio
This shows how much debt the business has compared with the owner’s equity.
A higher ratio usually suggests the business is relying more heavily on borrowed funds, which may increase risk.
How to interpret debt to equity ratio
- below 0.5:1 — usually lower debt and stronger stability
- around 1:1 — more balanced, with debt and equity at similar levels
- above 1.5:1 — higher reliance on debt and greater financial risk
- above 2:1 — often seen as risky, unless the industry normally uses high debt
- best interpreted by comparing with previous years, competitors and industry average
Strategies to improve stability
- reduce total liabilities by paying off debt
- increase equity through retained profits or owner investment
- avoid taking on too much extra borrowing
- improve profitability so more profit can strengthen equity over time
How to comment on a stability ratio
- define stability as long-term financial strength
- state the result clearly
- explain what it means about debt compared with equity
- compare with previous years, competitors or industry average
- say whether the business appears more or less risky
Worked example — stability ratio response
A transport business wants to measure its stability.
This year:
Total Liabilities = $180,000
Equity = $120,000
Industry average debt to equity ratio = 1.1:1
Last year’s debt to equity ratio = 1.2:1
Debt to Equity Ratio
= Total Liabilities ÷ Equity
= 180,000 ÷ 120,000
= 1.5
Debt to Equity Ratio = 1.5:1
Comment:
Stability refers to the long-term financial strength of a business.
The business has a debt to equity ratio of 1.5:1, meaning it has $1.50 of debt
for every $1 of equity.
This is higher than last year’s 1.2:1 and also above the industry average of 1.1:1.
This suggests the business is becoming more reliant on debt and may face greater
financial risk than many competitors.
📋 Overall summary of the three financial indicators
| Indicator | Meaning | Main ratio / measure | Financial statement needed | How to interpret | Strategies to improve |
|---|---|---|---|---|---|
| Profitability | Ability of the business to make profit from sales. | Gross Profit Ratio, Net Profit Ratio | Profit and Loss Statement | Usually higher is better. Best compared with previous years, competitors and industry average. | Increase prices, reduce cost of goods sold, reduce expenses, improve efficiency, focus on higher-margin products. |
| Liquidity | Ability of the business to meet short-term debts. | Current Ratio | Balance Sheet | Above 1:1 usually suggests enough current assets to cover current liabilities. Around 1.5:1 to 2:1 is often healthier, but industry matters. | Collect debts faster, increase cash, reduce current liabilities, sell unwanted assets, refinance short-term debt into long-term debt. |
| Stability | Long-term financial strength and level of financial risk. | Debt to Equity Ratio | Balance Sheet | Usually lower is safer. Around 1:1 or lower is often stronger, while above 1.5:1 suggests higher reliance on debt. | Reduce liabilities, increase equity, retain profits, avoid excessive borrowing, strengthen profitability over time. |
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Biz Fact: Airlines often have high debt-to-equity ratios because planes are extremely expensive assets.