Business Ratios: Compare Profit, Liquidity and Stock
A business can earn more gross profit from each shilling of sales while having fewer readily available assets for each shilling due soon. Ratios answer different questions. The useful skill is to name the question, select the correct denominator and explain the result without turning a possible cause into a fact.
All figures below belong to fictional Tawi Stationery. They are classroom records in KSh, not market prices or advice about a real business. Period A and Period B are consecutive years of equal length. Sales and cost of sales are annual totals; inventory, receivables, cash and current liabilities are balances on the stated dates. Inventory is valued at cost. There are no prepayments or other current assets in this simplified case.
Choose the formula before substituting
| Measure | Calculation | Unit and interpretation |
|---|---|---|
| Gross margin | Gross profit ÷ net sales × 100 | Percentage of sales remaining after cost of sales |
| Mark-up | Gross profit ÷ cost of sales × 100 | Gross profit as a percentage of goods’ cost |
| Inventory turnover | Cost of sales ÷ average inventory | Times during the period |
| Current ratio | Current assets ÷ current liabilities | State as x:1 at a date |
| Quick ratio | (Cash + receivables) ÷ current liabilities | State as x:1; inventory excluded here |
Gross profit is net sales less cost of sales. Average inventory here means (opening inventory + closing inventory) ÷ 2. A two-date average is convenient, but it can hide strong seasonal changes. If monthly balances are supplied, a more representative average may be possible. Do not mix annual cost of sales with an unrelated month’s inventory.
| Record | Period A | Period B |
|---|---|---|
| Net sales | 480,000 | 600,000 |
| Cost of sales | 360,000 | 420,000 |
| Opening inventory | 60,000 | 84,000 |
| Closing inventory | 84,000 | 126,000 |
| Closing receivables | 66,000 | 54,000 |
| Closing cash | 30,000 | 20,000 |
| Closing current liabilities | 90,000 | 125,000 |
Worked case 1: the same profit, two denominators
In A, gross profit = 480,000 − 360,000 = KSh120,000. Gross margin = 120,000 ÷ 480,000 × 100 = 25%. Mark-up = 120,000 ÷ 360,000 × 100 = 33.33%, rounded to two decimal places. Both answers describe the same gross profit. Margin compares it with sales; mark-up compares it with cost.
In B, gross profit = 600,000 − 420,000 = KSh180,000. Margin = 180,000 ÷ 600,000 × 100 = 30%. Mark-up = 180,000 ÷ 420,000 × 100 = 42.86%. Margin rose by 5 percentage points, from 25% to 30%. This means KSh30 of gross profit per KSh100 of sales, compared with KSh25 previously. It does not mean net profit rose by five points: operating expenses are not supplied.
A quick reasonableness check is that positive mark-up exceeds positive margin when cost is below sales. A claim that A’s margin is 33.33% has probably used the cost denominator. Naming the denominator is a stronger check than memorising a percentage.
Worked case 2: inventory moves less quickly
A’s average inventory = (60,000 + 84,000) ÷ 2 = KSh72,000. Turnover = 360,000 ÷ 72,000 = 5 times. B begins with A’s closing inventory, so the consecutive records agree. B’s average = (84,000 + 126,000) ÷ 2 = KSh105,000; turnover = 420,000 ÷ 105,000 = 4 times.
Cost of sales increased, yet average inventory increased proportionately more. The calculation therefore shows slower turnover under this measure. It does not show exactly how many times every item sold. Some lines may sell quickly while others remain unsold. A planned seasonal purchase, a wider range or unwanted accumulation could produce different interpretations. Item-level ages and monthly balances would help distinguish them.
Worked case 3: profitability and liquidity disagree
A’s current assets = 84,000 + 66,000 + 30,000 = KSh180,000. Current ratio = 180,000 ÷ 90,000 = 2:1. Quick ratio = (66,000 + 30,000) ÷ 90,000 = 1.07:1, rounded. B’s current assets = 126,000 + 54,000 + 20,000 = KSh200,000. Current ratio = 200,000 ÷ 125,000 = 1.60:1. Quick ratio = 74,000 ÷ 125,000 = 0.592:1, or 0.59:1 rounded.
A defensible conclusion is: “Gross margin improved, but inventory turnover and both closing liquidity ratios fell. B holds KSh0.592 of quick assets per KSh1 of current liabilities in this model.” The higher margin does not cancel the liquidity evidence. Conversely, the lower ratios do not prove the business cannot pay. We need payment dates, expected collections, inventory saleability and available cash-flow information. Current liabilities concern obligations classified as current, not every long-term debt.
Three solved practice tasks
Task 1: a denominator repair
A fictional kiosk has net sales of KSh150,000 and cost of sales of KSh105,000. A learner labels 45,000 ÷ 105,000 × 100 as margin. Correct the label and calculate margin.
Solution: Gross profit is KSh45,000. The supplied calculation is mark-up, 42.86%. Margin is 45,000 ÷ 150,000 × 100 = 30%. The numerator was sound; the label and chosen denominator were inconsistent.
Task 2: use average stock
Annual cost of sales is KSh288,000. Opening stock is KSh40,000 and closing stock KSh56,000. Find turnover and explain why dividing by 56,000 answers a different calculation.
Solution: Average stock = (40,000 + 56,000) ÷ 2 = KSh48,000. Turnover = 288,000 ÷ 48,000 = 6 times annually. Using closing stock alone ignores the stated averaging method and produces about 5.14 times.
Task 3: separate stock from quick assets
At one date, inventory is KSh72,000, receivables KSh36,000, cash KSh12,000 and current liabilities KSh60,000. There are no other current assets. Calculate both liquidity ratios and give one limitation.
Solution: Current assets total KSh120,000, giving 2:1. Quick assets total KSh48,000, giving 0.8:1. The large difference reflects inventory’s inclusion only in the current ratio. Neither answer tells us whether receivables will be collected before bills fall due.
Frequently asked questions
Is gross margin the same as mark-up?
No. Both use gross profit, but margin divides by net sales and mark-up divides by cost of sales. Always write the denominator before calculating.
Can I use sales for inventory turnover?
Not for the cost-based method used here. Inventory is valued at cost, so use cost of sales for a consistent comparison. State any different convention explicitly.
Why average two inventory balances?
It gives a simple estimate of stock held during the period. It is less informative when balances fluctuate sharply; more frequent observations may be needed.
Does 2:1 prove good liquidity?
No. Appropriate ratios depend on circumstances, and current assets may not turn into cash when required. Neither 2:1 nor 1:1 is a universal target.
What if the denominator is zero?
Do not divide by zero or report a normal ratio. State that the measure is undefined by this formula, identify the zero balance and interpret the underlying records separately.
Does higher gross margin prove higher net profit?
No. Net profit also depends on expenses and other relevant items. The supplied gross figures alone cannot establish that result.
Why is a ratio not a diagnosis?
A ratio summarises selected amounts. Different events can produce the same result, so explain the observed change and name additional evidence before claiming a cause.
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