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How do we use ratios together to advise a business, and what are the limitations of relying on ratio analysis?

Interpret financial statements using ratios to advise users, and explain the limitations of ratio analysis

A focused answer to the O-Level Principles of Accounts outcome on interpretation. Using profitability, liquidity and efficiency ratios together to advise users, comparing year on year, and the limitations of ratio analysis.

Generated by Claude Opus 4.89 min answerUpdated 2026-06-06

Reviewed by: AI editorial process; not yet individually human-reviewed

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What this dot point is asking
The answer
Examples in context
Try this

What this dot point is asking

SEAB wants you to interpret financial statements by using ratios together to advise users, and to explain the limitations of ratio analysis. The central insight is that no single ratio tells the whole story: profitability, liquidity and efficiency must be read together, against a trend or a benchmark, and even then ratios are only part of the picture.

The answer

Reading ratios together

Each family of ratios answers a different question:

Family	Question it answers	Key ratios
Profitability	Is the business making good profits?	Gross/profit margin, ROCE
Liquidity	Can it pay its short-term debts?	Current ratio, quick ratio
Efficiency	How well does it use working capital?	Inventory turnover, collection/payment periods

A complete judgement weighs all three. A business can be profitable yet illiquid, or liquid yet inefficient; only together do the ratios reveal its real condition.

Comparing for meaning

A ratio means little in isolation. It is interpreted by comparison:

Year on year (trend) - is the figure improving or worsening?
Against another business in the same trade.
Against an industry norm, if known.

Advising users

Different users focus on different ratios. An owner watches profitability and efficiency; a lender focuses on liquidity and whether profits can service a loan; a supplier looks at the collection period and liquidity before granting credit. Good advice links the ratios to the user's decision and recommends an action.

Limitations of ratio analysis

Ratios are useful but limited:

They use historic figures that may not reflect the present or future.
They ignore non-financial factors (staff, reputation, location, competition).
Different accounting policies (depreciation, inventory valuation) make businesses hard to compare.
Rising prices (inflation) distort comparisons across years.
A single ratio without context can mislead.

Worked example

A business reports for two years. Year 1: gross margin $30\%$ , profit margin $12\%$ , current ratio $2 : 1$ , collection period 40 days. Year 2: gross margin $30\%$ , profit margin $7\%$ , current ratio $1.2 : 1$ , collection period 65 days. Interpret the change and advise.

Step 1: Profitability

The gross margin is unchanged at $30\%$ , so trading is as profitable per sale. But the profit margin has fallen from $12\%$ to $7\%$ , so running expenses have risen, eating into final profit.

Step 2: Liquidity

The current ratio has dropped from $2 : 1$ to $1.2 : 1$ . Short-term resources now only just cover short-term debts, a clear weakening of liquidity.

Step 3: Efficiency

The collection period has stretched from 40 to 65 days, so customers are paying more slowly. This ties up cash and partly explains the weaker liquidity.

Step 4: Advise

The business should control its expenses (to restore the profit margin) and tighten credit control (reminders, limits, or a cash discount) to bring the collection period down and rebuild liquidity. Reading the ratios together shows that slow collection and rising costs are squeezing both profit and cash.

Examples in context

Example 1. Profitable but sinking. A shop reports a healthy $14\%$ profit margin but a current ratio of $0.7 : 1$ and a 75-day collection period. Despite good profits, it cannot pay its bills on time because cash is locked in slow-paying customers. Reading the ratios together warns the owner that profit on paper is not the same as cash in hand.

Example 2. The limits of a like-for-like comparison. Two firms look different on paper: one uses straight-line depreciation, the other reducing balance, and one values inventory more cautiously. Their profit margins and asset figures are not strictly comparable. An analyst must note these policy differences before drawing conclusions, a clear limitation of raw ratio comparison.

Try this

Q1. State the three families of ratios and what each measures. [3 marks]

Cue. Profitability (how much profit is made), liquidity (ability to pay short-term debts), efficiency (how well working capital is used).

Q2. A business is profitable but has a current ratio of $0.8 : 1$ . State what this combination tells the owner. [2 marks]

Cue. It is making profits but may struggle to pay short-term debts, so it has a liquidity problem despite being profitable.

Q3. State two limitations of ratio analysis. [2 marks]

Cue. Any two, such as ratios use historic figures, ignore non-financial factors, are distorted by different accounting policies, or can mislead without context.

Exam-style practice questions

Practice questions written in the style of SEAB exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.

Original8 marksTwo businesses in the same trade report for the year: Business A - gross profit margin

25\%

, profit margin

10\%

, current ratio

1.8 : 1

, inventory turnover 8 times. Business B - gross profit margin

35\%

, profit margin

6\%

, current ratio

0.9 : 1

, inventory turnover 4 times. (a) Compare their performance. (b) State which you would prefer to lend to, with a reason.

Show worked answer →

(a) Comparison:

Trading: Business B has the higher gross margin ( $35\%$ vs $25\%$ ), so it makes more on each sale, but its profit margin is lower ( $6\%$ vs $10\%$ ), meaning its running expenses are eating up much of that gross profit.
Liquidity: Business A's current ratio ( $1.8 : 1$ ) is far healthier than B's ( $0.9 : 1$ ); B has more current liabilities than current assets and may struggle to pay short-term debts.
Efficiency: Business A turns inventory over 8 times a year vs B's 4, so A sells stock twice as fast.

(b) I would prefer to lend to Business A: although B has a higher gross margin, A has better final profitability, stronger liquidity and faster stock turnover, so it is more likely to repay a loan.

Markers reward a structured comparison across profitability, liquidity and efficiency, and a justified lending choice (Business A) based on liquidity and overall profitability.

Original5 marksState and explain three limitations of using ratio analysis to judge a business.