Reading income statements, balance sheets, and using financial ratios
📑 Income statement⚖️ Balance sheet📊 Profitability ratios⏱ 22 min📝 3 practice questions
Learning Objectives
By the end of this lesson you will be able to…
Explain the purpose of financial statements and who uses them
Read and interpret an income statement (profit & loss account)
Understand the structure of a balance sheet
Calculate and interpret gross profit margin and net profit margin
Calculate and interpret current ratio and acid test ratio
Why They Matter
Purpose of Financial Statements
Key Idea
Financial statements provide a clear picture of financial health — allowing stakeholders to assess profitability, liquidity and the value of a business.
Who uses them?
Shareholders — assess return on investment and dividends
Banks — decide whether to lend money
Managers — monitor performance and plan decisions
HMRC — calculate tax owed
Potential investors — evaluate the business before buying in
Two main statements
Income Statement (P&L) — shows revenue, costs, and profit over a period
Balance Sheet — snapshot of assets, liabilities and equity at a point in time
Financial Statement 1
The Income Statement
Definition
Shows a business's revenue, costs and profits over a period (e.g. one year). Also called the profit and loss account.
A snapshot of the business's financial position at one point in time. Shows what the business owns (assets), what it owes (liabilities), and the owners' equity.
e.g. Net profit £80k, Revenue £500k → NPM = (80 ÷ 500) × 100 = 16%
What do they mean? A higher margin is better — it means the business keeps more of each pound of revenue as profit. Compare against industry benchmarks and previous years.
Liquidity Ratios
Liquidity Ratios
What is Liquidity?
Liquidity measures a business's ability to meet its short-term debts using current assets. A business can be profitable but still fail if it runs out of cash.
Current Ratio
Current Ratio = Current Assets ÷ Current Liabilities
e.g. CA = £120k, CL = £80k → 120 ÷ 80 = 1.5 : 1 (ideal range: 1.5 – 2.0)
Acid Test Ratio (Quick Ratio)
Acid Test = (Current Assets − Stock) ÷ Current Liabilities
Why exclude stock? Stock cannot always be converted to cash quickly (perishables, specialist items). The acid test gives a more conservative view of liquidity.
Interpreting Results
Using Ratios to Make Decisions
Compare over time — has the GPM improved or fallen year on year? Investigate why
Compare with competitors — is the business performing above or below the industry average?
Low GPM → costs of production too high? Or prices set too low?
Low NPM vs high GPM → overheads may be excessive (e.g. high rent, large wage bill)
Current ratio below 1 → business cannot cover short-term debts — risk of insolvency
Current ratio too high (3+) → too much cash tied up in current assets — not being invested efficiently
Practice Question 1 of 3
A business has revenue of £800,000, cost of goods sold of £480,000, and total operating expenses of £200,000. What is its net profit margin?
A40%
B15%
C25%
D60%
Correct: B — 15%. Gross Profit = £800k − £480k = £320k. Net Profit = £320k − £200k = £120k. Net Profit Margin = (£120k ÷ £800k) × 100 = 15%. The gross profit margin is 40% (320 ÷ 800), but after deducting overheads the net margin falls to 15%.
Practice Question 2 of 3
A business has current assets of £90,000 (including stock of £30,000) and current liabilities of £60,000. What is its acid test ratio?
A1.5 : 1
B1.0 : 1
C0.5 : 1
D3.0 : 1
Correct: B — 1.0 : 1. Acid Test = (Current Assets − Stock) ÷ Current Liabilities = (£90k − £30k) ÷ £60k = £60k ÷ £60k = 1.0 : 1. An acid test of exactly 1:1 means the business can just meet its short-term obligations without relying on selling stock. The current ratio would be 90 ÷ 60 = 1.5:1.
Practice Question 3 of 3
A retailer's gross profit margin is 45% but its net profit margin is only 5%. What does this suggest?
AThe business has very low costs of goods sold relative to revenue
BThe business's operating overheads are very high, consuming most of the gross profit
CThe business has excellent liquidity
DThe business should increase its prices immediately
Correct: B. A GPM of 45% is healthy — the business marks up its products well. But the NPM is only 5%, meaning that operating expenses (overheads) — rent, wages, utilities, marketing — are consuming 40 percentage points of that gross profit. The business needs to investigate whether its overhead structure is sustainable or whether cost-cutting is needed.
Key Takeaways
What to Remember
Income Statement: Revenue − COGS = Gross Profit; Gross Profit − Overheads = Net Profit
Balance Sheet: Assets = Liabilities + Equity — a snapshot of financial position