What ratio must be determined to calculate the earning power of a business?

• A. Liquidity ratio
• B. Profitability ratio
• C. Debt ratio
• D. Efficiency ratio

Answer: (B)

The profitability ratio is crucial for calculating the earning power of a business because it measures the company's ability to generate profit relative to its revenue, assets, or equity. Profitability ratios provide insights into how effectively a business is converting its sales into profit. By using measurements such as net profit margin, return on assets (ROA), and return on equity (ROE), stakeholders can evaluate how much profit a company is producing from its operations compared to its total sales, investments, and shareholder equity. This assessment is vital for potential investors and management when determining financial health and operational efficiency.

The other ratios serve different functions. The liquidity ratio focuses on the company’s ability to meet short-term obligations, which doesn’t directly address earning power. The debt ratio assesses the level of debt in relation to the assets but isn’t a direct measure of profitability or earning potential. Meanwhile, the efficiency ratio looks at how well a company uses its resources and manages its expenses, which is important but not as directly tied to profitability as the profitability ratio itself.