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3.5

Profitability and liquidity ratio analysis

Unit 3 · Finance and accounts · SL and HL

Ratios turn raw accounts into information you can compare across years and against competitors. This page covers the three profitability ratios and two liquidity ratios examined at SL and HL, with the strategies a business could use to improve each. Paper 2 almost always asks you to calculate some of them and comment. We use the accounts of Ombak Boards from 3.4.

🎯What you need to be able to do

  • Calculate and interpret gross profit margin, profit margin and return on capital employed (ROCE).
  • Calculate and interpret the current ratio and acid test (quick) ratio.
  • Evaluate possible strategies to improve these ratios.

📚The business management

Profitability ratios

\[ \text{gross profit margin (GPM)} = \frac{\text{gross profit}}{\text{sales revenue}} \times 100 \]

How much of each dollar of sales is left after the direct cost of the goods sold. Depends on pricing and on the cost of materials and direct labour.

\[ \text{profit margin} = \frac{\text{profit before interest and tax}}{\text{sales revenue}} \times 100 \]

How much of each dollar of sales is left after all operating costs, including overheads. A big gap between GPM and profit margin points to high expenses.

\[ \text{ROCE} = \frac{\text{profit before interest and tax}}{\text{capital employed}} \times 100 \qquad \text{capital employed} = \text{non-current liabilities} + \text{equity} \]

The return the business earns on all the long-term capital invested in it: the key measure of how efficiently capital is used. Compare it with the interest rate on savings or loans: a ROCE below the cost of borrowing suggests capital could be better used elsewhere.

Liquidity ratios

Liquidity is the ability to pay short-term debts as they fall due. A profitable business can still fail if it runs out of cash (3.7).

\[ \text{current ratio} = \frac{\text{current assets}}{\text{current liabilities}} \]

A common guide is about 1.5 to 2: below 1, the business may struggle to pay its debts; well above 2, cash may be tied up unproductively in stock or idle balances.

\[ \text{acid test (quick) ratio} = \frac{\text{current assets} - \text{stock}}{\text{current liabilities}} \]

A stricter test, excluding stock because it may be slow or hard to sell. A guide is about 1. Supermarkets can operate safely below 1 because their stock sells fast and customers pay in cash.

All benchmarks depend on the industry; the most useful comparisons are with the same business over time and with competitors.

Five ratio cards for Ombak Boards in 2025: gross profit margin 480 divided by 1200 gives 40 per cent; profit margin 180 divided by 1200 gives 15 per cent; ROCE 180 divided by 250 plus 660 gives 19.8 per cent; current ratio 300 divided by 150 gives 2.0 to 1; acid test ratio 300 minus 140, divided by 150, gives 1.07 to 1.
Ombak Boards’ ratios, calculated in the worked example below.

Strategies to improve the ratios

Raise GPM
raise prices (if demand is price inelastic); find cheaper suppliers or negotiate bulk discounts; reduce waste; shift the product mix towards higher-margin products. Risks: lost sales, lower quality.
Raise profit margin
everything above, plus cut overheads: cheaper premises, less waste in marketing, delayering, energy efficiency. Risks: cuts may damage morale, service or growth.
Raise ROCE
increase profit (as above) or reduce capital employed: sell unused assets, repay debt. Risks: selling assets may limit future capacity.
Improve liquidity
sell unused assets or sale-and-leaseback; collect debts faster (discounts for early payment, factoring); reduce stock levels (JIT); negotiate longer credit from suppliers; convert overdraft into a long-term loan; inject new share capital.
If liquidity is too high
idle cash earns little: invest in productive assets, repay expensive debt, or return cash to shareholders.

✏️Worked example

Using Ombak Boards’ 2025 accounts ($000: sales 1200, gross profit 480, PBIT 180, current assets 300 including stock 140, current liabilities 150, non-current liabilities 250, equity 660), calculate the five ratios and comment. A competitor has a GPM of 45%, a profit margin of 12% and an acid test ratio of 0.8.
GPM = 480 ÷ 1200 × 100 = 40%
Profit margin = 180 ÷ 1200 × 100 = 15%
ROCE = 180 ÷ (250 + 660) × 100 = 180 ÷ 910 × 100 = 19.8%
Current ratio = 300 ÷ 150 = 2.0 : 1
Acid test = (300 − 140) ÷ 150 = 1.07 : 1

Comment: Ombak’s GPM is lower than the competitor’s (40% vs 45%), so its direct costs are relatively high or its prices lower; but its profit margin is higher (15% vs 12%), so it controls overheads better. A ROCE of almost 20% is a strong return, well above typical interest rates. Liquidity is healthy: a current ratio of 2 and acid test just above 1 mean it can meet short-term debts, and it is more liquid than the competitor. It could look for cheaper materials to raise GPM.

Check it. Capital employed = non-current liabilities + equity = total assets − current liabilities: 1060 − 150 = 910. Both routes give the same figure.
Using profit after tax, or gross profit, in ROCE and profit margin. The IB formulae use profit before interest and tax. And always state ratios with units (% or “: 1”) and interpret them, not just calculate.

📝Practise

Work through these on paper, then reveal the answer.

1. [2 marks] Sales $600 000, cost of sales $390 000. Calculate the gross profit margin.
Gross profit = 210 000. GPM = 210 000 ÷ 600 000 × 100 = 35%.
2. [2 marks] Current assets $84 000 (including stock $39 000); current liabilities $60 000. Calculate the current and acid test ratios.
Current ratio = 84 ÷ 60 = 1.4 : 1. Acid test = (84 − 39) ÷ 60 = 45 ÷ 60 = 0.75 : 1.
3. [2 marks] PBIT $45 000; non-current liabilities $100 000; equity $200 000. Calculate ROCE.
ROCE = 45 000 ÷ 300 000 × 100 = 15%.
4. [4 marks] A café’s gross profit margin is stable at 65% but its profit margin fell from 18% to 9%. Explain what this suggests and one possible response.
A stable GPM means prices and direct costs (ingredients) have not changed proportionally. The fall in profit margin must come from rising overheads: rent, salaries, marketing or utilities. The café should identify which expense rose and cut or control it (for example renegotiating rent, reducing energy use or better staff scheduling).
5. [4 marks] Explain why a very high current ratio (say 4 : 1) may not be good.
It suggests too much money is tied up in current assets: excess stock (storage costs, risk of obsolescence), uncollected debts, or idle cash earning little. These resources could instead be invested in productive assets or used to repay debt, improving profitability and ROCE.
6. [10 marks] A retailer’s acid test ratio has fallen to 0.5. Discuss strategies it could use to improve its liquidity.

Options: chase debtors or offer discounts for early payment (quick, but cuts revenue); reduce stock through promotions or JIT ordering (frees cash, but risks stock-outs); negotiate longer supplier credit (costless, but may damage relationships); sale and leaseback of premises (large cash inflow, but ongoing rent and loss of the asset); replace the overdraft with a long-term loan (cuts current liabilities, but adds interest); new equity (no repayment, but dilution).

Evaluation: note that a retailer with fast-selling stock can operate with a low acid test ratio, so compare with competitors. A combination of stock reduction and supplier negotiation is quick and cheap; structural measures suit a persistent problem.

🔗Go deeper — other people’s work

These are external resources, not mine. If one stops working, tell me and everything above it on this page still stands.

  • AccountingCoach — financial ratios explained with examples.
  • Annual reports of listed companies — practise calculating ratios from real accounts.
  • Investopedia — industry benchmarks for margins and liquidity ratios.