Unit 3: Finance and Accounts
3.5 - Profitability and Liquidity Ratio Analysis
Understanding Financial Performance Through Ratio Analysis
Introduction to Ratio Analysis
Ratio analysis is a quantitative method of evaluating a company's financial performance and position by examining relationships between different financial statement figures.
Purpose of ratio analysis:
- Performance measurement: Track how well the business is doing
- Trend analysis: Compare performance over time
- Benchmarking: Compare with competitors and industry standards
- Decision-making: Support strategic and operational decisions
- Identify problems: Highlight areas needing attention
- Stakeholder communication: Provide meaningful information to investors, lenders, managers
Two main categories:
- Profitability ratios: Measure profit-generating ability
- Liquidity ratios: Measure ability to pay short-term debts
1. Profitability Ratios
Profitability ratios assess how effectively a business generates profit from its operations, sales, assets, or investments.
Three key profitability ratios in IB Business Management:
- Gross Profit Margin (GPM)
- Net Profit Margin (NPM)
- Return on Capital Employed (ROCE)
A. Gross Profit Margin (GPM)
Definition
Gross Profit Margin shows the percentage of revenue remaining after deducting the cost of goods sold (COGS). It measures how efficiently a business produces or purchases its products.
Formula
\[ \text{Gross Profit Margin (GPM)} = \frac{\text{Gross Profit}}{\text{Sales Revenue}} \times 100\% \]Where:
\[ \text{Gross Profit} = \text{Sales Revenue} - \text{Cost of Goods Sold (COGS)} \]Example Calculation
ABC Manufacturing Company:
- • Sales Revenue: $500,000
- • Cost of Goods Sold: $300,000
Step 1: Calculate Gross Profit
\[ \text{Gross Profit} = \$500,000 - \$300,000 = \$200,000 \]Step 2: Calculate GPM
\[ \text{GPM} = \frac{\$200,000}{\$500,000} \times 100\% = 40\% \]Interpretation: ABC Manufacturing retains 40 cents as gross profit for every dollar of sales, which covers operating expenses and generates net profit.
Interpretation
- Higher GPM = Better: More revenue available to cover operating expenses
- Increasing trend: Improving production efficiency, better pricing power, or reduced costs
- Decreasing trend: Rising costs, intense price competition, or production problems
Industry benchmarks (approximate):
- Retail grocery: 20-30%
- Retail clothing: 40-50%
- Software companies: 70-90%
- Restaurants: 60-70%
- Manufacturing: 25-40%
Ways to Improve Gross Profit Margin
- Increase selling prices: If demand is relatively price inelastic
- Reduce COGS: Negotiate better supplier prices, bulk purchasing, find cheaper materials
- Improve production efficiency: Reduce waste, streamline processes, automation
- Change product mix: Focus on higher-margin products
- Reduce shrinkage: Minimize theft, damage, and obsolescence
- Improve inventory management: Reduce costs from overstocking or stockouts
B. Net Profit Margin (NPM)
Definition
Net Profit Margin shows the percentage of revenue that remains as profit after ALL expenses have been deducted. It measures overall profitability and efficiency.
Formula
\[ \text{Net Profit Margin (NPM)} = \frac{\text{Net Profit Before Interest and Tax}}{\text{Sales Revenue}} \times 100\% \]Alternative (if specified):
\[ \text{Net Profit Margin} = \frac{\text{Net Profit After Interest and Tax}}{\text{Sales Revenue}} \times 100\% \]Note: IB exams typically use profit before interest and tax unless stated otherwise.
Example Calculation
XYZ Retail Store:
- • Sales Revenue: $800,000
- • Cost of Goods Sold: $480,000
- • Operating Expenses: $200,000
Step 1: Calculate Gross Profit
\[ \text{Gross Profit} = \$800,000 - \$480,000 = \$320,000 \]Step 2: Calculate Net Profit
\[ \text{Net Profit} = \$320,000 - \$200,000 = \$120,000 \]Step 3: Calculate NPM
\[ \text{NPM} = \frac{\$120,000}{\$800,000} \times 100\% = 15\% \]Interpretation: XYZ Retail Store keeps 15 cents as net profit for every dollar of sales after paying all expenses.
Interpretation
- Higher NPM = Better: More efficient overall operations
- NPM always lower than GPM: Operating expenses reduce the profit margin
- Large gap between GPM and NPM: High operating expenses
- Increasing NPM: Improving cost control and operational efficiency
- Decreasing NPM: Rising expenses faster than revenue growth
Industry benchmarks (approximate):
- Grocery retail: 1-3%
- Technology companies: 15-25%
- Banking: 20-30%
- Airlines: 5-10%
- Pharmaceutical: 15-20%
Ways to Improve Net Profit Margin
- All methods for improving GPM (price increases, reduce COGS)
- Reduce operating expenses: Cut unnecessary overhead, renegotiate contracts
- Increase sales volume: Spread fixed costs over more units
- Improve productivity: More output from same input
- Eliminate loss-making products: Focus on profitable items
- Automate processes: Reduce labor costs
- Outsource non-core activities: Can be more cost-effective
C. Return on Capital Employed (ROCE)
Definition
Return on Capital Employed measures how efficiently a business uses its long-term capital to generate profit. It shows the return investors earn on their investment in the business.
Formula
\[ \text{ROCE} = \frac{\text{Net Profit Before Interest and Tax}}{\text{Capital Employed}} \times 100\% \]Where Capital Employed can be calculated as:
\[ \text{Capital Employed} = \text{Total Assets} - \text{Current Liabilities} \]Or:
\[ \text{Capital Employed} = \text{Non-Current Assets} + \text{Working Capital} \]Or:
\[ \text{Capital Employed} = \text{Share Capital} + \text{Reserves} + \text{Non-Current Liabilities} \]Example Calculation
Tech Solutions Ltd:
- • Net Profit (before interest and tax): $180,000
- • Share Capital: $500,000
- • Retained Earnings: $200,000
- • Long-term Loans: $300,000
Step 1: Calculate Capital Employed
\[ \text{Capital Employed} = \$500,000 + \$200,000 + \$300,000 = \$1,000,000 \]Step 2: Calculate ROCE
\[ \text{ROCE} = \frac{\$180,000}{\$1,000,000} \times 100\% = 18\% \]Interpretation: For every $100 of long-term capital invested, Tech Solutions generates $18 in profit.
Interpretation
- Higher ROCE = Better: More efficient use of long-term capital
- Compare with borrowing costs: ROCE should exceed interest rates on loans
- Compare with alternatives: Should exceed returns from low-risk investments
- Good ROCE: Generally >15% considered strong, but varies by industry
- Increasing ROCE: Improving capital efficiency
Key insight:
- If ROCE > cost of borrowing → Effective use of debt
- If ROCE < cost of borrowing → Destroying shareholder value
Ways to Improve ROCE
- Increase net profit: Higher revenues or lower costs
- Reduce capital employed: Pay off long-term debt, return capital to shareholders
- Improve asset utilization: Generate more sales from existing assets
- Sell underperforming assets: Remove assets with low returns
- Lease instead of buy: Reduces capital employed
- Better working capital management: Reduce inventory and receivables
Comparison of Profitability Ratios
| Ratio | Formula | What It Measures | Good Result |
|---|---|---|---|
| Gross Profit Margin | \(\frac{\text{Gross Profit}}{\text{Sales Revenue}} \times 100\%\) | Production/purchasing efficiency | Higher %, varies by industry |
| Net Profit Margin | \(\frac{\text{Net Profit}}{\text{Sales Revenue}} \times 100\%\) | Overall profitability | Higher %, positive trend |
| ROCE | \(\frac{\text{Net Profit}}{\text{Capital Employed}} \times 100\%\) | Efficiency of capital use | >15%, exceeds borrowing cost |
2. Liquidity Ratios
Liquidity ratios measure a business's ability to meet short-term financial obligations using its liquid assets. They assess whether a company can pay its bills on time.
Why liquidity matters:
- Survival: Even profitable businesses fail if they can't pay bills
- Creditworthiness: Lenders and suppliers assess liquidity before extending credit
- Flexibility: Good liquidity allows businesses to seize opportunities
- Crisis management: Liquid assets provide buffer during difficult times
Two key liquidity ratios:
- Current Ratio
- Acid Test Ratio (Quick Ratio)
A. Current Ratio
Definition
Current Ratio measures whether a business has enough current assets to pay its current liabilities. It shows short-term financial health.
Key terms:
- Current Assets: Assets convertible to cash within one year (cash, accounts receivable, inventory, marketable securities)
- Current Liabilities: Debts due within one year (accounts payable, short-term loans, overdrafts, accrued expenses)
Formula
\[ \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} \]Note: Expressed as a ratio (e.g., 2:1 or simply 2), NOT a percentage
Example Calculation
Green Valley Retail:
Current Assets:
- • Cash: $50,000
- • Accounts Receivable: $80,000
- • Inventory: $120,000
- • Total: $250,000
Current Liabilities:
- • Accounts Payable: $70,000
- • Short-term Loan: $30,000
- • Total: $100,000
Calculate Current Ratio:
\[ \text{Current Ratio} = \frac{\$250,000}{\$100,000} = 2.5:1 \]Interpretation: Green Valley has $2.50 in current assets for every $1.00 of current liabilities.
Interpretation
General guidelines:
- Ratio < 1: WARNING - Cannot cover short-term debts with current assets. Serious liquidity problem.
- Ratio = 1 to 1.5: Adequate but tight liquidity. Manageable but limited cushion.
- Ratio = 1.5 to 2: IDEAL - Good liquidity, comfortable safety margin.
- Ratio > 2.5: Excessive liquidity - May indicate inefficient use of resources (too much cash sitting idle).
Context matters: Acceptable ratios vary by industry and business model.
Ways to Improve Current Ratio
- Increase current assets: Retain more cash, sell fixed assets for cash
- Reduce current liabilities: Pay off short-term debts, convert to long-term debt
- Improve cash collection: Chase overdue receivables
- Better inventory management: Sell slow-moving stock
- Inject new capital: Owners invest more money or issue new shares
B. Acid Test Ratio (Quick Ratio)
Definition
Acid Test Ratio (also called Quick Ratio) is a more stringent measure of liquidity that excludes inventory from current assets. It shows whether a business can pay debts immediately using only its most liquid assets.
Why exclude inventory?
- Inventory takes time to sell
- May not sell at full value (discounts needed)
- Some inventory may be obsolete or slow-moving
Formula
\[ \text{Acid Test Ratio} = \frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}} \]Alternative notation:
\[ \text{Acid Test Ratio} = \frac{\text{Liquid Assets}}{\text{Current Liabilities}} \]Where Liquid Assets include: Cash, marketable securities, accounts receivable
Example Calculation
Using Green Valley Retail data from previous example:
- • Current Assets: $250,000
- • Inventory: $120,000
- • Current Liabilities: $100,000
Calculate Acid Test Ratio:
\[ \text{Acid Test Ratio} = \frac{\$250,000 - \$120,000}{\$100,000} = \frac{\$130,000}{\$100,000} = 1.3:1 \]Interpretation: Green Valley has $1.30 in liquid assets for every $1.00 of current liabilities.
Comparison:
- • Current Ratio: 2.5:1
- • Acid Test Ratio: 1.3:1
- • Difference shows significant inventory holding
Interpretation
General guidelines:
- Ratio < 0.5: SERIOUS PROBLEM - Cannot pay debts without selling inventory
- Ratio = 0.5 to 1: Adequate for most businesses, but depends on industry
- Ratio = 1 to 1.5: IDEAL - Strong liquidity position
- Ratio > 2: Very strong, but may indicate excess cash not being invested
Industry variations:
- Supermarkets: 0.2-0.4 (normal due to quick inventory turnover)
- Service businesses: 0.8-1.5 (little or no inventory)
- Manufacturing: 0.5-1.0 (depends on production cycle)
Ways to Improve Acid Test Ratio
- All methods for improving current ratio
- Reduce inventory levels: Implement just-in-time inventory systems
- Speed up inventory turnover: Sell stock faster
- Convert inventory to cash: Sales, clearance, or discounting
- Improve cash management: Chase receivables aggressively
Current Ratio vs. Acid Test Ratio
| Aspect | Current Ratio | Acid Test Ratio |
|---|---|---|
| Formula | \(\frac{\text{Current Assets}}{\text{Current Liabilities}}\) | \(\frac{\text{Current Assets - Inventory}}{\text{Current Liabilities}}\) |
| Includes Inventory | Yes | No |
| Strictness | Less strict | More strict |
| Ideal Range | 1.5 to 2:1 | 1 to 1.5:1 |
| Best For | General liquidity assessment | Immediate liquidity assessment |
Problems with Too Much Liquidity
Very high liquidity ratios can indicate:
- Idle cash: Money not being invested for growth
- Opportunity cost: Missing investment opportunities
- Lower returns: Cash earns minimal interest
- Inefficiency: Not utilizing assets productively
Balance is key: Maintain enough liquidity for safety while investing excess cash for returns.
3. Limitations of Ratio Analysis
Important Considerations
- Historical data: Based on past performance, may not predict future
- Industry differences: Ratios vary significantly across industries
- Accounting policies: Different methods affect comparability
- Seasonal variations: Ratios fluctuate throughout the year
- Company size: Difficult to compare large and small companies
- External factors: Economic conditions, regulations affect performance
- Window dressing: Companies may manipulate figures before reporting
- Inflation: Can distort historical comparisons
- Qualitative factors: Ratios ignore management quality, employee morale, brand strength
4. IB Business Management Exam Tips
Essential Formulas to Memorize
Profitability Ratios:
- GPM: \(\frac{\text{Gross Profit}}{\text{Sales Revenue}} \times 100\%\)
- NPM: \(\frac{\text{Net Profit}}{\text{Sales Revenue}} \times 100\%\)
- ROCE: \(\frac{\text{Net Profit}}{\text{Capital Employed}} \times 100\%\)
Liquidity Ratios:
- Current Ratio: \(\frac{\text{Current Assets}}{\text{Current Liabilities}}\)
- Acid Test: \(\frac{\text{Current Assets - Inventory}}{\text{Current Liabilities}}\)
Common Exam Questions
- "Calculate the gross profit margin for Company X" (2 marks)
- "Explain the difference between current ratio and acid test ratio" (4 marks)
- "Analyse the financial performance using ratio analysis" (6 marks)
- "Discuss whether Company Y should be concerned about its liquidity position" (10 marks)
- "Evaluate the usefulness of profitability ratios for stakeholders" (10 marks)
Calculation Tips
- Show all steps: Write formula, substitute values, calculate
- Use correct format: Percentages for profitability, ratios for liquidity
- Include units: $ for money, % for percentages, :1 for ratios
- Round appropriately: Usually to 2 decimal places
- Interpret results: Always explain what the ratio means
- Compare: With previous years, competitors, or industry standards
- Context matters: Consider industry norms and business type
Sample Exam-Style Question
Question: Blue Sky Airlines has the following financial data for 2024:
- • Sales Revenue: $50 million
- • Gross Profit: $15 million
- • Net Profit (before interest and tax): $3 million
- • Current Assets: $12 million
- • Inventory: $2 million
- • Current Liabilities: $10 million
- • Capital Employed: $25 million
a) Calculate:
- i) Gross Profit Margin (2 marks)
- ii) Net Profit Margin (2 marks)
- iii) Current Ratio (2 marks)
- iv) Acid Test Ratio (2 marks)
b) Analyse the financial performance of Blue Sky Airlines (6 marks)
Answers:
- i) GPM = (15/50) × 100% = 30%
- ii) NPM = (3/50) × 100% = 6%
- iii) Current Ratio = 12/10 = 1.2:1
- iv) Acid Test = (12-2)/10 = 1:1
✓ Unit 3.5 Summary: Profitability and Liquidity Ratios
You should now understand that profitability ratios measure profit-generating ability: Gross Profit Margin shows production efficiency (Gross Profit ÷ Sales Revenue × 100%), Net Profit Margin measures overall profitability (Net Profit ÷ Sales Revenue × 100%), and Return on Capital Employed assesses capital utilization efficiency (Net Profit ÷ Capital Employed × 100%). Liquidity ratios measure ability to pay short-term debts: Current Ratio includes all current assets (Current Assets ÷ Current Liabilities) with ideal range 1.5-2:1, while Acid Test Ratio excludes inventory for stricter assessment ((Current Assets - Inventory) ÷ Current Liabilities) with ideal range 1-1.5:1. Higher profitability ratios generally indicate better performance, while liquidity ratios need balance—too low risks insolvency, too high suggests inefficient use of resources. Ratio analysis should consider industry norms, trends over time, and comparisons with competitors, while recognizing limitations such as historical nature, accounting differences, and inability to capture qualitative factors. These ratios are essential tools for stakeholders to evaluate financial health and make informed decisions.