Welcome to 3.5 Profitability & Liquidity ratios
This workbook follows the IB BM syllabus and Surridge & Gillespie to help you master profit and liquidity ratios.
Why this topic matters
Profitability ratios show how well a business turns revenue into profit. Liquidity ratios show whether it can pay its short-term debts on time. Together they help managers, lenders and investors judge financial performance.
How to use this mini-course
- Work through Ratios 101 to learn the formulas and what they mean.
- Read Using the ratios to see how to interpret changes over time and between firms.
- Complete the three calculate ratios practices.
- Answer the interpretation MC questions – these are close to exam-style AO2–AO4 tasks.
- Use the Flashcard studio to secure the key vocabulary.
- Finish with the 20-question quiz and review the explanations.
Ratios 101 – profitability & liquidity
The core 3.5 ratios and what they tell us.
Profitability ratios – how good is performance?
These compare profit with sales revenue or capital employed:
- Gross profit margin (GPM) – gross profit as a percentage of sales revenue.
- Net profit margin (NPM) – net profit before interest and tax as a percentage of sales revenue.
- Return on capital employed (ROCE) – net profit before interest and tax as a percentage of capital employed.
Net profit (before interest and tax) = gross profit − overheads (indirect expenses).
Liquidity ratios – can we pay our short-term debts?
- Current ratio – relationship between current assets and current liabilities.
- Acid-test (quick) ratio – like the current ratio but excluding inventories from current assets.
Key formulas
GPM = (gross profit ÷ sales revenue) × 100
NPM = (net profit before interest & tax ÷ sales revenue) × 100
ROCE = (net profit before interest & tax ÷ capital employed) × 100
current ratio = current assets ÷ current liabilities
acid-test = (current assets − inventories) ÷ current liabilities
Quick check – matching ideas to formulas
1. Which of these is a profitability ratio?
2. Which ratio is most directly about short-term cash-flow safety?
3. ROCE uses which profit figure?
Using the ratios – comparisons & stakeholders
What counts as “good” depends on time, competitors and stakeholder expectations.
Comparing over time and between firms
- Compare ratios with previous years to identify trends.
- Compare with similar businesses (benchmarks) in the same industry.
- Always consider the reasons behind changes – not just the numbers.
Stakeholder views
- Shareholders focus on profitability, especially ROCE and net profit margin.
- Banks and other lenders pay close attention to liquidity (current and acid-test ratios).
- Managers use both sets of ratios to make decisions about pricing, cost control and financing.
Quick check – reading stories from ratios
1. GPM increases but NPM stays the same. What is the most likely explanation?
2. Current ratio falls from 2.0:1 to 1.1:1 while profitability is unchanged. Which stakeholder is most likely to be concerned?
Practice – calculate profitability and liquidity ratios
Use the data for each business to calculate the main 3.5 ratios.
How to answer
Enter your answers to 1 decimal place for % ratios and to 2 decimal places for the current and acid-test ratios. Do not type the % sign.
Scenario – BrightTech Electronics
For the year ended 31 December: sales revenue = $1 200 000; cost of sales = $720 000; overhead expenses (excluding interest and tax) = $240 000; net profit before interest and tax = $240 000; capital employed = $1 000 000. Current assets = $350 000 (including inventories of $110 000); current liabilities = $200 000.
| Ratio | Your answer |
|---|---|
| Gross profit margin (%) | |
| Net profit margin (%) | |
| ROCE (%) | |
| Current ratio | |
| Acid-test ratio |
Remember: gross profit = sales – cost of sales; net profit = gross profit – overheads.
Scenario – FreshBakes Bakery
For the year ended 30 June: sales revenue = $800 000; cost of sales = $480 000; overhead expenses (excluding interest and tax) = $200 000; net profit before interest and tax = $120 000; capital employed = $600 000. Current assets = $260 000 (including inventories of $80 000); current liabilities = $160 000.
| Ratio | Your answer |
|---|---|
| Gross profit margin (%) | |
| Net profit margin (%) | |
| ROCE (%) | |
| Current ratio | |
| Acid-test ratio |
Compare these figures with BrightTech – which firm has stronger profitability and liquidity?
Scenario – UrbanFitness Gyms
For the year ended 31 August: sales revenue = $1 000 000; cost of sales = $400 000; overhead expenses (excluding interest and tax) = $480 000; net profit before interest and tax = $120 000; capital employed = $800 000. Current assets = $500 000 (including inventories of $200 000); current liabilities = $350 000.
| Ratio | Your answer |
|---|---|
| Gross profit margin (%) | |
| Net profit margin (%) | |
| ROCE (%) | |
| Current ratio | |
| Acid-test ratio |
UrbanFitness has a strong gross margin but weaker net margin – why?
Practice – interpreting profitability and liquidity ratios
Choose the best explanation for each scenario. Think about trends, comparisons and stakeholder views.
Multiple-choice interpretation questions
1. UrbanFitness has a gross profit margin of 60% but a net profit margin of only 12%. What does this suggest?
2. BrightTech's current ratio is 1.75:1 and its acid-test ratio is 1.20:1. Which statement is most accurate?
3. FreshBakes improves its net profit margin from 12% to 16% in one year. Sales revenue is unchanged. Which is the best explanation?
4. A retailer has a current ratio of 0.8:1 and an acid-test ratio of 0.5:1. What is the main concern?
5. Two firms in the same industry have similar net profit margins, but Firm A has a much higher ROCE than Firm B. What does this suggest?
Flashcard studio – 3.5 key terms
Flip through the language of profitability and liquidity ratios.
Deck
Click a term in the list to jump straight to that card.
End-of-topic quiz – 3.5 profitability & liquidity (20 Qs)
Questions move from simple definitions through calculations to interpretation and evaluation.