Key Idea: Topic 3.5 is about calculating profitability and liquidity ratios and then interpreting what they mean for the business. At HL, students are expected to analyse ratios more critically, compare results properly, and connect them to wider issues such as expense control, stock dependence, gearing and future borrowing ability.
📈 Profitability: **Gross profit margin (GPM) —** gross profit ÷ revenue × 100. **Shows —** trading efficiency. **Focus —** direct costs / COGS. **High GPM —** good pricing or low COGS.
💧 Liquidity: **Current ratio —** current assets ÷ current liabilities. **Acid test —** (current assets − stock) ÷ current liabilities. **Shows —** ability to pay short-term debts. **Low liquidity —** possible cash-flow pressure.
🔍 What results may mean: **GPM falls —** direct costs are rising or prices are too low. **NPM falls —** total expenses are hurting profit. **Current ratio high but acid test low —** too much cash tied up in stock. **Improving ratios —** performance may be getting stronger.
⚠️ Limits of ratio analysis: **One ratio alone —** not enough evidence. **Old data only —** past performance may not continue. **Window dressing —** accounts can be made to look stronger. **No non-financial factors —** ratios ignore staff, quality, brand and market change.
HL exam tip: Do not just calculate a ratio and stop — always explain what the result means for the business and whether it is likely to worry managers, lenders or suppliers.
Past-paper tip: Recent HL papers and markschemes reward precise use of gearing and efficiency logic alongside ratios. A good HL answer often connects low liquidity to stock dependence, slow debt collection, borrowing pressure or limited flexibility to expand.
Use both the current ratio and the acid test when analysing liquidity — one alone can be misleading.
Example: A strong answer: The acid test is 0.67:1, below the ideal 1:1. This suggests the business may struggle to pay short-term debts without selling stock, so liquidity is weaker than it first appears.
Important: Common triggers: calculate ratios, comment on profitability or liquidity, compare results over time, explain why margins changed, explain why liquidity is weak, discuss limitations, recommend improvements.
- Calculate the ratio and show working if required
- State the result clearly
- Explain what it means
- Compare it with another value, ideal level or benchmark
- Explain one likely business consequence
- Recommend action or note a limitation