Key Idea: In 3.5, IB wants you to calculate profitability and liquidity ratios, then explain what they mean for the business. This topic is not just about formulas — it is about interpretation, comparison and judgment.
📈 Profitability: **Gross profit margin (GPM) —** gross profit ÷ revenue × 100. **Shows —** how strong the business is at making profit from trading. **Focus —** direct costs / cost of goods sold. **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 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 is 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 changes.
Do not just calculate a ratio and stop — always explain what the result means for the business.
Use both the current ratio and the acid test when analysing liquidity — one alone can be misleading.
Always show full working for calculations to secure method marks.
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, explain limitations, recommend improvements.
- Calculate the ratio and show working
- State the result
- Explain what it means
- Compare it with another value
- Recommend action or note a limitation