Key Idea: Ratios turn a set of accounts into a few numbers that can be compared. This topic is how profitable and how liquid a business is, and what it can do to improve.
Profitability
- Gross profit margin = gross profit ÷ sales revenue × 100 (Lena's: 70.00%).
- Profit margin = profit before interest and tax ÷ sales revenue × 100 (5.31%).
- ROCE = profit before interest and tax ÷ capital employed × 100 (12.14%).
Liquidity
- Current ratio = current assets ÷ current liabilities (Lena's: 1.33).
- Acid test = (current assets − stock) ÷ current liabilities (1.08).
- Too low: bills may not be paid. Too high: money sits idle.
Improving and comparing
- Profitability: raise prices, cut cost of sales, cut expenses.
- Liquidity: collect debts faster, hold less stock, swap an overdraft for a long-term loan.
- Compare over time and with similar firms; a ratio shows what, not why.
The words to know
| Word | Means | Do not confuse with |
|---|---|---|
| Gross profit margin | gross profit as a percentage of sales revenue | profit margin, which is after expenses |
| Profit margin | profit before interest and tax as a percentage of sales revenue | profit for the period, which is a $ figure |
| ROCE | profit before interest and tax as a percentage of capital employed | profit margin, which divides by sales |
| Capital employed | non-current liabilities + total equity | total assets |
| Current ratio | current assets ÷ current liabilities | a percentage: it is written as a number, such as 1.33 |
| Acid test ratio | (current assets − stock) ÷ current liabilities | the current ratio, which includes stock |
| Working capital | current assets − current liabilities | capital employed |
Calculate: formula, figures from the case, answer with its unit (% or a number), working shown. Comment: better or worse than before or than a rival, by how much, and the likely reason in the case.
Exam-style question
For 2025 Lena's Bakery Ltd had sales revenue of $1,600,000 and profit before interest and tax of $85,000. Calculate the bakery's profit margin (show all your working).
Model answer plan
See the mark-by-mark plan — for / against / judgement, with marking guidance — in study mode.
Important: Gross profit margin uses gross profit; profit margin and ROCE use profit before interest and tax. Profit for the period is never the top line of these ratios. And the current and acid test ratios are numbers, not percentages.
Tap each card to check yourself.
Lena's gross profit margin is 70% but her profit margin is 5.31%. What does the gap show? Expenses are high: wages, rent and utilities take most of the gross profit.
Capital employed at Lena's? $350,000 non-current liabilities + $350,000 equity = $700,000.
Why is the acid test lower than the current ratio? It leaves out stock, which may not turn into cash quickly.
Name one way to raise the current ratio. Any one: replace the overdraft with a long-term loan, collect debts faster, sell unused assets, keep more profit.
Name one way to raise the gross profit margin. Any one: raise prices, buy ingredients more cheaply, cut waste.
Why compare with a similar firm, not Goldcrust? A chain of 400 bakeries buys and sells on a different scale, so its ratios are not a fair comparison.
Exam tips
- Learn which profit goes on top of each ratio.
- Percentages for the three profitability ratios; plain numbers for the two liquidity ratios.
- Show the formula line: a slip in the arithmetic then still earns the working mark.
- A comment needs a comparison: last year, a rival, or the industry average.
- Match the strategy to the ratio: prices and cost of sales move the gross margin; expenses move the profit margin.