IB Business Management SLTopic 3 — Profitability & Liquidity RatiosPaper 1 & 2Core skill~12 min read
Measuring Profitability
A profit of $2m sounds impressive until you learn it came from $200m of sales and $40m of investment. Ratios turn raw figures into something you can actually compare — against last year, against a rival, against leaving the money in the bank.
📚 What you need to know
Ratio analysis pulls figures out of the two final accounts to judge performance.
Profit margin = (profit before interest and tax ÷ sales revenue) × 100.
Return on capital employed (ROCE) = (profit before interest and tax ÷ capital employed) × 100.
Capital employed = non-current liabilities + equity.
Higher and rising is better for all three. A ratio on its own means nothing — it needs a comparison.
Margins improve by raising revenue or cutting costs; ROCE improves by raising profit or using less capital.
Where each ratio comes from
Picture every dollar of revenue as a bar. Costs eat into it from the left, and whatever survives is profit. The two margins measure how much survives at two different points.
This picture answers the classic question “gross margin rose but profit margin fell — why?” in one glance: the middle block grew.
Gross profit margin
What proportion of revenue survives the direct cost of the goods themselves. A high margin means either a strong selling price or cheap inputs. Supermarkets run on low margins and huge volumes; jewellers run on the opposite.
Same idea, but after the overheads. It tells you how much of every dollar of revenue turns into profit before the lenders and the government take their share.
Profit margin
(profit before interest and tax ÷ sales revenue) × 100
Return on capital employed
Sometimes called the primary ratio, because it answers the investor’s real question: for every dollar tied up in this business, how much profit comes back each year? It is the only one of the three that compares profit with money invested rather than sales.
ROCE differs hugely between industries, so compare it with the same firm’s past, a direct rival, or a savings rate — never with a business in another sector.
A ROCE around 20% or above is generally seen as strong. What matters more in an answer is the direction of travel: investors like ROCE that is stable and rising, because that suggests growth without extra risk.
Improving the ratios
Ratio
Ways to raise it
The catch
Gross profit margin
Raise prices; sell a premium range; negotiate cheaper materials; cut waste; buy in bulk
Higher prices can lose customers; cheaper inputs can damage quality; bulk buying needs storage
Gross profit margin
Sell more units through promotions and marketing
Promotions and campaigns cost money themselves
Profit margin
Everything above, plus reduce overheads: fewer staff, cheaper premises, new suppliers of utilities
Cutting staff hits morale and productivity; relocating has its own costs
ROCE
Raise profit without adding new capital
Easier to say than to do
ROCE
Keep profit steady but reduce capital, e.g. sell unused assets or repay debt
Selling assets may limit future capacity
Worked examples
WORKED EXAMPLE 1
Both margins [4 marks]
A firm’s revenue was $640,000. Cost of sales was $224,000 and profit before interest and tax was $96,000. Calculate the gross profit margin and the profit margin.
Step 1: gross profit$640,000 − $224,000 = $416,000Step 2: gross profit margin(416,000 ÷ 640,000) × 100 = 65%Step 3: profit margin(96,000 ÷ 640,000) × 100 = 15%GPM 65% | Profit margin 15%the 50 percentage point gap is the overheads: for every $1 of sales, 50c goes on running the business
WORKED EXAMPLE 2
Return on capital employed [4 marks]
A company has equity of $12.4m and non-current liabilities of $3.6m. Its profit before interest and tax was $2.6m. Calculate its ROCE.
Step 1: capital employed$12.4m + $3.6m = $16.0mStep 2: divide profit by capital employed2.6 ÷ 16.0 = 0.1625Step 3: express as a percentage0.1625 × 100 = 16.25%ROCE = 16.25%finish with meaning: every $1 of long-term capital generated 16.25c of profit this year, far above a savings account
WORKED EXAMPLE 3
Two years compared [8 marks]
Year 1 (in $000): revenue 400, gross profit 160, profit before interest and tax 60. Year 2: revenue 460, gross profit 175, profit before interest and tax 64. Analyse performance.
Step 1: gross profit marginsYear 1: (160 ÷ 400) × 100 = 40.00%Year 2: (175 ÷ 460) × 100 = 38.04%Step 2: profit marginsYear 1: (60 ÷ 400) × 100 = 15.00%Year 2: (64 ÷ 460) × 100 = 13.91%Step 3: read it properly
Both profits rose in cash terms, but both margins fell. The firm is selling more and keeping less of each sale.
Growth bought with thinner marginslikely causes: discounting to win the extra sales, or materials costing more — name one and say what you would check
💡 Exam tip
Two decimal places unless told otherwise, and always the % sign.
Check the units before you divide. $0.37m and $370,000 are the same; mixing them ruins the answer.
Never leave a ratio bare. Follow it with what it means for this business.
Compare like with like: the same firm over time, or a rival in the same industry.
Use profit before interest and tax for both the profit margin and ROCE, not profit after tax.
A rising ratio is not automatically good news. Ask how it was achieved and what it cost.
⚠ Common mix-up
Gross profit used in the profit margin. The profit margin uses profit before interest and tax.
Forgetting to multiply by 100. 0.1625 is not an answer; 16.25% is.
Capital employed taken as equity only. Add the non-current liabilities.
Comparing ROCE across industries. A software firm and a shipping firm are not comparable.
Assuming higher profit means higher margin. Worked example 3 shows exactly the opposite.
Recommending “cut costs” with no detail. Say which costs, and what the risk of cutting them is.
Up next: Measuring Liquidity — profitable is not the same as able to pay the bills on Friday.
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