3.5 Profitability & liquidity ratio analysis

This section of the syllabus examines the role of ratio analysis for financial strategic analysis. It requires students to understand the purpose and use of financial ratios, including how to calculate and interpret profitability and liquidity ratios. Students also need to examine the various strategies that can be used to improve a firm's profitability and liquidity ratios.

Ratio analysis is a financial analysis tool used in the interpretation and assessment of an organization's final accounts, i.e., the firm's financial statements, consisting of the balance sheet and income statement (profit and loss account). Such analysis helps decision-makers and other stakeholders to evaluate a business organization's financial performance by exposing various financial strengths and weaknesses. Finally, ratio analysis helps to make meaningful historical and inter-firm comparisons by analysing past data of the business, and those of other businesses in the same (or even different) industries for benchmarking purposes.

The learning outcomes (or assessment objectives) for this section of the syllabus are:

• The following profitability ratios (AO2, AO4):
  •  Gross profit margin (GPM)
  •  Profit margin
  •  Return on capital employed (ROCE)
• Possible strategies to improve these profitability ratios (AO3)
• The following liquidity ratios (AO2, AO4):
  •  Current ratio
  •  Acid-test (quick ratio)
• Possible strategies to improve these liquidity ratios (AO3)

Note: There are four additional ratios that HL students need to learn (see Unit 3.6).