IB Business Liquidity Ratios and Probability Ratios

Liquidity Ratio

financial ratios that examine an organisation's ability to pay its short-term liabilities and debts. Refers to the ease with which a business can convert its assets into cash without affecting its market value.  

Current Ratio

A short-term liquidity ratio used to calculate the ability of an organisation to meet its short-term debts (within the next twelve months of the balance sheet date). Calculates the value if an organisation's liquid assets relative to its short-term liabilities. 

Current Ratio Equation

Current Assets **/** Current Liabilities  

Acid Test ( Quick Ratio )

A short-term liquidity ration used to measure an organisation's ability to pay its short-term (within the next twelve months of the balance sheet date), without the need to sell any stock (inventories). 

Acid Test Equation

Current Assets – Stocks **/** Current Liabilities  

Ratio Analysis

a quantitative management planning and decision-making tool, used to analyse and evaluate the financial performance of a business. 

Gross Profit Margin

a profitability ratio that measures an organisation's gross profit expressed as a percentage of its sale revenue. 

Gross Profit Margin Equation

(%) = Gross Profit **/** Sales Revenue x 100

Profit Margin

a profitability ratio that measures a firm's overall profit (after all costs of production have been deducted) as a percentage of sales revenue. 

Profit Margin Equation

Profit before interest and tax **/** sales revenue =

Return on Capital Employed (ROCE)

A profitability ratio that measures a firm's efficiency and profitability in relation to its size (as measured by the value of the organisation's capital employed). 

ROCE Equation

Profit before interest and tax **/** Capital Employed x 100 =

Capital Employed

the value of all sources of finance available for business at a point in time, including internal and external finance. 

Capital Employed Equations (2)

Non-current liabilities + Share capital + Retained earnings.

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non-current liabilities + equity

Sales Revenue Equation

Cost of Sales (COS) = Gross Profit 

How to improve profit margin:

Find a cheaper insurance company 

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Lease payments for capital equipment and other fixed (non-current) assets 

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Reduce mortgage payments 

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Reduce phone and internet payments 

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Reduce rent on commercial buildings/land 

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Reduce Employee salaries 

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Reduce Utility Bills 

How to improve GPM:

Changing the firm's promotional strategies to persuade more customers to buy the firm's goods.  

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Launching new goods and/or services that have a higher gross profit margin. 

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Reducing the prices of products sold in highly competitive markets in order to attract more customers.  

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Outsourcing production or other operations to third-party suppliers.  

How to improve ROCE:

Increasing the firm's sales revenue by using strategies such as reduced prices to attract more customers.  

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Reduce cost of production through methods such as using alternative supplies.  

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Selling unused-assets.  

How to improve current ratios:

Attract more customers, perhaps by changing pricing strategy and/or improving its promotional strategies.  

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Encourage customers to pay by cash, thereby improving the firm's cash inflows.  

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Use any available has to pay off short-term debts, thereby reducing the interest (debt) burden on the business in the long run.  

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Negotiate with supplies for an extended trade credit period (e.g. from 30 days to 40 days), thereby improving its own liquidity position.  

How to improve acid ratios:

Use the same methods that improve the current ratio (essentially, any combination of methods that raise cash inflows for the business and/or reduce its cash outflows) 

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Improve its stock control management system in order to reduce the cash outflows associated with poor stock control management. This is because the value of a firm's acid test ration improves as its level of stocks falls.