IB Business Liquidity Ratios and Probability Ratios

Liquidity Ratio

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.

non-current liabilities + equity

Sales Revenue Equation

Cost of Sales (COS) = Gross Profit

How to improve profit margin:

Find a cheaper insurance company

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

Reduce mortgage payments

Reduce phone and internet payments

Reduce rent on commercial buildings/land

Reduce Employee salaries

Reduce Utility Bills

How to improve GPM:

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

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

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

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.

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

Selling unused-assets.

How to improve current ratios:

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

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

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

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)

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.