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IB Syllabus 3.5
IB Syllabus 3.5
The learning outcomes (or assessment objectives) for this section of the IB Business Management 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 ratioPossible strategies to improve these liquidity ratios (AO3)
In-Class Activities
In-Class Activities
Day 1: Strategies to Improve Profitability and Liquidity Ratios
Day 1: Strategies to Improve Profitability and Liquidity Ratios
Complete this table for evaluating strategies to improve profitability and liquidity ratios:
https://docs.google.com/document/d/1sK5yiX-V3RCbIdz8rJgY0IzIVqvIPWZVMwCN2KFz288/edit?usp=sharing
Day 2: Case Study Options
Day 2: Case Study Options
Option 1: Research a company
Research a company and find their:
Profitability ratios (Gross Profit Margin, Profit Margin, ROCE)
If you use Yahoo Finance you can find the Income Statement and Balance Sheet on the "Financial" Tab
Note that Profit Margin is also called Operating Profit Margin and is different from Net Profit Margin, which we don't learn about)
Liquidity ratios (Current Ratio, Acid Test Ratio)
Based on the ratios would you invest into the company? Why or why not?
If you were a bank would you lend them money? Why or why now?
Option 2: Case Study Practice Questions
14. Cedar Hill Books (CHB)
15. Fresh Cucina (FC)
Homework
Homework
Read Kognity +
Option 1: IB DB Google Slides
Complete all practice questions in the slides as well
Option 2: 3.5-3.6 Case Study Questions:
14. Cedar Hill Books (CHB)
15. Fresh Cucina (FC)
Complete all practice questions except for the 10 mark questions
Additional Homework: 3.5 Liquidity Practice Exam Questions
What you should know
By the end of this subtopic, you should be able to:
define the following terms: (AO1)
profitability ratio
liquidity ratio
gross profit margin
profit margin
return on capital employed
capital employed
liquidity
current ratio
acid test (quick) ratio
explain and calculate profitability ratios: gross profit margin, profit margin and return on capital employed (AO2, AO4)
discuss possible strategies to improve profitability ratios (AO3)
explain and calculate liquidity ratios: current ratio and acid (quick) test ratio (AO2, AO4)
discuss possible strategies to improve liquidity ratios (AO3)
https://quizlet.com/_czxlhh?x=1jqt&i=4jrhob
https://www.gimkit.com/view/641af4a3d6a5f20032a908f8
Acid test ratio
Also known as the quick ratio, this short-term liquidity ratio measures an organization’s ability to pay its short-term debts without having to sell any stock (inventories).
Capital employed
The value of all sources of finance for a business, including internal and external finance.
Current ratio
A short-term liquidity ratio used to calculate the ability of an organization to meet its short-term debts (within the next twelve months of the balance sheet date).
Gross profit margin (GPM)
A profitability ratio that measures an organization’s gross profit expressed as a percentage of its sales revenue. It is also an indicator of how well a business can manage its direct costs of production.
Liquidity
Refers to the ease with which a business can convert its assets into cash without affecting its market value, i.e., it measures a firm’s ability to repay short-term liabilities without having to use external sources of finance.
Liquidity ratios
These are financial ratios that examine an organization’s ability to pay its short-term liabilities and debts, namely the current and acid test ratios.
Profit
The financial surplus after all costs, including expenses, have been paid.
Profit margin ratio
A profitability ratio that measures a firm’s overall profit (after all costs of production have been deducted) as a percentage of its sales revenue. It is also an indicator of how well a business can manage its indirect costs (overhead expenses).
Ratio analysis
A quantitative management planning and decision-making tool, used to analyse and evaluate the financial performance of a business. These can be further categorised as profitability, liquidity, and efficiency ratio analysis.
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 organization’s capital employed).
3.5 Extra Notes
3.5 Extra Notes
What is Ratio Analysis?
Ratio analysis is a quantitative financial analysis tool for judging the financial performance of the business based on financial statements (balance sheet and profit & loss account). There are different types of ratios: profitability, liquidity and efficiency. The first two types of ratios are covered in this class, and efficiency ratios are covered in the next class for HL students only.
The following profitability ratios (AO2, AO4):
The following profitability ratios (AO2, AO4):
Profitability ratios examine organisation’s profit-making ability. The three types of profitability ratios are:
• Gross profit margin (GPM)
• Profit margin
• Return on capital employed (ROCE)
Gross profit margin (GPM)
Gross profit margin (GPM)
A profitability ratio that shows the gross profit as a percentage of sales revenue.
You will need profit and loss account to obtain data for calculation of profit margin.
The higher the gross profit margin is, the better. For example, gross profit of $150 from sales revenue of $250 is 60%. It means that for every $100 of sales, $60 is gross profit.
Example:
Profit margin
Profit margin
A profitability ratio that shows the profit before interest and tax as a percentage of sales revenue.
Note: Also known as Operating Profit Margin (if you look this up on other websites). Outside of IB Net Profit Margin also minuses interest and tax...
The higher the profit margin, the better the organisation controls its expenses. For example, profit margin of $100 from sales revenue of $250 is 40%. It means that for every $100 of sales, $40 is profit margin.
The profit margin is a better measure of profitability than the gross profit margin. The profit margin takes into account both the direct costs of producing the products and the indirect costs or expenses.
It is an important ratio as it shows how well managers can control indirect costs, also known as overheads or expenses. These are costs not directly related to the production of a good or service.
Indirect costs: rent, administrative staff salaries, insurance, promotion and other costs.
Example:
From the statement of profit or loss of Pap-Pie Ltd in Table 1, the profit before interest and tax is $310 000 and the sales revenue $1 000 000. The profit margin is therefore calculated as:
This indicates that out of every $100 in sales revenue, $31 is the company’s profit after the cost of sales and all expenses have been deducted.
Return on capital employed (ROCE)
Return on capital employed (ROCE)
A profitability ratio that shows the profit before interest and tax as a percentage of capital employed.
ROCE stands for Return on Capital Employed and measures the profit generated from the capital used in a business.
A higher ROCE percentage means the business is more efficiently converting the capital employed (resources) into profits.
Capital employed is the value of all sources of longer-term internal and external finance for a business. The formula for calculating capital employed is as follows:
The higher the ROCE, the more profit organisation generates from invested capital. For example, 25% ROCE shows that for every $100 invested, $25 profit is generated. ROCE benchmarks are different in different industries but usually a benchmark of an acceptable ROCE is around 20%.
ROCE should be compared to other businesses in the same industry. If below industry average, it means less efficient use of resources versus competitors.
ROCE can also be compared over time. An increasing ROCE shows improved efficiency at converting resources to profits.
ROCE should be higher than interest rates for risk-free savings accounts. If not, capital may be better placed in low-risk savings.
For social enterprises, ROCE may be lower as they distribute value more widely to stakeholders through actions like fair wages and environmental initiatives. These lower the financial return but increase other returns.
ROCE is calculated using the ‘profit before interest and tax’, because this allows businesses to better compare financial performance over time. Taking out the impact of interest rates and taxes, which are not in the business’s control, enables the business and stakeholders to see the performance of the business.
Example:
Profit before interest and tax = $310 000
Non-current liabilities = $180 000
Equity = $530 000
Pap-Pie Ltd's ROCE of 44% means for every $100 of capital/resources used, it generates $44 in profits.
How do I know if my profit margin is good?
Profit margins vary significantly depending on the industry. You'll have to compare it in regards to:
Industry norms and benchmarks
Historical performance trends
Economic conditions
What do you think the profit margins are of:
Grocery store?
Software developer?
Grocery stores:
Average GPM: 20-30%
Average Profit Margin: 1-3%
Average ROCE: 4.9-8.7%
Software developers:
Average GPM: 70-80%
Average profit margin: 30-40%
Average ROCE: 20-30%
Possible strategies to improve these profitability ratios (AO3)
Possible strategies to improve these profitability ratios (AO3)
Strategies to improve Gross Profit Margin (GPM)
Strategies to improve Gross Profit Margin (GPM)
improve sales revenue
Reduce prices to potentially increase sales (works well for elastic goods with lots of competition)
May negatively impact brand if it's cheaper and thought of as inferior
Increase prices to increase revenue per sale (works well for inelastic goods that don't have much competition and therefore demand may not drop)
May be unethical depending on the product (eg. medicine)
Increased promotion
More customers know about your product
Advertising is an increase in costs with no guarantee of improving sales
decrease costs
Cheaper suppliers
May result in lower quality and thus lower brand image and sales
Cut labour costs
Costs will be lower, but staff motivation may worsen
Benefits and limitations of strategies to improve sales revenue
Benefits and limitations of strategies to decrease costs
Strategies to improve Profit Margin
Strategies to improve Profit Margin
Same as GPM:
Improve sales revenue
decrease costs
Improve working capital
Negotiate longer trade credit periods with suppliers
Negotiate discounts from suppliers, perhaps if you pay sooner for an early payment discount
Reduce Expenses: Rent, Electricity, Stationary, Administration Costs
Rent. This could be achieved by negotiating a lower rental payment for existing premises, or by relocating to new premises. The disadvantage of moving may be that the new location is less convenient for customers or has lower quality facilities.
Electricity. This could be achieved by monitoring and lowering electricity use, or by using alternative, lower-cost sources of energy. The business must ensure, however, that lower electricity use does not result in a lower quality product.
Stationery. A business could aim to lower paper use by relying more on digital communication. However, this could also increase energy use, causing higher expenses elsewhere.
Administration costs. This could be achieved through reducing administrative staffing or by lowering salaries or perks. However, the business must be careful not to damage staff motivation by taking these measures.
Strategies to improve ROCE (Return on Capital Employed)
Strategies to improve ROCE (Return on Capital Employed)
Minimize non-current liabilities by reducing long-term loans
May result in not buying or selling non-current assets which are needed to be productive
Decrease equity by paying out more dividends
This decreases your internal sources of finance and cash which you may need for future investments or for operations.
The following liquidity ratios (AO2, AO4):
The following liquidity ratios (AO2, AO4):
Current ratio
Current ratio
The current ratio is a liquidity ratio that calculates the business’s current (short-term) assets relative to its current (short-term) liabilities.
Desirable ratio depends on the industry, but it is usually between 1.5:1 to 2:1.
If current ratio is lower than 1:1, it indicates that organisation is experiencing liquidity problems.
If the ratio is more than 2:1, it means too much of one or some of the following: cash, debtors, or stock.
If current ratio is too high then the assets could be used more effectively
Cash. Cash is a depreciating asset. Its value decreases over time due to inflation, so it not a good idea to hold too much cash.
Debtors. If an organisation holds too much of debtors, it means that it sells a lot of its product on credit, i.e. it means that debtors receive products, but pay for them later. It might result in bad debt — a situation when debts cannot be repaid. This should be avoided.
Stock (unsold goods). This indicates that there is too much of unsold goods that take up storage place and do not generate any value. This situation is also undesirable.
The current ratio measures a business's ability to pay off its short-term debts and liabilities that are due within one year or the firm's operating cycle (whichever is longer) with its current assets.
Learning about the current ratio helps people understand a business's short-term financial health and liquidity position. It indicates whether a company has enough resources on hand to meet its imminent payment obligations falling due.
Example:
current assets = $70 000
current liabilities = $20 000
This means that every $1 of current liabilities that Pap-Pie Ltd owes to its trade creditors, it has $3.50 in liquid current assets to cover those liabilities.
This is a very safe current ratio!
Note that if the current ratio was below 1.5 it would be considered at high risk of insolvency, especially if it was below 1.
Acid-test / quick ratio
Acid-test / quick ratio
The acid test (quick) ratio is a narrower indicator of a business’s ability to pay its short-term debts.
The acid test ratio excludes stock (inventory) from the current assets.
Stocks are excluded because they are the least liquid of current assets.
Whether a business can sell stock depends on many factors that may be out of the control of the business.
Desirable ratio depends on the industry, but should be higher than 1:1. If it’s lower than 1:1, it is an indicator of liquidity problems.
If acid test ratio is more than 2:1, it might mean too much of cash or debtors, which might result in too much of depreciating asset or bad debt accordingly.
Example:
current assets = $70 000
stock = $20 000
current liabilities = $20 000
This means that for every $1 of current liabilities Pap-Pie Ltd incurs, the business has $2.50 worth of liquid assets to cover the liabilities. This is lower than the current ratio, but is still relatively high for a business with the same downsides as mentioned in the section on the current ratio.
This is a very safe acid test ratio!
Note that if the acid test ratio was below 1 it may have liquidity problems and may be considered at high risk of insolvency.
https://youtu.be/BCaoQNkeoy0?si=yl06rnpibYKlXMlA
Possible strategies to improve these liquidity ratios (AO3)
Possible strategies to improve these liquidity ratios (AO3)
Strategies to improve the Current Ratio & Acid-Test / Quick Ratio
Strategies to improve the Current Ratio & Acid-Test / Quick Ratio
Can improve Current Ratio & Acid-Test / Quick Ratio by increasing current assets
Benefits and limitations of methods to increase current assets
Can improve Current Ratio & Acid-Test / Quick Ratio by decreasing current liabilities
Benefits and limitations of methods to decrease current liabilities
IB Formula Sheet 2024.pdf
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