Calculate and interpret gross profit margin, profit margin, ROCE, the current ratio and the acid test ratio, and evaluate strategies to improve them and the limits of ratio analysis.
Each is in the Business glossary, with every other term in the subject.
A liquidity ratio that divides current assets minus stock by current liabilities, showing whether a business can pay its short-term debts without selling its stock.
The total long-term finance invested in a business, equal to its non-current liabilities plus equity.
A liquidity ratio that divides current assets by current liabilities, showing whether a business has enough short-term assets to cover its short-term debts.
Gross profit expressed as a percentage of sales revenue, showing how much of each $1 of sales is left after paying the cost of sales.
The ability of a business to meet its short-term debts when they fall due by turning its current assets into cash quickly enough.
A ratio that compares current assets, or the most liquid current assets, with current liabilities to show whether a business can pay its short-term debts.
Profit before interest and tax expressed as a percentage of sales revenue, showing how much of each $1 of sales is left after cost of sales and expenses.
The ability of a business to make a profit in relation to its sales revenue or the capital invested in it.
Define ratio analysis, profitability and liquidity.
Calculate the gross profit margin, profit margin and return on capital employed (ROCE) from final accounts.
Calculate the current ratio and the acid test (quick) ratio from a statement of financial position.
Explain what each ratio shows and comment on its value over time and against competitors.
Explain why profitability and liquidity are different and why a business needs both.
Evaluate strategies to improve profitability ratios.
Evaluate strategies to improve liquidity ratios.
Discuss the limitations of ratio analysis.
Final accounts give a business’s figures in absolute amounts, such as a profit of $480,000 or current assets of $1.2 million. On their own these numbers say little, because a profit of $480,000 is excellent for a small shop and very poor for a national retailer. Ratio analysis turns the figures into ratios and percentages, so that managers, investors and lenders can judge how well a business is performing and compare it with its own past and with its competitors.
Two families of ratios measure different aspects of performance. Profitability ratios measure how well a business turns its sales and its capital into profit, and liquidity ratios measure whether it can pay its debts as they fall due. Both depend on the figures in the statement of profit or loss and the statement of financial position, so they rest on the final accounts.
Ratio analysis links to the key concepts. Ratios measure the effect of change in costs, prices or competition, and comparing them over time shows how a business adapts. Ratios also raise questions of
78 exam-style questions on this subtopic, written in the style of the IB papers. The first has its markscheme open. Counted on
Kiri Organics
[1] Kiri Organics (KO) is a private limited company in Nelson, New Zealand, that makes skincare products from native plants such as mānuka and kawakawa. It sells through pharmacies, gift shops and its own website. Its owners, Hana and Rāwiri Tane, describe KO as “a brand that cares for skin and for the land”.
[2] At the start of 2025 KO switched all of its ingredient and packaging suppliers to certified organic growers and a supplier of compostable packaging. Unit costs rose sharply, but KO increased its prices by only 3 % because Hana feared losing customers to cheaper brands. KO also hired two extra sales staff for its website.
[3] Rāwiri now wants to raise prices by a further 10 %. The marketing manager estimates that this would reduce sales volume by about 4 %. Hana is worried that KO’s pharmacy customers, who sell mainly to price-conscious shoppers, will stock fewer KO products.
Table 1: Extracts from KO’s statements of profit or loss for the years ending 31 December (NZ$000)
2024 | 2025 | |
|---|---|---|
Sales revenue | 3 200 | 3 500 |
Cost of sales | 1 280 | 1 750 |
Expenses | 1 280 | 1 400 |
Table 2: KO’s profitability ratios for 2024
Ratio | 2024 |
|---|---|
Gross profit margin |
The official deck for this part of the syllabus.
What is ratio analysis?
Why are ratios more useful than the absolute figures in the final accounts?
With a free account, Augment remembers where you stopped and what you have practiced.
A ratio that measures profit as a percentage of sales revenue or capital employed, such as the gross profit margin, profit margin and ROCE.
A quantitative management tool that uses figures from the final accounts to calculate ratios, which are compared over time and with other businesses to judge financial performance.
Profit before interest and tax expressed as a percentage of capital employed, measuring the profit generated from the long-term finance invested in a business.
A ratio compares one figure with another. A profit of $480,000 means more when it is set against the sales revenue that produced it or the capital invested to earn it. Ratios therefore allow fair comparisons between businesses of different sizes and between years in which a business has grown or shrunk.
Ratios fall into groups that answer different questions. Profitability ratios ask how much profit the business makes from its sales and from the capital invested in it. Liquidity ratios ask whether it can meet its short-term debts. A third group, efficiency ratios, asks how well it uses its resources, such as how quickly it sells its stock, and how heavily it relies on borrowing.
The diagram shows where each ratio’s figures come from. Gross profit margin and profit margin divide a profit figure by sales revenue, so both come from the statement of profit or loss. The current ratio and the acid test ratio compare items on the statement of financial position. ROCE divides a profit figure from one statement by the capital employed from the other.
Ratio analysis serves every stakeholder with an interest in the business’s finances. Each group looks at the ratios that answer its own question.
Stakeholder | Main question | Ratios of most interest |
|---|---|---|
Managers | Is the business meeting its targets, and where should it improve? | All, especially profit margins and ROCE against targets |
Shareholders and potential investors | Is the return on the money invested good enough? | ROCE and profit margin, compared with other investments |
Banks and other lenders | Will loans and interest be repaid on time? | Current ratio, acid test ratio; profitability for long-term loans |
Suppliers | Will the business pay for goods bought on credit? | Current ratio and acid test ratio |
Employees and trade unions | Is the business secure, and can it afford pay rises? | Profit margin and liquidity |
Competitors | How does our performance compare? | Profit margins and ROCE |
Government and tax authorities | Is the business viable, and is tax being paid on the profit made? | Profitability ratios |
A single ratio means little until it is compared with something. Analysts use three comparisons, usually together.
Over time (trend analysis): the same ratio for the same business in several years shows whether performance is improving or getting worse.
With competitors or the industry (inter-firm comparison): the ratio of a rival, or the industry average, shows whether a value is good for that type of business.
With targets: managers set target ratios as part of their objectives and check results against them.
The worked examples use the accounts of Harbour Outdoor Ltd, a retailer of outdoor clothing and camping equipment (hypothetical data). In 2025 the business opened two new shops and began selling to sports clubs on credit. Its sales revenue rose by 14.29%, but competition led it to cut prices and its suppliers raised their charges.
Harbour Outdoor Ltd | 2025 ($000) | 2024 ($000) |
|---|---|---|
Sales revenue | 4,800 | 4,200 |
Cost of sales | (2,880) | (2,394) |
Gross profit | 1,920 | 1,806 |
Expenses | (1,440) | (1,302) |
Profit before interest and tax | 480 | 504 |
Interest | (60) | (40) |
Profit before tax | 420 | 464 |
Tax | (105) | (116) |
Profit for period | 315 | 348 |
Dividends | (115) | (148) |
Retained profit | 200 | 200 |
The statement of profit or loss runs from sales revenue down to retained profit. Gross profit is sales revenue minus cost of sales, and profit before interest and tax (PBIT) is gross profit minus expenses. These two profit figures are the ones the profitability ratios use.
Harbour Outdoor Ltd | 2025 ($000) | 2024 ($000) |
|---|---|---|
Non-current assets | ||
Property, plant and equipment | 3,000 | 2,600 |
Accumulated depreciation | (600) | (500) |
Non-current assets | 2,400 | 2,100 |
Current assets | ||
Cash | 80 | 220 |
Debtors | 520 | 350 |
Stock | 600 | 430 |
Current assets | 1,200 | 1,000 |
Total assets | 3,600 | 3,100 |
Current liabilities | ||
Bank overdraft | 150 | 50 |
Trade creditors | 450 | 400 |
Other short-term loans | 150 | 50 |
Current liabilities | 750 | 500 |
Non-current liabilities | ||
Borrowings—long term | 1,000 | 950 |
Non-current liabilities | 1,000 | 950 |
Total liabilities | 1,750 | 1,450 |
Net assets | 1,850 | 1,650 |
Equity | ||
Share capital | 500 | 500 |
Retained earnings | 1,350 | 1,150 |
Total equity | 1,850 | 1,650 |
The statement of financial position is a snapshot on 31 December. Current assets and current liabilities are used for the liquidity ratios, and non-current liabilities plus equity give the capital employed used for ROCE. In both years total assets minus total liabilities equals equity, as the accounting equation states.
Profitability is the ability of a business to generate profit relative to the size of the business, its sales or the capital invested in it. A large profit can still mean low profitability if it took a huge amount of sales or capital to earn it.
A profitability ratio expresses a profit figure as a percentage of sales revenue or of capital employed. The three profitability ratios are the gross profit margin, the profit margin and the return on capital employed.
The gross profit margin (GPM) shows the percentage of sales revenue left as gross profit once the cost of sales has been paid. Cost of sales is the direct cost of the goods sold, such as the purchase price of stock for a retailer or raw materials and production wages for a manufacturer.
A gross profit margin of 40% means that every $1 of sales leaves 40 cents of gross profit and costs 60 cents in cost of sales. The 40 cents must pay for all the other expenses, such as rent, salaries and marketing, before any profit remains.
The bar shows the link between the two margins. The gross profit margin measures the part of revenue left after cost of sales; the profit margin measures the much smaller part left after expenses as well.
A higher gross profit margin means the business adds more value to the goods it buys or makes. It may charge a premium price, buy cheaply in bulk, or sell a mix of products with high margins. A falling margin usually has one of three causes: lower selling prices, higher cost of sales, or a shift in the sales mix towards low-margin products.
What counts as a “good” gross profit margin depends heavily on the industry. Supermarkets sell high volumes at low margins and earned gross profit margins of around 6.5–7.5% in 2025/26. Luxury goods companies sell low volumes at very high prices: Hermès, the French luxury house, had a gross profit margin of 71.11% in 2025, because the price of a handbag is far above the cost of making it.
Sources: Hermès International, 2025 annual financial report (gross profit €11,379m, revenue €16,002m).
The profit margin shows the percentage of sales revenue left as profit before interest and tax, once both the cost of sales and the expenses have been paid. It measures how well the business controls all its operating costs, not only its direct costs.
The gap between the gross profit margin and the profit margin is the share of revenue spent on expenses. If the gross profit margin is steady but the profit margin falls, the problem lies in expenses such as rent, salaries, advertising or energy rather than in prices or the cost of sales.
A negative profit margin means the business makes a loss before interest and tax. The online grocery technology company Ocado Group had sales revenue of £1,381.7 million and an operating loss of £271.2 million in the year to November 2025, a profit margin of −19.63%. Its profit for the period was positive only because of a one-off gain of £787.3 million from discontinued operations, which shows why the profit margin uses profit before interest and tax rather than the final profit figure.
Sources: Ocado Group plc, Annual Report and Accounts 2025.
YouTubeProfit margins compare profit with sales, but they ignore how much money was invested to earn that profit. Two businesses with the same profit margin may need very different amounts of capital: a software firm needs a few offices, a steelworks needs furnaces worth billions. Return on capital employed (ROCE) compares profit with the long-term finance invested in the business.
Capital employed is the total long-term finance used by the business: the money provided by shareholders (equity) plus long-term borrowing (non-current liabilities). The same figure equals total assets minus current liabilities, because it is the finance that pays for the non-current assets and the working capital.
ROCE divides profit before interest and tax by this figure. Using profit before interest is consistent, because interest is the reward paid to the lenders whose loans are part of capital employed.
ROCE is often seen as the most important profitability ratio, because it measures the return on all the long-term money invested. A ROCE of 16.84% means each $100 of capital employed generated $16.84 of profit before interest and tax in the year. Investors compare ROCE with what the same money could earn elsewhere: if a bank deposit pays 4% with almost no risk, a business with a ROCE of 3% is not using its capital well.
Interest depends on how a business is financed, not on how well it operates. A business funded mainly by loans pays more interest than an identical one funded by shareholders. Using profit before interest and tax lets analysts compare the operating performance of the two on equal terms.
Tax is left out for a similar reason: tax rates differ between countries and over time. ROCE also matches its two parts. Capital employed includes long-term loans, so the profit figure must be the one available to reward all the providers of that capital, lenders (through interest) as well as shareholders.
Profit is the difference between revenue and costs, so every strategy to raise profitability works through one of three routes: increase revenue without a matching increase in costs, cut costs without losing revenue, or reduce the capital needed to earn the profit. Each route has risks and trade-offs.
The gross profit margin depends only on selling prices and the cost of sales, so strategies target one or both.
Strategy | How it raises the gross profit margin | Risks and limits |
|---|---|---|
Raise selling prices | More revenue per unit while the cost per unit is unchanged. | Customers may switch to rivals, so sales volume and total gross profit may fall. Works best with a strong brand and loyal customers. |
Find cheaper suppliers | Lower cost of sales per unit. | Quality may fall, damaging reputation; delivery may be less reliable; very low supplier prices can raise ethical questions about suppliers’ wages and conditions. |
Negotiate bulk discounts | Economies of scale in purchasing cut the cost per unit. | Buying more means holding more stock, which ties up cash and risks waste or obsolete stock. |
Reduce waste in production | Fewer materials used per unit sold. | May require investment in training or new equipment first. |
Change the sales mix | Sell more of the products with high margins (premium ranges, own brands, services). | Customers may not want the high-margin products; the brand may lose its value appeal. |
Raising prices shows the main trade-off clearly. A higher price always raises the gross profit margin if costs stay the same, but it does not always raise gross profit. If customers are sensitive to price, the fall in sales volume can more than cancel the extra margin on each unit.
Any strategy that raises the gross profit margin also raises the profit margin, as long as expenses do not rise. In addition, a business can reduce its expenses, the overheads that do not vary directly with each sale.
Cut overheads: move to cheaper premises, renegotiate rent, or share offices; reduce energy use (LED lighting, better insulation), which also supports environmental sustainability.
Reduce labour costs: reorganise rotas, automate tasks or reduce the number of managers. This can harm motivation and service quality, and job cuts raise ethical questions.
Spend marketing more efficiently: switch from expensive promotion to cheaper targeted digital campaigns. Cutting marketing too far can reduce future sales.
Outsource non-core activities: outsourcing cleaning, IT or delivery to specialists that do them more cheaply, at the cost of some control over quality.
Grow sales while keeping overheads fixed: expenses such as rent and salaries do not rise with every extra sale, so higher sales spread them more thinly and raise the profit margin.
Cost cutting brings a quick improvement but has limits. Once the obvious waste has gone, further cuts start to remove things customers value, such as staff in stores, product quality or after-sales service. Many businesses therefore combine cost control with strategies to grow revenue.
ROCE rises if profit before interest and tax rises while capital employed stays the same, or if the same profit is earned with less capital. Every strategy that raises the profit margin therefore helps ROCE. The business can also reduce capital employed.
Sell assets that earn little or nothing: unused land, empty buildings or old machines. The cash can repay long-term loans, which lowers capital employed.
Use sale and leaseback: sell a building and rent it back. Non-current assets fall and the cash can repay debt, although rent then adds to expenses and the business loses the asset.
Invest only in projects with a return above the current ROCE: new investment raises capital employed, so it raises ROCE only if it earns a higher return than the existing assets. Investment appraisal helps to choose such projects.
Reducing capital employed can raise ROCE in the short run while weakening the business in the long run. A firm that sells its best stores and stops investing in new equipment may report a high ROCE for a few years while falling behind its competitors.
No strategy is right for every business. The best choice depends on the cause of the low profitability, which is why ratio analysis matters: a falling gross profit margin points to prices or the cost of sales, while a steady gross profit margin with a falling profit margin points to expenses. Several further factors shape the decision.
Market and competition: a business with a strong brand or few rivals can raise prices; one in a price-sensitive market, such as grocery, usually cannot.
Time frame: cost cuts work quickly, but cuts to training, research or marketing can reduce future revenue. Revenue strategies such as building a brand take longer but last.
Stakeholders: shareholders gain from higher margins, but employees may lose jobs or bonuses, suppliers may be squeezed and customers may pay more. A strategy that damages trust can reduce profitability later.
Objectives: a business aiming for growth or market share may accept lower margins for a time, as Harbour Outdoor did when it cut prices to win customers for its new shops.
The state of the economy: in a recession customers resist price rises, so cost control matters more; when the economy grows, firms have more room to raise prices.
A reasoned judgment usually favours strategies that improve efficiency without removing what customers pay for, such as reducing waste, buying better or growing sales over fixed overheads. Short-term cuts that raise the ratio this year can lower it in later years.
Liquidity is the ability of a business to pay its short-term debts, such as suppliers’ bills, wages, overdraft repayments and tax, when they fall due. An asset is “liquid” if it can be turned into cash quickly without losing value: cash is perfectly liquid, debtors are fairly liquid, stock is less liquid and buildings are illiquid.
A liquidity ratio compares the assets that will turn into cash within a year with the debts that must be paid within a year. Lenders and suppliers watch these ratios closely, because a business that cannot pay its debts may be forced to close, however profitable it is on paper.
Sources: Ocado Group plc, Annual Report and Accounts 2025 (current assets £936.2m, current liabilities £469.2m).
The current ratio compares all current assets (cash, debtors and stock) with all current liabilities (overdrafts, trade creditors and other short-term loans). It shows how many dollars of current assets the business has for each dollar it must pay within a year.
The current ratio is written as a number (1.60) or as a ratio (1.60 : 1). A value of 1.60 means the business has $1.60 of current assets for every $1 of current liabilities.
As the scale shows, a current ratio of between 1.5 and 2 is often considered comfortable. Below 1, current liabilities are greater than current assets, so the business could not pay all its short-term debts even if it turned every current asset into cash. A very high current ratio, say above 3, is not always good: it may mean that cash is lying idle instead of being invested, that stock is building up unsold, or that customers are slow to pay.
The right level depends on the type of business. Supermarkets sell for cash every day, sell their stock within days and pay their suppliers some weeks later, so they can operate safely with a current ratio well below 1. Tesco’s current ratio was 0.59 in February 2026. A manufacturer that holds months of raw materials and sells on 60-day credit needs a much higher current ratio to be safe.
The current ratio treats all current assets as equally able to pay debts, but stock is often hard to turn into cash quickly. Clothes can go out of fashion, food can perish, and components may be sold only after they have been made into finished products. The acid test ratio is a stricter test of liquidity that leaves stock out.
The diagram shows why the two ratios can tell different stories. Harbour Outdoor has $1.60 of current assets for every $1 of current liabilities, but without its stock it has only 80 cents. If its suppliers and the bank all asked for payment at once, it would need to sell stock quickly, perhaps at reduced prices, to pay them.
An acid test ratio of about 1 is a common guide: the business could pay all its current liabilities from cash and debtors alone. A value well below 1 is a warning for most businesses, although supermarkets and fast-food chains again operate safely lower because they turn their stock into cash so quickly. The gap between the two liquidity ratios shows how much a business relies on stock to stay liquid.
YouTubeLiquidity improves when a business has more liquid assets relative to its short-term debts. Strategies therefore increase current assets (especially cash), reduce current liabilities, or replace short-term debts with long-term finance. Day-to-day cash shortages are dealt with through cash flow management; the strategies in the table are judged by their effect on the two ratios.
Strategy | Effect on the liquidity ratios | Drawbacks |
|---|---|---|
Sell unused non-current assets for cash | Cash (a current asset) rises, so both ratios rise. | The asset may be needed later; a quick sale may raise a low price. |
Sale and leaseback of property | A large cash inflow raises both ratios. | Rent adds to expenses for years, lowering profit margins; the business no longer owns the asset. |
Convert short-term borrowing into a long-term loan | Current liabilities fall, so both ratios rise. | Interest is paid for longer; long-term debt increases the business’s financial risk. |
Raise new share capital or retain more profit | Cash rises with no new current liability. | Issuing shares dilutes control; retaining profit means lower dividends. |
Reduce stock levels (sell stock, buy less) | Acid test rises if stock is sold for cash; the current ratio changes little. | Lower stock risks running out and losing sales. |
Collect debts faster or sell debts (factoring) | Swaps debtors for cash: both ratios are unchanged, but liquidity in practice improves. | Shorter credit terms may lose customers; factoring costs a fee. |
Some of the strategies in the table improve the business’s ability to pay its debts without changing the ratios, because they only swap one current asset for another. Collecting $200,000 from debtors turns a fairly liquid asset into cash, which makes it easier to pay suppliers, but current assets stay at the same total. Analysts should therefore look at the make-up of current assets as well as the two ratios.
Holding more liquid assets makes a business safer but usually less profitable. Cash in a bank account earns little interest, and stock held “just in case” costs money to store and may lose value. Money tied up in current assets is money not invested in shops, machines or research that could earn a higher return. A business therefore aims for enough liquidity to be safe, not the most liquidity possible.
Many liquidity strategies also move a problem rather than solve it. Replacing an overdraft with a long-term loan improves both ratios immediately, but the debt still has to be repaid, and the business pays interest for longer. A sale and leaseback raises cash once but commits the business to rent for many years. If the underlying cause is weak profitability, the liquidity problem will return.
The best strategy depends on:
The cause of the problem: rapid growth (as at Harbour Outdoor), slow-paying customers, too much stock or falling profits each need a different response.
The type of business: a supermarket can live with low ratios; a manufacturer with long production times cannot.
The cost and availability of finance: loans are cheaper when interest rates are low; a business with weak profits may be refused a loan.
Stakeholder relationships: paying suppliers later improves cash in the short run but can damage trust and lead to worse terms.
Time frame: selling assets helps now; improving profitability and stock control helps for years.
For a growing business such as Harbour Outdoor, a sensible judgment would be to replace some short-term borrowing with long-term finance that matches the long life of the new shops, and to control stock more tightly. Selling assets would be less suitable, because the business needs them to grow.
A ratio becomes useful only when it is compared and explained. Good interpretation goes from the number, to the trend or comparison, to the cause, and then to what it means for the business and its stakeholders.
The five ratios calculated for Harbour Outdoor Ltd show how the pieces fit together.
Ratio | 2024 | 2025 |
|---|---|---|
Gross profit margin | 43.00% | 40.00% |
Profit margin | 12.00% | 10.00% |
ROCE | 19.38% | 16.84% |
Current ratio | 2.00 | 1.60 |
Acid test ratio | 1.14 | 0.80 |
The value of ratios depends on the accuracy of the figures behind them and on the judgment of the person reading them. Their main limitations are:
Limitation | Why it matters |
|---|---|
Based on historical data | Final accounts describe the past year. Ratios may already be out of date when they are published and may not predict future performance, especially in a fast-changing market. |
A snapshot at one date | The statement of financial position shows one day. A toy retailer’s stock and cash on 31 December, just after Christmas, are very different from those in October, so liquidity ratios depend on the date chosen. |
Different accounting policies | Businesses can value stock or depreciate assets differently, and may define items such as “operating profit” in their own way, so ratios of two firms may not be directly comparable. |
Window dressing | Managers may make the accounts look better at the year-end, for example by delaying payments to suppliers or chasing debtors just before the statement date, which flatters the liquidity ratios. |
Ignores qualitative factors | Ratios say nothing about staff morale, brand reputation, the quality of management, customer loyalty or the business’s ethical and environmental record. |
Inflation | Rising prices increase revenue and profit in money terms, so ratios over several years may show growth that is not real; assets bought long ago may be valued well below today’s prices, which raises ROCE. |
One ratio alone can mislead | A high current ratio can hide unsold stock; a high ROCE can come from old, fully depreciated assets that soon need replacing. Ratios must be read together. |
One-off events and different periods | Selling a division, a one-off gain or a longer accounting year (53 weeks instead of 52) distorts comparisons between years or firms. |
Comparisons need similar businesses | Industry averages hide very different firms, and a diversified business may have no true competitor to compare with. |
Because of these limitations, ratios are best used as a starting point for questions. A fall in the acid test ratio shows a manager where to investigate, and the explanation comes from the business’s context, its market and its plans. Ratios are most reliable when they are calculated for several years, compared with similar businesses and combined with qualitative information.
Each of the four key concepts links to the use of ratios in a different way.
Key concept | How it applies to ratio analysis |
|---|---|
Change | Ratios over several years measure how a business responds to change in prices, costs, competition and the economy, and whether its strategies are working. |
Creativity | Creative solutions, such as a new product with a higher margin or a new way to reduce waste, can raise profitability; creativity in reporting, such as window dressing, can mislead stakeholders. |
Ethics | Honest presentation of accounts lets stakeholders trust the ratios. Squeezing suppliers or employees to lift a ratio raises ethical questions. |
Sustainability | A business needs enough profitability and liquidity to survive in the long run; strategies that raise ratios only in the short run (cutting training or maintenance) may threaten that. |
Tesco and J Sainsbury are the two largest supermarket groups in the United Kingdom. Both sell mainly groceries in large stores, convenience stores and online; Tesco also has businesses in Ireland and central Europe, and Sainsbury’s owns the general merchandise retailer Argos. Because they operate in the same market, their published accounts allow a fair comparison of profitability and liquidity.
Figures for FY2025/26 (£m) | Tesco PLC | J Sainsbury plc |
|---|---|---|
Sales revenue | 73,712 | 33,647 |
Cost of sales | (68,174) | (31,441) |
Gross profit | 5,538 | 2,206 |
Expenses (net of other operating income) | (2,553) | (1,309) |
Profit before interest and tax | 2,985 | 897 |
Current assets | 8,483 | 3,514 |
of which stock | 2,840 | 1,987 |
Current liabilities | 14,329 | 6,331 |
Non-current liabilities | 13,688 | 6,462 |
Equity | 11,457 | 6,150 |
Capital employed | 25,145 | 12,612 |
Sources: Tesco PLC, Annual Report and Financial Statements 2026 (53 weeks ended 28 February 2026; cost of sales includes £799m of insurance service expenses); J Sainsbury plc, Annual Report and Financial Statements 2026 (52 weeks ended 28 February 2026). Statutory figures.
Tesco is much larger, with more than twice the sales revenue of Sainsbury’s, so the absolute figures cannot be compared directly, but the ratios can. As the chart shows, Tesco earned a higher gross profit margin (7.51% against 6.56%), a higher profit margin (4.05% against 2.67%) and a much higher ROCE (11.87% against 7.11%).
Both gross profit margins are very low, which is normal for grocery retailing: supermarkets compete fiercely on price and make their profit through very high sales volumes. Tesco’s figures also include fuel sales from its petrol stations, which have very thin margins. Tesco’s higher margins reflect its scale: as the largest buyer of groceries in the country, it can negotiate lower purchase prices and spread the costs of its distribution centres and head office over more sales.
Tesco has used several of the strategies to improve profitability ratios. Tesco’s “save to invest” programme aimed at around £500 million of cost savings in 2025/26 and delivered £535 million; the savings were used partly to keep prices low through Aldi Price Match on more than 600 lines. Tesco also raised sales of its premium Finest range by 15% in the UK, a change in the sales mix towards higher-margin products, and fitted doors to the fridges in 79% of its UK convenience stores to cut energy costs. These choices show the trade-off in practice: cost savings protect the profit margin, but much of the gain is reinvested in lower prices to defend market share.
The chart shows that Tesco’s current ratio of 0.59 and Sainsbury’s of 0.56 are well below 1, which would be alarming for a manufacturer but is normal for supermarkets. Customers pay at the till in cash or by card, so supermarkets have very few debtors. Food sells within days, so stock is small relative to sales. Suppliers, by contrast, are paid on credit some weeks later: Tesco’s trade and other payables were £10,746 million, more than its entire current assets. In effect, suppliers finance the stock on the shelves, which is why current liabilities exceed current assets without causing a liquidity crisis.
The change in Sainsbury’s ratios shows a limitation of ratio analysis. In 2024/25 its statement of financial position still included Sainsbury’s Bank, whose loans to customers and deposits from savers were held for sale; the banking business was transferred to NatWest on 1 May 2025. Its current assets fell from £8,535 million to £3,514 million and its current liabilities from £11,384 million to £6,331 million. The fall in the acid test ratio from 0.58 to 0.24 therefore mainly reflects the removal of the bank from the group’s accounts; the supermarket business itself changed much less.
The ratios suggest that Tesco is the more profitable and slightly more liquid of the two, mainly because of its scale. The comparison has limits. Tesco’s year had 53 weeks and Sainsbury’s 52, which adds about 2% to Tesco’s revenue and profit. Each company presents some items differently: Tesco’s cost of sales includes its insurance business, and Sainsbury’s profit includes income from property. One year’s figures say nothing about future competition from discounters such as Aldi and Lidl, which is one reason both firms spend heavily on prices.
Explain why a current ratio of 0.59 is less worrying for Tesco than it would be for a car manufacturer.
Using the data, analyse how Tesco’s scale helps it to earn a higher ROCE than Sainsbury’s.
Discuss whether Tesco should use its cost savings to cut prices or to raise its profit margin.
Sources: Tesco PLC, Annual Report and Financial Statements 2026 and 2025; J Sainsbury plc, Annual Report and Financial Statements 2026 and 2025. Ratios calculated from the statutory statements.
Ratio analysis appears mostly in Paper 2, which has a quantitative focus, and occasionally in Paper 1. Typical questions ask you to calculate one or two ratios from given accounts [2–4], to comment on or explain the result [2–4], to explain strategies to improve a ratio [4] and, in Section B, to evaluate or recommend a strategy using the ratios [10].
The extended response asks you to use ratios as evidence, weigh options and reach a judgment.
Ratio analysis turns figures from the final accounts into ratios that can be compared over time, with competitors and with targets.
Gross profit margin = (gross profit ÷ sales revenue) × 100; profit margin = (profit before interest and tax ÷ sales revenue) × 100.
ROCE = (profit before interest and tax ÷ capital employed) × 100, where capital employed = non-current liabilities + equity.
Current ratio = current assets ÷ current liabilities (1.5–2 is a common guide); acid test ratio = (current assets − stock) ÷ current liabilities (about 1 is a common guide).
What counts as a good value depends on the industry: supermarkets have low margins and current ratios below 1.
Profitability improves through higher prices, lower costs, a better sales mix or less capital; liquidity improves through more cash, fewer short-term debts or longer-term finance. Every strategy has trade-offs.
Ratios are limited by historical data, accounting policies, window dressing, one-off events and the absence of qualitative factors.
I can define ratio analysis, profitability and liquidity.
I can calculate the gross profit margin, profit margin and ROCE from final accounts, to 2 decimal places.
I can calculate capital employed as non-current liabilities plus equity.
I can calculate the current ratio and the acid test ratio and explain why stock is left out of the acid test.
I can comment on a ratio using a comparison, a cause from the case and its meaning for the business.
I can explain why a profitable business can have poor liquidity.
I can evaluate strategies to improve profitability and liquidity ratios, including their trade-offs.
I can discuss the limitations of ratio analysis.
60.00 %
Profit margin | 20.00 % |
Define the term profit margin.
2 marks
Award [1] for a partial definition that shows some understanding, e.g. “the profit a business makes on its sales” or a description with no reference to revenue.
Award [2] for a full definition, e.g. a profitability ratio that shows profit before interest and tax as a percentage of sales revenue; it measures how much of each dollar of sales is left as profit after all costs of sales and expenses have been paid.
Award [0] for a tautological answer such as “the margin of profit”.
Candidates are not expected to word their definition exactly as above.
Using Table 1, calculate KO’s gross profit margin for 2025 (show all your working).
2 marks
= 50.00 %
Award [1] for correct working and [1] for the correct answer. Award [1] for a correct answer with no working.
Award a maximum of [1] if the % sign is missing.
Using Table 1, calculate KO’s profit margin for 2025 (show all your working).
2 marks
Using Tables 1 and 2 and your answers to (b), explain the change in KO’s profitability between 2024 and 2025.
4 marks
Points may include:
The gross profit margin fell from 60.00 % to 50.00 %: cost of sales rose by 36.7 % (NZ$1 280 000 to NZ$1 750 000) while revenue rose by only 9.4 %, because organic ingredients and compostable packaging raised unit costs and prices rose by only 3 % (paragraph 2).
The profit margin halved from 20.00 % to 10.00 %. As well as the lower gross profit, expenses rose by NZ$120 000, probably because of the two extra website sales staff.
Profit before interest and tax fell from NZ$640 000 to NZ$350 000 even though sales revenue increased, so KO is selling more but keeping much less of each dollar.
The fall may be partly a deliberate choice: the switch supports KO’s environmental image and may build brand value over time.
Award [1]–[2] for a description of the falls in the ratios with little explanation of the causes.
Award [3]–[4] for an explanation of both ratios that uses the data and the case (cost of sales, prices, expenses). Accept OFR from (b).
Discuss whether KO should raise its prices by 10 % to improve its gross profit margin.
10 marks
Illustrative figures (not required): if volume falls 4 %, revenue = 3 500 × 1.10 × 0.96 = NZ$3 696 000 and cost of sales = 1 750 × 0.96 = NZ$1 680 000, so gross profit = NZ$2 016 000 and the GPM rises to 54.55 %. If expenses stay at NZ$1 400 000, PBIT = NZ$616 000 and the profit margin rises to 16.67 %.
Arguments for the price rise:
Raising price is a direct way to improve GPM because cost of sales per unit does not change; on the estimate, GPM recovers to about 54.55 % and PBIT rises by about NZ$266 000.
Demand appears not to be very sensitive to price: a 10 % price rise reduces volume by only 4 %, so revenue rises.
Certified organic ingredients and compostable packaging add real value; a premium price is consistent with a brand “that cares for skin and for the land” and may strengthen its image as a premium brand.
Website customers, who buy directly from KO, may be loyal to its sustainability values and less sensitive to price.
Higher profit protects the long-term (economic) sustainability of KO, the “profit” leg of the triple bottom line.
Arguments against:
The 4 % fall in volume is only an estimate; pharmacy customers are price-conscious (paragraph 3), so volume could fall much more.
Pharmacies may give KO less shelf space, which could damage brand awareness and long-term sales.
Competitors that are cheaper may win market share; KO already raised prices by 3 % in 2025.
Other strategies may improve GPM with less risk: negotiating long-term contracts or bulk discounts with organic growers, reducing packaging waste, or promoting higher-margin products and website sales.
The profit margin also fell because of higher expenses, so a price rise alone will not fully restore the 2024 profit margin of 20.00 %.
Possible conclusion: a judgement such as a smaller or selective price rise (for example, on website sales and gift-shop ranges only), combined with cost savings from suppliers. A recommendation for or against the 10 % rise can gain full marks if it is supported by the data and the case.
Baltic Freight Solutions
[1] Baltic Freight Solutions (BFS) is a logistics company based in Riga, Latvia. It stores and transports goods for food retailers and online sellers in the Baltic states. In 2025 BFS borrowed €1.5m, at an interest rate of 7 % a year, to buy a fleet of refrigerated trucks.
[2] Later in 2025 BFS lost its contract with a supermarket chain, and its warehouse in Daugavpils has been empty since September. The warehouse has a book value of €2.0m and still costs BFS €80 000 a year in security, insurance and maintenance.
[3] The finance director, Ilze Kalniņa, proposes selling the warehouse for €2.0m. She would use €600 000 to clear BFS’s bank overdraft and €1.4m to repay part of its long-term loans. The operations director, Andris Ozols, disagrees: online sales in the region are growing quickly and he believes BFS could win new storage contracts within a year. Property prices in Daugavpils are currently low.
Table 1: Extracts from BFS’s final accounts for the years ending 31 December (€000)
2024 | 2025 | |
|---|---|---|
Sales revenue | 7 200 | 8 000 |
Profit before interest and tax | 1 080 | 900 |
Cash | 320 | 150 |
Debtors | 1 100 | 1 350 |
Stock | 80 | 100 |
Current liabilities (including bank overdraft) | 1 000 | 1 600 |
Non-current liabilities | 3 000 | 4 500 |
Equity | 6 000 | 6 500 |
In 2025 the bank overdraft was €600 000.
Table 2: Selected ratios for BFS in 2024
Ratio | 2024 |
|---|---|
Profit margin | 15.00 % |
ROCE | 12.00 % |
Acid-test ratio | 1.42 |
Using Table 1, calculate BFS’s return on capital employed (ROCE) for 2025 (show all your working).
2 marks
Using Table 1, calculate BFS’s acid-test ratio for 2025 (show all your working).
2 marks
Using Tables 1 and 2 and your answers to (a) and (b), comment on the changes in BFS’s profitability and liquidity between 2024 and 2025.
4 marks
Evaluate Ilze Kalniņa’s proposal to sell the Daugavpils warehouse.
10 marks
Casa Mireles
Casa Mireles (CM) is a family business in Guadalajara, Mexico, that makes hand-carved wooden furniture for homes and hotels. In 2025 a hotel group cancelled an order for 300 dining sets after CM had already made most of them, leaving the finished sets in CM’s warehouse. To pay its carpenters and timber suppliers, CM increased its bank overdraft.
Table 1: Extracts from CM’s statement of financial position as at 31 December 2025 (MXN 000)
MXN 000 | |
|---|---|
Cash | 180 |
Debtors | 1 020 |
Stock | 2 400 |
Bank overdraft | 900 |
Trade creditors | 1 500 |
Table 2: CM’s liquidity ratios in 2024
Ratio | 2024 |
|---|---|
Current ratio | 1.80 |
Acid-test ratio | 0.90 |
Using Table 1, calculate CM’s current ratio for 2025 (show all your working).
2 marks
Using Table 1, calculate CM’s acid-test ratio for 2025 (show all your working).
2 marks
Using Table 2 and your answers to (a), comment on the change in CM’s liquidity between 2024 and 2025.
4 marks
Explain two strategies CM could use to improve its acid-test ratio.
4 marks
= 10.00 %
Award [1] for correct working and [1] for the correct answer. Accept OFR for gross profit from (b)(i).
Award a maximum of [1] if the % sign is missing, unless it has already been penalized in (b)(i).
Limitations of the stimulus: only two years of data; the volume estimate is the marketing manager’s view; no information on competitors’ prices, on the split of sales by channel, or on how customers value the organic switch.
Additional guidance:
If the response makes no use of the data in Tables 1 and 2 or the marketing manager’s estimate, award a maximum of [4].
A one-sided response can be awarded a maximum of [5].
A response without a judgement on whether KO should raise its prices will usually not exceed [6].
Marks should be allocated according to the markbands.
Markbands (10-mark extended response, Papers 1 and 2)
Marks | Level descriptor |
|---|---|
0 | The response does not reach the standard described below. |
1–2 | Little understanding of what the question demands. Business management tools and theories are barely used, or are irrelevant or inaccurate. Little or no reference to the stimulus material. No arguments are made. |
3–4 | Some understanding of what the question demands. Some use of tools and theories, but mostly inaccurate or not relevant. Use of the stimulus is superficial, often no more than the name of the organisation or person. Arguments are mostly unsubstantiated. |
5–6 | Understands what the question demands but addresses it only partially. Some relevant, accurate use of tools and theories. Some relevant use of the stimulus beyond names, but it does not effectively support the argument. Arguments are substantiated but mostly one-sided. |
7–8 | Mostly addresses what the question demands. Mostly relevant, accurate use of tools and theories. The stimulus generally supports the argument, with some lapses in clarity or relevance. Arguments are substantiated and show some balance. |
9–10 | Clear focus on what the question demands. Relevant, accurate use of tools and theories. Relevant stimulus material is integrated effectively to support the argument. Arguments are substantiated and balanced, and the limitations of the case or stimulus material are explained. |
A response with no judgement or conclusion is unlikely to reach the top band of a discuss, evaluate, examine or recommend question.