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IB DP Business Management — Unit 3: Finance and Accounts | SL | 3.4 Profitability and Liquidity Ratio Analysis
📋 What You Will Learn
- Define liquidity and explain why it is distinct from profitability as a measure of financial health
- State and apply the formulae for the current ratio and the acid-test (quick) ratio
- Interpret ratio results against benchmarks and identify what they reveal about a firm's short-term financial position
- Analyse the statement of financial position to extract the correct figures for each ratio
- Evaluate the usefulness and limitations of liquidity ratios as decision-making tools
- Recommend appropriate action when a business faces a liquidity problem
📊 Topic Importance
| Paper | Relevance | Common Question Types |
|---|---|---|
| Paper 1 | High | Calculate ratios from the pre-seen company's accounts; "Evaluate" or "Recommend" a course of action to improve liquidity |
| Paper 2 | High | Section B: calculate current ratio and acid-test from a stimulus balance sheet; Section C: discuss liquidity management linked to a concept (e.g. change, sustainability) |
| Paper 3 (HL) | Moderate | Use liquidity ratios to justify a recommendation for a social enterprise facing cash constraints |
🔍 Guiding Question A business can be profitable on paper yet still collapse — so how do managers and creditors judge whether a firm can actually pay its bills when they fall due?
🌍 Why This Matters In 2023, UK retailer Wilko — a profitable business for much of its history — entered administration not because it was losing money on every sale, but because it could not meet short-term payments to suppliers. Liquidity, not profitability, was the fatal weakness. A single ratio calculated months earlier might have flagged the danger.
What Is Liquidity — and Why Does It Matter?
Profitability tells you whether a business is making money over time. Liquidity tells you whether it can survive the next few weeks. A firm can be highly profitable in its income statement and still become insolvent if it cannot convert assets into cash quickly enough to pay creditors.
📘 Liquidity The ability of a business to meet its short-term financial obligations as they fall due — that is, to convert assets into cash quickly enough to pay creditors, wages, and other current liabilities without disruption to operations.
- Liquid assets are assets that can be converted to cash quickly and without significant loss of value — cash itself, trade receivables, and short-term investments.
- Illiquid assets — such as property, machinery, and inventory — take time or incur costs to convert to cash.
- Liquidity is a short-term concern; solvency is the long-term equivalent (can the business pay all its debts, ever?).
- Poor liquidity is one of the most common