The Truth About Profitability and Liquidity Ratios

Why Some Businesses Sink While Others Stay Afloat: The Truth About Profitability and Liquidity Ratios

Let's go back to 2024 for a sec, It's December 2024, and Party City - you know, that shop with the birthday balloons and terrible Halloween costumes - is shuttering all 700 of its stores. For the second time in less than two years, they've filed for bankruptcy. Meanwhile, just down the high street, Greggs is boasting record sales. In 2024, they pulled in £2.01 billion in revenue and opened nearly 150 new shops. Same economy. Same customers dealing with the cost-of-living crisis. Completely different outcomes.

What's the difference? Well, it's not just about selling better sausage rolls (though that helps). It's about understanding two critical things that every business needs to survive: profitability and liquidity. Think of profitability as your ability to make money, and liquidity as your ability to actually pay your bills when they're due. You can be profitable and still go bust if you can't pay your rent next Tuesday.

Let's dig into how businesses actually measure these things, and more importantly, why this entry is extremely relevant whether you're running a corner shop or analysing companies for your IB Business Management exams.

Profitability: It's Not Just About Making Money

Everyone knows what profit is, but not everyone knows how to properly measure it. That's where profitability ratios come in. They're basically the report card for how well a business turns sales into actual money they can keep.

Gross Profit Margin: The First Cut

Greggs reported a profit margin of 7.6% in 2024, slightly down from the previous year. But what does that actually mean?

Gross Profit Margin (GPM) is the most basic profitability measure. It tells you what percentage of your sales revenue you keep after paying for the stuff you sold. The formula is dead simple:

GPM = (Gross Profit ÷ Sales Revenue) × 100

Let's say you run a food truck selling gourmet burgers. You make £10,000 in sales revenue this month. The ingredients, packaging, and direct costs (your cost of sales) come to £6,000. Your gross profit is £4,000, giving you a GPM of 40%.

That 40% is what you've got left to pay for everything else - rent, wages, electricity, that dodgy neon sign you bought on eBay.

In the real world, GPM varies greatly by industry. UK construction companies average just 2.4% profit margins - they're operating on razor-thin margins where one delayed project can sink them. Meanwhile, luxury goods or software companies might see GPMs of 60-80% because their cost of sales is relatively low.

How to improve your GPM:

• Negotiate better deals with suppliers (lower cost of sales)

• Raise prices without losing too many customers (higher revenue per unit)

• Launch premium products with better margins

• Cut out the middleman where possible

Profit Margin: The Reality Check

Gross profit is all well and good, but it doesn't tell the whole story. You've also got to pay for literally everything else - salaries, rent, marketing, that software subscription you forgot to cancel. That's where profit margin (also called net profit margin) comes in.

Profit Margin = (Profit Before Interest and Tax ÷ Sales Revenue) × 100

Using our burger truck example: if you've got that £4,000 gross profit but £3,000 in expenses (rent, wages, insurance), your actual profit is £1,000. That gives you a profit margin of 10%.

The average profit margin for UK small businesses stood at 8.8% in Q2 2024, down from 10.7% the year before - a sign that rising costs are squeezing businesses everywhere.

This is the number that really matters. You can have brilliant gross profit margins, but if your expenses are out of control, you're going nowhere fast.

How to improve profit margin:

• Cut unnecessary expenses (do you really need that office plant subscription?)

• Relocate to cheaper premises if rent is killing you

• Automate processes to reduce labour costs

• Improve efficiency - waste less, produce more

Return on Capital Employed (ROCE): The Efficiency Trophy

ROCE tells you how efficiently you're using the money invested in your business. It's something big for investors because it shows whether their cash is actually working hard or just sitting there like a lazy houseplant.

ROCE = (Profit Before Interest and Tax ÷ Capital Employed) × 100

Capital employed is basically all the money that's been pumped into the business - both debt and equity. You'll find it on the balance sheet as non-current liabilities plus equity.

Think of it like this: if you invest £100,000 in a business and it generates £15,000 in profit, your ROCE is 15%. That's actually pretty decent - better than leaving it in most savings accounts. The average net rate of return for UK private companies was 8.8% in Q2 2024, so anything above that and you're doing alright.

How to improve ROCE:

• Increase sales revenue through better marketing or new products

• Reduce costs through economies of scale

• Use your assets more efficiently (don't let stock sit around gathering dust)

• Improve quality management to reduce waste

When Profitable Companies Still Go Down: The Liquidity Crisis

You're profitable on paper, your profit margins look great, but you can't pay your suppliers this Friday because all your money is tied up in stock or owed to you by customers who pay late.

Welcome to a liquidity crisis.

IB Business Management Real-life example: In 2025, Kohl's faced mounting pressure from vendors demanding stricter payment terms, with some cases extending payment schedules to 90 days, triggering lawsuits from suppliers like PSK Collective for £8 million in unpaid invoices. This is what happens when liquidity dries up - suppliers lose trust, credit gets cut off, and suddenly you're in a death spiral.

Liquidity ratios measure whether you've got enough cash and near-cash assets to pay your short-term debts. There are two main ones you need to know.

Current Ratio: The Safety Net

The current ratio is the most straightforward liquidity measure:

Current Ratio = Current Assets ÷ Current Liabilities

Current assets are things you can turn into cash within a year: actual cash, money owed to you by customers (debtors), and stock. Current liabilities are debts due within a year: bank overdrafts, money you owe suppliers (creditors), and short-term loans.

If your current assets are £15 million and current liabilities are £7.5 million, your current ratio is 2:1. For every £1 you owe in the short term, you've got £2 in liquid assets. Lovely.

The bare minimum is 1:1, but honestly, that's cutting it fine. Most businesses aim for 1.5:1 or 2:1 to give themselves a buffer.

A current ratio that's too high isn't necessarily brilliant either. If it's sitting at 5:1, that might mean you're hoarding cash that should be invested in growth, or you've got mountains of unsold stock cluttering your warehouse.

How to improve your current ratio:

• Encourage customers to pay in cash (offer discounts for immediate payment)

• Move excess cash into accounts that earn interest but keep it accessible

• Pay off short-term debts using your cash reserves

• Negotiate longer payment terms with suppliers (giving you more breathing room)

• Convert short-term debt into long-term debt (spreading repayments over more time)

Acid Test Ratio: The Harsh Truth

The acid test ratio (also called the quick ratio) strips out stock from current assets because, let's face it, not all stock is easy to shift quickly.

Acid Test Ratio = (Current Assets – Stock) ÷ Current Liabilities

If you run a furniture shop and half your current assets are sofas that have been sitting in the showroom for six months, those aren't exactly "liquid." You can't pay your electricity bill with a sofa (trust me, British Gas won't accept it).

Say your current assets are £15.6 million, stock is £1.8 million, and current liabilities are £11.2 million. Your acid test ratio is (£15.6m - £1.8m) ÷ £11.2m = 1.23:1.

Anything below 1:1 is a red flag. It means that without selling your stock, you can't cover your short-term debts.

How to improve the acid test ratio:

• Use the same strategies as the current ratio

• Get better at stock management - don't order more than you can sell

• Introduce just-in-time inventory systems

• Clear out slow-moving stock, even at a discount, to free up cash

IB Business Management Real-life Examples

Greggs

Greggs grew revenue by 11% to £2.01 billion in 2024 with a profit margin of 7.6%. They're not operating on massive margins - 7.6% isn't exactly luxury-brand territory - but they're efficient, they manage costs well, and crucially, they've maintained strong liquidity throughout economic turbulence.

They've done this by:

• Opening 140-150 new locations annually (increasing revenue)

• Investing in digital transformation and their app

• Managing evening trade growth (diversifying income streams)

• Controlling costs despite rising wages and input prices

The 2024-2025 Retail Bankruptcy Wave

In 2024, nearly 20 significant retail bankruptcies occurred, including Party City (second bankruptcy in two years), Big Lots, Express, and The Container Store. These weren't all unprofitable businesses - some made money on paper. But they shared common liquidity problems:

• Too much debt choking cash flow

• Inventory management disasters (stock they couldn't sell)

• Delayed payments triggering supplier crises

• Inability to adapt to e-commerce and changing consumer habits

Over 15,000 US retail stores closed between 2024 and 2025, driven by inflation, e-commerce disruption, and shifting consumer preferences. Many of these could have survived with better liquidity management.

Why Is This Relevant For Your IB Business Management Exams

Examiners love ratio analysis because they want to see you:

1. Calculate the ratios correctly (obviously)

2. Interpret what they mean (a 40% GPM is brilliant for a restaurant, terrible for a tech company)

3. Compare over time (are ratios improving or deteriorating?)

4. Make recommendations (what should the business actually do about it?)

Remember: a single ratio in isolation tells you almost nothing. You need context. You need comparisons. You need to understand the industry, the economic climate, and the specific circumstances of the business.

Also, keep in mind that profitability and liquidity often pull in opposite directions. Actions that boost profitability (like offering long credit terms to customers to win sales) can destroy liquidity (because you're waiting months to get paid).

The Bottom Line

Party City had profitability problems and liquidity problems. Greggs has figured out how to stay profitable while maintaining healthy liquidity. The difference between success and bankruptcy often comes down to understanding these numbers and, more importantly, doing something about them before it's too late.

So next time you're walking past a Greggs, munching on a sausage roll, just remember: you're looking at a masterclass in ratio management. And when you see another shop closing down with "Everything Must Go" signs, there's a good chance their ratios were flashing red long before the shutters came down.

Stay well,