3.5. Profitability and Liquidity Ratio Analysis

Question 1

Purpose of profitability and liquidity ratio analysis

Answer 1

To analyse the firm’s position (e.g. short-term liquidity, long-term liquidity, etc.)

Assess financial performances (i.e. ability to control expenses)

Compare actual with projected or budgeted figures (variance analysis)

Aid in decision-making (to invest or not)

Question 2

Ratio comparison can be between

Answer 2

Historical comparison (2 different time periods to show trends)

Inter-firm comparisons (same industry)

Question 3

Profitability ratios

Answer 3

These examine profit in relation to other figures

Relevant to profit-seeking businesses
Stakeholders’ interest

Absolute profit – tell little on a firm’s performance

Question 4

Gross profit margin equation

Answer 4

(Gross profit / Sales revenue) x 100

Question 5

What does the gross profit margin show?

Answer 5

Shows the value of gross profit as a percentage of sales revenue

Question 6

How to improve the gross profit margin?

Answer 6

Raising sales revenue

Increase or decrease prices (depending on price elasticity)

Marketing

Reducing direct costs

Question 7

Net profit margin equation

Answer 7

(Net profit before interest and tax / Sales revenue) x 100

Question 8

What does the profit margin show?

Answer 8

Shows the percentage of sales turnover turned into net profit

Question 9

What does the difference between GPM and NPM represent?

Answer 9

Larger difference means more difficult overhead control

Question 10

How to improve the profit margin?

Answer 10

Same as GPM but costs can be examined further

Negotiate preferential payment terms with creditors and suppliers to improve working capital

Negotiate cheaper rent

Reduce indirect costs

Question 11

What does the return on capital employed (ROCE) measure?

Answer 11

Measures the financial performance of a firm compared with the amount of capital invested

Question 12

What is the equation for ROCE?

Answer 12

(Net profit before interest and tax / Capital employed)

Question 13

ROCE can be improved by

Answer 13

Employ strategies to improve net profits

Technically decreasing capital employed will improve the ratio, but this is not desirable

Question 14

ROCE should be higher than what?

Answer 14

ROCE should be higher than interest rate in banks

Question 15

Benchmark for ROCE

Answer 15

20% ROCE, but has to be put into context of the business and the industry in which it operates

Question 16

Use of liquidity ratios

Answer 16

Ability of the firm to pay its short term liabilities

Question 17

Current ratio shows what?

Answer 17

Relationship between current assets and current liabilities

Question 18

Equation of current ratio?

Answer 18

(Current assets / Current liabilities)

Question 19

Desirable ratio for current ratio

Answer 19

1.5 – 2.0

Question 20

What does it means if current ratio is over 2?

Answer 20

May mean too much stocks (inventory) or too much stagnant money (just standing there not being spent)

Question 21

What does it means if current ratio is under 1.5?

Answer 21

Too low = too many debtors or current liabilities

Question 22

How to improve current ratio?

Answer 22

Raising the value of current assets

Reducing the value of current liabilities

Question 23

What does acid test ratio show?

Answer 23

Relationship between the current assets (disregarding stock) and current liabilities

Question 24

Why is acid test ratio done?

Answer 24

This is done because stock may not be a liquid asset

Question 25

Equation of acid test ratio

Answer 25

(Current assets less stocks / Current Liabilities)

Question 26

Desirable ratio for acid test ratio

Answer 26

AT LEAST 1:1

Question 27

What does it mean if acid test ratio is less than 1:1?

Answer 27

Liquidity crisis (not being able to pay short term debts

Question 28

What does it mean if acid test ratio is too high?

Answer 28

Too high indicates holding too much cash and not using it effectively

Question 29

What are the affected stakeholders?

Answer 29

The banks, creditors, and investors

Question 30

How to improve acid test ratio?

Answer 30

Raise level of current assets

Lower current liabilities