Profitability and Liquidity

Question 1

ratio

Answer 1

one number expressed in terms of another (i.e. in a class there are 30 girls and 20 boys, so the male to female ratio is 2:3, that is for every 2 boys there are 3 girls in the class)

Question 2

ratio analysis

Answer 2

A quantitative management tool for analysing and judging the financial performance of a business. We do this by calculating the financial ratios from the organization’s final accounts.
Current figures are normally compared with historical figures to asses if the financial performance of the company has improved.
They are also used to compare performance with competitors

Question 3

purpose of ratio analysis

Answer 3

Assess a firm’s financial position
Examine a firms financial performance
Compare actual figures with projected or budgeted figures (this is know as variance analysis)
Help with decision making (i.e. if investors should risk their money on the business)

Question 4

ratios are compared in two ways

Answer 4

historical, inter-firm

Question 5

historical

Answer 5

compares the same ratio in two different time periods for the same business (i.e. trends that might help the managers to asses the financial performance over time)

Question 6

inter-firm

Answer 6

involved comparing the ratios of firms in the same industry (i.e. the two firms might have the same profits but their sales revenue is different). Care should be taking on comparing business in the same industry, it has to be ‘like to like’ (i.e. Coca- Cola with Pepsi)

Question 7

3 types of ratios

Answer 7

profitability ratios, efficiency ratios, liquidity ratios

Question 8

profitability ratios

Answer 8

assesses the performance of the firm in terms of profitability. It basically examines the profit in relation to other figures (i.e. the ratio of profit to sales revenue).

Question 9

two types of profitability ratios

Answer 9

Gross margin profit (GPM)
Net profit margin (NPM)

Question 10

gross margin profit (GPM)

Answer 10

expressed as a percentage (%) is found by dividing the gross profit by the sales revenue:
𝑮𝑷𝑴=(𝒈𝒓𝒐𝒔𝒔 𝒑𝒓𝒐𝒇𝒊𝒕)/(𝒔𝒂𝒍𝒆𝒔 𝒓𝒆𝒗𝒆𝒏𝒖𝒆)x100

Question 11

possible strategies to improve GPM

Answer 11

Increase prices, use cheaper supplies, aggressive promotional strategies, reduce direct labour costs

Question 12

net profit margin (NPM)

Answer 12

measure of the profit that remains after deducting all costs from the sales revenue. It represents the percentage of the sales turnover that is turned into net profit.
𝑵𝑷𝑴=(𝒏𝒆𝒕 𝒑𝒓𝒐𝒇𝒊𝒕 𝒃𝒆𝒇𝒐𝒓𝒆 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒂𝒏𝒅 𝒕𝒂𝒙)/(𝒔𝒂𝒍𝒆𝒔 𝒓𝒆𝒗𝒆𝒏𝒖𝒆)x100

Question 13

difference between NPM and GPM

Answer 13

The NPM is a better measure than the GPM as it takes into account both (direct and indirect) costs. Same as with the GPM, the higher the NPM the better is for the firm.
The difference between the GPM and the NPM represent the expenses.

Question 14

strategies to improve NPM

Answer 14

negotiate preferential payment terms with creditors and suppliers, reduce indirect costs, negotiate cheaper rent

Question 15

efficiency ratios

Answer 15

show how well a firm’s financial resources are being used. Basically, how well an organizations internally utilizes its assets and liabilities.
The only efficiency ratio used by SL is the Return on Capital Employed (ROCE) ratio which measures both the efficiency and profitability of a firm’s invested capital.

𝑹𝑶𝑪𝑬=(𝑵𝒆𝒕 𝒑𝒓𝒐𝒇𝒊𝒕 𝒃𝒆𝒇𝒐𝒓𝒆 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒂𝒏𝒅 𝒕𝒂𝒙)/(𝒄𝒂𝒑𝒊𝒕𝒂𝒍 𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒅)x100

Question 16

capital employed formula

Answer 16

𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒅 =𝒏𝒐𝒏−𝒄𝒖𝒓𝒓𝒆𝒏𝒕 𝒍𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔+𝒆𝒒𝒖𝒊𝒕𝒚

Question 17

equity formula

Answer 17

equity = share capital + retain profit

Question 18

strategies to improve ROCE

Answer 18

reduce the amount of loan capital, pay additional dividends to stakeholders (reduce retain profits thus increase ROCE)

Question 19

liquidity ratios

Answer 19

calculate how easily a firm can pay its short term financial obligations (debt) from its current assets. Basically how quickly an asset can be converted into cash.

Question 20

2 main liquidity ratios

Answer 20

current ratio, acid test (quick ratio)

Question 21

current ratio

Answer 21

compares the firms current assets and the current liabilities (which we can obtain from the balance Sheet).

𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒓𝒂𝒕𝒊𝒐=(𝒄𝒖𝒓𝒓𝒆𝒏𝒕 𝒂𝒔𝒔𝒆𝒕𝒔)/(𝒄𝒖𝒓𝒓𝒆𝒏𝒕 𝒍𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔 )

Question 22

current ratio levels

Answer 22

Most business will aim for a Current ratio higher than 1. More specifically:
A ratio between 1.5 and 2.5 would suggest acceptable liquidity
A low ratio (possibly below 1) might indicate liquidity problems
A very high current ratio (i.e. 5) is not so good since it might suggest that there is ‘too much’ assets that are not properly used (i.e. too much stock that needs to be sold, too much cash is been held and not invested)

Question 23

possible strategies to improve current ratios

Answer 23

reduce bank overdrafts, sell long term assets for cash,

Question 24

acid test (quick) ratio

Answer 24

this is a more accurate indicator that shows how well a firm can meet its short-term obligations since it removes the stock as part of the current assets.

𝑨𝒄𝒊𝒅 𝒕𝒆𝒔𝒕 𝒓𝒂𝒕𝒊𝒐=(𝒄𝒖𝒓𝒓𝒆𝒏𝒕 𝒂𝒔𝒔𝒆𝒕𝒔−𝒔𝒕𝒐𝒄𝒌)/(𝒄𝒖𝒓𝒓𝒆𝒏𝒕 𝒍𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔 )

By removing the stock the firm gets rid of the less liquid current assets and focusses on the most liquid ones (i.e. cash in the bank).
The acid ratio shows to creditors how much of a firms short-term debit can be paid by selling its liquid assets at short notice.

Question 25

acid test ratio levels

Answer 25

Same as with the current ratio an acid ratio of less than 1 might indicate liquidity problems. Ultimately that means that the firm wont be able to pay its short-term debts.
A high acid ratio has the same repercussion as a current ratio except that there is no stock to be considered.

Question 26

strategies to improve acid test ratio

Answer 26

sell of stock at discount price, increase its credit period

Question 27

limitations of financial ratios

Answer 27

It is difficult to generalize about whether a ratio is good or not, it all depends on the type of business.
Different accounting practices can distort comparisons even within the same company (i.e. leasing versus buying equipment)
A company may have some good and some bad ratios, making it difficult to tell if it’s a good or weak company.

Question 28

limitations of financial ratios pt 2

Answer 28

Seasonal factors can also distort ratio analysis. Understanding seasonal factors that affect a business can reduce the chance of misinterpretation (i.e. a retailer’s inventory may be high in the summer in preparation for the back-to-school season)
Many large firms operate different divisions in different industries. For these companies it is difficult to find a meaningful set of industry-average ratios.