PROFITABILITY AND LIQUIDITY RATIO ANALYSIS Flashcards
Profitability Ratios
Asses the performance of a firm in terms of its profit-generating ability. Two types: Gross profit margin and profit margin.
Gross Profit margin
It is calculated by dividing the gross profit by the sales revenue, expressed as a percentage.
Strategies to improve gross profit margin
- Increase prices in markets where there is less competition or where there is less price sensitivity. This increases sales revenue. However, it could damage the image of the business with loyal consumers.
- Source cheaper suppliers in order to cut down its purchase costs. Help reduce cost or sales. Careful not to compromise the quality of the goods.
- Aggressive promotional strategies to persuade customers. careful not to use expensive campaigns.
- Reduce direct labor costs by increasing productivity. Care should be taken to not demotivate.
Profit Margin
Measure of the profit that remains after deducting all costs from the sales revenue.
It is calculated by dividing the profit before interest and tax with the sales revenue and times by 100.
Strategies to improve profit margin
- Carefully check indirect costs to see what unnecessary expenses can be avoided. Example: reducing expenditure on holiday packages for senior managers. Careful to not demoralize the managers who are used to expensive holidays.
- Negotiate with key stakeholders with the aim of cutting costs. Example: Landlords for cheaper rent or suppliers. However, it can drive business to unideal situations and a firm could loose its prestige.
All the measures should be collectively used in effort to both raise gross profit margins and profit margin.
Return on capital employed
Measures the profitability of a firm’s invested capital. It assesses the returns a firm is making from its capital employed.
Return on capital employed formula
profit before interest and tax / capital employed x 100
Startegies to improve ROCE
- Reduce the amount of long-term loans, to reduce interest costs, while still ensuring that profit before interest and tax remains unchanged. However the long term loans may be needed to purchase essential fixed assets.
- Could declare and pay additional dividends to shareholders. This will reduce the retained profit and thus raise the ROCE. However, reducing retained profit leads to less ploughed-back profit for future investment.
Capital employed formula
non-current liabilities + equity
Liquidity Ratios
Measure the ability of a firm to pay off its short-term debt obligations. Suffieicnt liquidity levels are needed to pay day to day bills.
Liquidity is a measure of how quickly an asset can be converted into cash.
Liquid assets include: cash, debtors and stock.
Two types of liquidity ratios: current ratio and acid test ratio
Current ratio
Compares a firm’s current assets to its current liabilities.
Many recommend the range 1.5:2 because it ensures sufficient working capital to pay off short term debts of the business.
Current Ratio formula
current assets/current liabilities
A high current ratio could mean:
- Too much cash being held and not inveted. Could be used to purchase non current assets.
- Many debtors, increasing the possibility of bad debts
- Too much stock is being held, leading to high warehouse storage costs.
Startegies to improve current ratios
- Reduce bank overdrafts and seek long term loans. This reduces current liabilities and thus improve current ratios. However, it could increase the interest payable and the gearing ratio, thereby affecting its efficiency and future liquidity position.
- Sell existing long term assets for cash. Increases the available working capital. However, if the same long term assets are needed the business will have to lease them which can be costly
Acid Test Ratio
More precise indicator of how well a firm is able to pay its short-term obligations. It removes the stock from the current assets because it is the least liquid current asset, because in some cases there is no guarantee that a stock will be sold and it can lead to obsolete items.
