3.5 - profitability and liquidity ratio analysis Flashcards
(37 cards)
what is a ratio
A ratio is 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)
what are the 3 points of a ratio analysis
- It is 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
state 4 purposes of a ratio analysis
- 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)
what are the 2 ways ratios are compared
- Historical – 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)
- Inter-firm – 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)
what are 3 things you can address about a formula
- How does the firm perform over time? (based on trend)
- How is the business performing? (based on financial data)
- What extra things need to be considered if they are not in the data? (business objectives)
what are the 3 wats ratios can be expressed
- Numbers in terms of another (2:3)
- Percentages
- number of days
what does a profitability ratio do
it 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).
what are the 3 types of profitability ratio
- gross margin profit (GPM)
- net profit margin (NPM)
- return on capital employed (ROCE)
state the formula for gross profit margin (GPM)
GPM = gross profit/sales revenue X 100 –> %
If a firm has a gross profit of £120 million and a sales revenue of £200 million , that means that the firms GPM will be 60%.
what does this tell us
This means that for every £100 of sales £60 is gross profits (leaving the remaining £40 as cost of production.
What does a higher GPM mean
The higher the GPM the better it is for the business as gross profit goes towards paying expenses
What are 4 possible strategies to improve the GPM
Increase prices - Firms can increase their prices in less competitive markets or where customers are not sensitive to prices changes. Inevitably, an increase in price raises the sales Revenue. However, this could damage the image of the business and some loyal customers will feel betrayed.
Use cheaper suppliers - This will help reducing the cost of sales and help increase the GPM. However, the firm needs to be careful not to compromise the quality of their products since they can create customer dislike.
Aggressive promotional strategies - This could definite increase sales and hence increase the GPM. However, too expensive promotional strategies could also increase the costs to the point that the increase in sales will not be worth it.
Reduce direct la out costs - Basically, use less staff (select the more productive staff and literally get rid of the rest). This could apply to either employees that produce more or employees that sell more. However, the company needs to be aware of staff demotivation and maybe face the opposite effect.
Define net profit margin (NPM)
This is a mesure 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
What is the equation for net profit margin
NPM= net profit before interest and tax/sales revenue x 100
What would a net profit margin ratio on 35% mean
A NPM ratio of 35% means that for every £100 of sales £35 is the net profit. This will be the amount of profit left after the production costs are accounted for.
Is the NPM or the GPM a better measure
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.
What represents the expenses
The difference between the GPM and the NPM represent the expenses.
State 3 strategies to improve the NPM
Negotiate preferential payment terms with creditors and suppliers - Firms can negotiate discounts or delay payments which will improve the firm’s working capital (total current assets and total current liabilities). However, debts to suppliers need to be paid anyway.
Reduce indirect costs - Organizations can analyse “where” can they cut costs. For example, manager can fly in business instead of first class; reduce advertising, stationary etc. This could, however, demotivate staff.
Negotiate cheaper rent - This is mainly to improve cash flow. Nevertheless, it could mean that the firms will need to a location that won’t be as attractive to customers.
Define efficiency ratio
Shows how well a firmes financial resources are being used. Basically, how well an organisations internally utilices it’s assets and liabilities
State the efficiency ration equation (ROCE)
ROCE =net profit before interest and tax/capital employed X 100
State the capital employed equation
Capital employed = non - current liabilities + equity
State the equity equation
equity = share capital + retain profit
State 3 points that a ROCE of 20% would show
r This means that for every £100 of capital invested the firm generates £20 as a net profit before interest and tax.
r The higher the ROCE the greater the return the firm gets form the capital employed and its an incentive for owners to put more money in the business.
r The ROCE analyses how well a firm is able to generate profits from its key sources of finance.
What are 2 strategies for improving the ROCE
Reduce the amount of loan capital - This can keep the net profit unchanged but the firm will face the challenges of the ‘lack’ of cash that was probably destined to something specific (i.e. buy new machinery)
Pay additional dividends to stake holders - This will reduce the retain profits and therefore increase the ROCE (assuming the net profit remains unchanged). However, reducing retain profit can affect the future ‘internal investment’ if the firm.
