3.5 Profitability and liquidity ratio analysis Flashcards
Ratio analysis
is a quantitative management tool that compares different financial figures to examine and judge the financial performance of a business. requires figures from final accounts
-used to assess whether financial performance has improved, can be compared to historical figures and rival businesses
Gross profit margin
shows the value of a firm’s gross profit expressed as a percentage of its sales revenue. can be found in profit and loss account
GPM= Gross profit/Sales Revenue x 100
-is expressed as a percentage figure
-The higher the better it is for a business as gross profit goes towards paying its expenses.
GPM improvements
Raising Sales revenue:
1) reducing the selling price of products for which there are many substitute products - this enables the firm to gain a competitive advantage by having lower prices.
2)Raising the selling price for products for which there are few substitutes
3)Using improved marketing strategies to raise sales revenue
—>special promotions and product extension strategies
4)seeking alternative revenue streams
Reducing Direct costs
-cutting direct/labour material costs
Profit Margin
PM=
(Profit before interest and tax/Sales revenue) x 100
Shows the percentage of sales turnover that is turned into overall profit. interest and tax rates fluctuate over time, so profit before interest and tax is useful for historical comparisons. It is a better measure for profitability than the GPM ratio as it accounts for both cost of sales and expenses.
Return on Capital Employed (ROCE)
Measures the financial performance of a firm based on the amount of capital invested. ROCE shows profit as a % of the capital invested into it
The higher the ROCE figure the better!!
ROCE=
(Profit before interest & tax/Capital employed) x 100
capital employed is the sum of owners’ equity plus non-current liabilities.
Capital employed = non-current liabilities + Equity
Liquidity Ratios
look at a businesses ability to pay its short term liabilities
current ratio
Current Assets/Current liabilities
Deals with a firms liquid assets and current liabilities, Reveals whether a firm is able to use its liquid assets to cover its short-term debts within 12 months
the ratio of 1.5 to 2.0 is desirable.
<1.0 means that the short-term debts of the business are greater than its liquid assets, which could jeopardise its survival
>1.5 suggests there is too much cash in the business, there are too many debtors that owe us, too much stock
Acid test Ratio (Quick Ratio
(Current assets - Stock) / Current liabilities
ignores the value of stock
should be 1:1
