3.5 Profitability & Liquidity Ratio Analysis Flashcards
(22 cards)
Define Ratio Analysis
- quantitative financial tool
- used to assess the financial performance + position of a business.
- helps stakeholders (managers, investors, banks, etc.) evaluate profitability, liquidity, + overall efficiency by analysing data from financial statements (balance sheet + income statement)
What are profitability Ratios
= measure a firm’s ability to generate profit relative to sales revenue, assets, or capital employed.
They show how efficiently a business converts its revenue into profit
Used by: Managers, investors, shareholders to assess financial performance and make comparisons over time or with competitors.
What is Gross Profit Margin
= profitability ratio that shows the percentage of sales revenue remaining after deducting cost of sales
State formula and interpretation of Gross Profit Margin
Formula:
GPM = (Gross Profit ÷ Sales Revenue) × 100
Interpretation:
Higher GPM = more efficient control over direct production costs (raw materials, labour).
State 4 strategies to improve Gross Profit Margin
- Increase price of products (if demand is price inelastic)
- Source cheaper raw materials or suppliers
- Reduce direct costs (e.g., through outsourcing or automation)
- Focus on high-margin products
Define profit margin
(sometimes referred as profitability)
= percentage of sales revenue left after all costs (direct and indirect) have been paid.
State formula and interpretation of Profit Margin
Formula:
PM = (Profit before interest and tax ÷ Sales Revenue) × 100
Interpretation:
Higher PM = stronger control over all expenses and overheads.
What are strategies to improve the Profit Margin
Reduce overheads (e.g., rent, utilities, admin staff costs)
Improve operational efficiency
Renegotiate fixed contracts to cut expenses (e.g., leases, insurance)
⬆️ revenue w/out raising costs (eg ⬆️ if demand inelastic)
What doesn’t affect Gross profit margin? And therefore what could I say could improve it?
Expenses don’t affect gross profit margin
; so when asked how to improve can’t say reduce expenses, but rather reducing costs to improving production efficiency
What is return on capital employed (ROCE)
= measures how efficiently a business generates profit from its capital employed
(Capital = anything that ⬆️ a firm’s ability to generate revenue (cash, assets, investment))
interpretation ROCE
Interpretation:
Higher ROCE = better return on investment for shareholders and lenders
Strategies to improve Return On Capital Employed
- Increase profit (by increasing revenue or reducing costs)
- Sell underused assets (⬇️ capital employed)
- Use cheaper sources of finance
Define liquidity ratios:
= measure a firm’s ability to meet its short-term debts using its current assets.
Used by: Creditors, suppliers, banks—to assess risk of default and short-term financial stability.
Define current ratios:
= shows whether a firm has enough liquid assets to pay off its short-term liabilities.
(For every current liability do you have enough current assets to cover that if there’s an emergency)
Formula, interpretation and ideal ratio for current ratio
Formula:
Current Ratio = Current Assets ÷ Current Liabilities
Interpretation:
Ideal ratio: 1.5–2:1 (if exceeds 2 often in efficient current assets, could be invested) (less than 1.5 = not good)
<1:1 = liquidity crisis risk. (Bc means they have more liabilities than assets)
Strategies to improve Current ratio:
- Increase current assets (e.g., boost cash via sales or loans)
- Decrease current liabilities (e.g., repay short-term loans)
- Negotiate better trade credit terms with suppliers
- Reduce bank overdrafts & seek instead long-term loans; BUT this increases gearing (portion of capital from loans vs equity) = business riskier + ⬇️attractive to investors
- Sell non-current assets for cash to ⬆️ current assets —> if asset was importantly they may have to now lease it instead = recurring rental = ⬆️ expenses in long term
Define Acid Test Ratio
= measures a firm’s ability to pay short-term liabilities without relying on inventory.
Formula acid test retail and interpretation +ideal ratio
Formula:
Acid-Test = (Current Assets – Stock) ÷ Current Liabilities
(We ignore stock(inventory) as it isn’t a very liquid asset, making this action more accurate in emergencies)
In an emergency if you have to turn you stock into something liquid, you’d have to sell it at a big discount
Interpretation:
Ideal ratio: 1:1and 1:1.5
<1 = firm may struggle without quickly converting stock.
State 1 reason why acid test ratio is better than liquidity ratio
✅ more realistic measure of the liquidity of a business as it ignores stock, which isn’t a very liquid asset, therefore better for emergencies
What are strategies to improve Acid Test ratio:
- Convert stock into cash faster (e.g., reduce inventory) (sell of stock at a discount for cash —> consider impact on revenue)
- Improve cash flow (e.g., encourage quicker customer payments)
- Reduce reliance on short-term borrowing
- Increase credit period for debtors to enable them to purchase more stock on credit —> may increase bad debts
Evaluate the use of ratio analysis (4/4)
✅ Identifies strengths & weaknesses in financial performance
✅ Supports budgeting, investment, and strategic decision-making
✅ Enables comparison with competitors or industry benchmarks
✅ Monitors progress over time
❌ Based on past data — may not reflect current conditions
❌ Ignores qualitative factors (e.g., brand reputation, staff morale)
❌ Doesn’t consider inflation, seasonality, or external shocks
What is capital employed + 3 formulas
Total funds used by the firm:
= non-current liabilities + equity (equity = share capital + retained earnings)
= total assets - current liabilities
= non current assets + (current assets - current liabilities)
Thing In bracket also = working capital
