Measuring the financial performance of a business Flashcards
What is profitability?
The ability to earn profit compared to a base figure such as sales, average assets or owner’s investment
What are the profitability indicators?
- Gross profit margin
- Net profit margin
- Return on assets
- Asset turnover
- Return on owner’s investment
Gross profit margin (GPM)
= (Gross profit / Net sales) x 100
- Measures the avg mark-up of inventory by calculating the percentage of sales revenue retained as gross profit after cost of goods sold has been deducted
- Expressed as percentage
How can GPM be improved?
- Increase avg selling price of stock
- Decrease avg cost prices (bulk buying, cheaper suppliers)
- Decrease sales returns
Net profit margin (NPM)
= (Net profit / Net sales) x 100
- Measures expense control by calculating % of sales retained as net profit
- Expressed as percentage
How can NPM be improved?
- Increase avg selling price of stock
- Decrease avg cost prices
- Decrease sales returns
Return on assets (ROA)
= (Net profit / Avg total assets) x 100
- Measures how effectively business has used assets to earn profit
- Expressed as percentage
How can ROA be improved?
- Reduce value of avg assets (use assets efficiently, sell idle/unproductive assets)
- Improve net profit through expense control
Asset turnover (ATO)
= Net sales / Avg total assets
- Measures the number of times in a period the value of assets is earned as sales revenue
- Expressed as times per period
How can ATO be improved?
- Increase net sales
- Decrease avg total assets
Return on owner’s investment (ROI)
= (Net profit / Avg OE) x 100
- Measures how effectively business has used owner’s capital to earn profit
- Expressed as percentage
How can ROI be improved?
- Improve net profit through expense control/sales growth
- Reduce avg OE by using liabilities to fund assets
What is liquidity?
The ability to meet short term debts as they fall due
What are the liquidity indicators?
- Cash flow cover
- Working capital ratio
- Quick asset ratio
Cash flow cover (CFC)
= Net flows from operating activities / Avg current liabilities
- Measures the number of times net cash flows from operating activities is able to cover avg current liabilities
- Expressed as times per period
How can CFC be improved?
- Increase net cash flows from operating activities
- Decrease avg current liabilities
Working capital ratio (WCR)
= Current assets / Current liabilities
- Measures the ratio of current assets to current liabilities
- Assesses firm’s ability to meet short term debts
- Expressed as a ratio current assets:1
How can WCR be improved?
- Increase CA
- Decrease CL
Quick asset ratio (QAR)
= (CA - inventory - prepaid expenses) / (Current liabilities)
- Measures the ratio of quick assets to current liabilities to assess the business’ ability to meet its immediate debts
- Expressed as ratio quick assets:1
How can QAR be improved?
- Increase CA
- Decrease CL
What is efficiency?
Using assets as well as possible to generate sales, cash flow, and profit.
What are the efficiency indicators?
- Inventory turnover
- Accounts payable turnover
- Accounts receivable turnover
Inventory turnover (ITO)
= (Avg inventory / Cost of good sold) x 365
- Measures avg number of days it takes the business to convert inventory into sales
- Expressed in number of days
How can ITO be improved?
- Decrease avg inventory
- Increase COGS
