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3.5. Profitability and Liquidity Ratio Analysis Summary

  • Profitability and liquidity ratio analysis
    • A management tool of analyzing and judging the financial performance of a business
    • Numbers are taken from the final accountsPurpose
      • To analyze the firm’s position (e.g. short-term liquidity, long-term liquidity, etc.)Assess financial performances (i.e. ability to control expenses)Compare actual with projected or budgeted figures (variance analysis)Aid in decision-making (to invest or not)
    • Ratio comparison can be:
      • Historical comparison (2 different time periods to show trends)
      • Inter-firm comparisons (same industry)
  • Profitability ratios
    • These examine profit in relation to other figures
    • Relevant to profit-seeking businesses
    • Stakeholders’ interest
    • Absolute profit – tell little on a firm’s performance
    • Gross profit margin
      • Shows the value of gross profit as a percentage of sales revenueGPM = (Gross profit / Sales revenue) x 100Improve the ratio by
        • Raising sales revenue
        • Increase or decrease prices (depending on price elasticity)MarketingReducing direct costs
      Net profit margin
      • Shows the percentage of sales turnover turned into net profitNPM = (Net profit before interest and tax / Sales revenue) x 100Differences between GPM and NPM represent expensesLarger difference means more difficult overhead control
      • Improve the ratio by
        • Same as GPM but costs can be examined further
        • Negotiate preferential payment terms with creditors and suppliers to improve working capitalNegotiate cheaper rent
        • Reduce indirect costs
    • Return on capital employed (ROCE)
      • Measures the financial performance of a firm compared with the amount of capital invested rose = (Net profit before interest and tax / Capital employed)Figures show profit as a % of the capital used to generate itROCE should be higher than interest rate in banksBenchmark: 20% ROCE, but has to be put into context of the business and the industry in which it operatesROCE is the key/primary ratio
        • Using your net profit before tax and interest as this allows better comparisons – can’t control interest and tax rates
        • Measures how well a firm is able to generate profit from its funds
      • ROCE can be improved by
        • Employ strategies to improve net profits
        • Technically decreasing capital employed will improve the ratio, but this is not desirable
  • Liquidity ratios
    • Ability of the firm to pay its short term liabilities current ratio
      • Relationship between current assets and current liabilities current ratio = (Current assets / Current liabilities)Reveals if a firm is able to use its liquid assets to cover its short term debtsDesirable ratio: 1.5 – 2.0> 2: may mean too much stocks (inventory) or too much stagnant money (just standing there not being spent)Too low = too many debtors or current liabilities
      • How to improve current ratio
        • Raising the value of current assets
        • Reducing the value of current liabilities
    • Acid test ratio
      • Relationship between the current assets (disregarding stock) and current liabilities
      • This is done because stock may not be a liquid asset
      • Acid test ratio = (Current assets less stocks / Current Liabilities)
      • Desirable Ratio is AT LEAST 1:1
      • < 1:1 ratio = liquidity crisis (not being able to pay short term debts
      • Too high indicates holding too much cash and not using it effectively
      • Affected stakeholders are the banks, creditors, and investors
      • How can it be improved
        • Raise level of current assets
        • Lower current liabilities

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