3.5 Flashcards
Gross profit margin
Calculated by dividing the gross profit by the sales revenue, expressed as a percentage
Ratio analysis
This is a financial analysis tool used to interpret and assess financial statements which helps evaluate a firm’s financial performance by determining trends and exposing strengths and weaknesses. It helps in decision-making by making historical or interfirm comparisons by analysing past ratios and the ratios of other businesses in similar industries.
Profit margin
Calculated by dividing the (net) profit before interest and tax by the sales revenue, expressed as a percentage
Profitability ratios
Assess the performance of a firm in terms of profit generating ability. Two types of profitability ratios are gross profit margin and profit margin.
Strategies to improve gross profit margin
- increase prices for products where price elasticity of demand is inelastic. A drawback of this is that it could damage the image of the business with loyal customers.
- Source cheaper suppliers of materials to cut down purchase costs which will reduce cost of sales and increase gross profit margin. The business needs to be careful not to compromise the quality of the materials bought which could lead to customer resentment.
- Adopt more aggressive promotional strategies to persuade customers to buy products but ensure that they do not use expensive campaigns that will lead to increased costs.this means that they could adopt SMM or they could use word-of-mouth promotion
- reduce direct labour costs by ensuring staff is productive or are able to sell more units of the goods produced. Unproductive staff will need to be let go of however this should be done with care to ensure that the remaining staff are not demotivated
Strategies to improve profit margin
- Referred to the strategies to improve gross profit margin
- Check indirect costs and avoid unnecessary expenses, for example reduce expenditure on expensive holiday packages for senior managers. But note that this could demoralise the managers who are used to the holiday packages
- Negotiate with key stakeholders to cut costs, for example with landlords for cheaper rent or with suppliers for product discounts.but this could potentially lead to the firm having to move to another location where the firm could lose prestige
Return on capital employed (ROCE)
Assesses the returns a firm is making from its capital employed
Formula for capital employed
Non-current liabilities + equity
The importance of ROCE
It acts as an incentive for business owners to inject more money into the business.it analyses and judges how well the firm is able to generate profit from its key sources of finance. comparisons of ROCE should be made throughout past years and to other firms to get a better assessment of the performance of the firm
Strategies to improve ROCE
- strategies to improve gross profit margin and profit margin
- try to reduce amount of long-term loans while ensuring that profit before interest and tax remains unchanged. an issue is that long-term loans may be needed to purchase essential fixed assets (machinery) which will aid the further production of goods that could be sold to generate more profit
- declare and pay additional dividends to shareholders which will reduce retained profit and hence raise ROCE, assuming profit before interest and tax remains unchanged or does not decrease. A problem is that reducing retained profit leads to less availability of it for future investment
Liquidity ratios
Liquidity ratios measure the ability of a firm to pay off short-term debt obligations, businesses needs sufficient levels of liquid assets to help them pay day-to-day bills. liquidity is a measure of how quickly an asset can be converted into cash. liquid assets include cash and others such as stock and debtors that can quickly be turned into cash (Current assets). 2 important liquidity ratios are current ratio and acid test ratio
Current ratio
A ratio that compares a firms current assets to its current liabilities
The range of a current ratio
A current ratio should be between 1.5:2.the range will allow for the availability of sufficient working capital to pay off short term debts.
Causes of a high current ratio
- too much cash being held and not invested, this should be used for example in purchasing non-current assets
- There are too many debtors, in increasing the possibility of bad debts
- Too much stock is being held leading to high warehouse storage costs
Strategies to improve current ratio
- reduce bank overdraft and seek long-term loans.this helps reduce current liabilities and improve the current ratio.however increasing long-term loans could increase interest payable and the gearing ratio could be affected, affecting the efficiency and future liquidity of the firm
- Sell existing long-term assets for cash which would increase the working capital available for the business.however if the long-term assets are needed the business will have to lease them which can be expensive.
Acid test ratio or quick ratio
A stringent ratio that subtracts stock from current assets and compares this to current liabilities
Why stock is removed in acid test ratio
Stock is the least liquid of current assets, allowing the ratio to focus on the most liquid ones. in some cases there is no guarantee that stock can be sold, eventually leading to obsolete items
Importance of acid test ratio
Indicates to creditors how much of a firm’s short-term debts can be met by selling its liquid assets at short notice. the recommended ratio is 1:1, if it is less the business is not in financial health and could potentially be facing a liquidity crisis and should be scrutinise with extreme caution by financial institutions.
Strategies to improve acid test ratio
- sell off stock at a discount for cash which will make more working capital available to pay off short-term debts. However, selling stock at a discount could reduce revenue generated thereby reducing firm’s profits.
- Increase credit period for debtors to enable them to purchase more stock on credit. the problem is that it may lead to increase bad debts in the business if the debtors do not pay.
