3.5 Liquidity ratio analyis

Question 1

Calculate the gross profit margin (GPM)

Answer 1

(Gross profit / sales revenue) x 100

Written out: Gross profit divided by sales revenue, multiplied by 100

Growth profit margin represents show effectively the business ‘adds value’ to the inputs

Question 2

Calculate net profit margin (NPM)

Answer 2

NPM = (net profit / sales revenue) x 100

Written out: Net profit divided by sales revenue, multiplied by 100

Measures the overall profitability

(THIS IS NET PROFIT BEFORE INTEREST AND TAX)

Question 3

What is ROCE

Answer 3

ROCE is return on capital employed, it measures the financial performance of a firm compared with the amount of capital invested. It indicates a firm’s profit.

Question 4

How to calculate ROCE

Answer 4

Net profit before interest and tax / capital employed x 100

ROCE = net profit before interest and tax divided by capital employed, multiplied by 100

(USES BOTH P&L AND BALANCE SHEET)

Question 5

Define profit margin

Answer 5

How successful a company is in turning sales revenue into profit

Question 6

Strategies to improve gross profit margins

Answer 6

Raising revenue

• Marketing strategies (offering promotions to customers) (which will increase expenses)
• Alternative revenue streams
• Changing the price (be careful here)

Cutting cost of good solds

• Cheaper suppliers, materials
• Cheaper labour (e.g. outsourcing
• Increase productivity (e.g. automation)
• Impact on brand image

Question 7

Strategies to improve net profit margins

Answer 7

• Reduce expenses/ overheads
• Cheaper rent
• Reduce marketing
• Reduce stationary costs (cheaper pens/ paper/ copy machine)
• First class versus economy class business tickets for EEs
• Reduce indirect cost (Less use of aircon)

Question 8

What are liquidity ratios

Answer 8

Liquidity ratios assess how easily firms can pay short term liabilities (debt)

Question 9

How to calculate current ratios (CR)

Answer 9

Current assets / current liabilities

(IDEALLY 1.5 - 2)

Question 10

How to calculate Acid-test ratio (ATR)

Answer 10

(current assets - stock) / current liabilities

(IDEALLY 1 - 1.5)

Question 11

How to raise CR and ATR

Answer 11

Hold more cash; E.g. don’t invest in new machinery immediately, Opportunity cost

Take out long term loans to inject cash; E.g. Long term loans to pay overdraft and creditors, increase interest payments and risky

Selling fixed assets for cash; E.g. sell your factory, May not get market value, now you have to pay rent (increase expenses, so reduces NPM), E.g. sale and lease back factory

Sale of inventories for cash; May have to sell at a discount , Reduces revenue and GPM

Question 12

Define current assets

Answer 12

cash coming in the next 12 months (stock, cash, debtors)

Question 13

Define current liabilities

Answer 13

cash going out in the next 12 months (overdraft, short term loan, creditors)

Question 14

Define capital employed

Answer 14

The total capital invested in the business

(non-current assets + current assets) - current liabilities + shareholder equity = capital employed

Question 15

How to increase ROCE

Answer 15

Increase NET profit by using capital more efficiently

Question 16

Purpose of ratio analysis

Answer 16

Examine a firm’s financial position

• Profitability
• Efficiency
• Liquidity (cash flow)

Allows better comparison

• E.g. company A and company B both make a net profit of $1M Which is better?
• Company A’s revenue was $10M, company B revenue was $100M