3.5. Profitability and Liquidity Ratio Analysis Flashcards
Purpose of profitability and liquidity ratio analysis
To analyse 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 between
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 equation
(Gross profit / Sales revenue) x 100
What does the gross profit margin show?
Shows the value of gross profit as a percentage of sales revenue
How to improve the gross profit margin?
Raising sales revenue
Increase or decrease prices (depending on price elasticity)
Marketing
Reducing direct costs
Net profit margin equation
(Net profit before interest and tax / Sales revenue) x 100
What does the profit margin show?
Shows the percentage of sales turnover turned into net profit
What does the difference between GPM and NPM represent?
Larger difference means more difficult overhead control
How to improve the profit margin?
Same as GPM but costs can be examined further
Negotiate preferential payment terms with creditors and suppliers to improve working capital
Negotiate cheaper rent
Reduce indirect costs
What does the return on capital employed (ROCE) measure?
Measures the financial performance of a firm compared with the amount of capital invested
What is the equation for ROCE?
(Net profit before interest and tax / Capital employed)
ROCE can be improved by
Employ strategies to improve net profits
Technically decreasing capital employed will improve the ratio, but this is not desirable
ROCE should be higher than what?
ROCE should be higher than interest rate in banks
Benchmark for ROCE
20% ROCE, but has to be put into context of the business and the industry in which it operates
Use of liquidity ratios
Ability of the firm to pay its short term liabilities
Current ratio shows what?
Relationship between current assets and current liabilities
Equation of current ratio?
(Current assets / Current liabilities)
Desirable ratio for current ratio
1.5 – 2.0
What does it means if current ratio is over 2?
May mean too much stocks (inventory) or too much stagnant money (just standing there not being spent)
What does it means if current ratio is under 1.5?
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
What does acid test ratio show?
Relationship between the current assets (disregarding stock) and current liabilities
Why is acid test ratio done?
This is done because stock may not be a liquid asset
Equation of acid test ratio
(Current assets less stocks / Current Liabilities)
Desirable ratio for acid test ratio
AT LEAST 1:1
What does it mean if acid test ratio is less than 1:1?
Liquidity crisis (not being able to pay short term debts
What does it mean if acid test ratio is too high?
Too high indicates holding too much cash and not using it effectively
What are the affected stakeholders?
The banks, creditors, and investors
How to improve acid test ratio?
Raise level of current assets
Lower current liabilities
