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) or with historical data, or with competitors
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
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
Reducing direct costs (or Cost of goods sold)
Increase or decrease prices (depending on price elasticity)
Marketing
How to improve a bad NPM if GPM is good?
Good GPM means, that Direct costs (COGS) are well controlled, and only acceptable amounts of direct costs are to be deducted. But l indirect costs, also called overheads or expenses, such as administrative salaries, and rent, are above acceptable and need to be addressed.
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 remaining as a net profit
What does the difference between GPM and NPM represent?
Larger difference means more difficult overhead/expences/indirect cost control
How to improve the profit margin?
Both types of costs may be needed to be examined, direct and indirect.
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 (less current liabilities)
ROCE can be improved by
Strategies to improve net profits mentioned above, such as reduction of different types of costs, raising sales etc
Technically, decreasing capital employed will improve the ratio, but this may not be 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 little cash?, too much current liabilities
(Level of debtors does not have direct effect if they don’t default)
How to improve current ratio?
Raising the value of current assets (e.g. offer to customers longer credit periods to boost sales/debtor value)
Reducing the value of current liabilities
(e.g. getting long-tern loan, which is not included in this calculation and repay short-term/ overdraft/current liabilities)
or raising or lowering both but one more than the other:
e.g. selling machinery and leasing it back will raise cash more than 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,
(e.g. as the level of stock will not have an effect on the ratio, selling it and getting cash will have a direct positive affect)
Lower current liabilities
Risks of High current ratio?
- too much cost held and missed opportunities (high opportunity cost)
- too many receivables (debtors) may lead to too much bad debt
- too much stock (if not acid test, stock may get obsolete, high storage costs etc)
