3.5. Profitability and Liquidity Ratio Analysis

Question 1

Purpose of profitability and liquidity ratio analysis

Answer 1

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)

Question 2

Ratio comparison can be between

Answer 2

Historical comparison (2 different time periods to show trends)

Inter-firm comparisons (same industry)

Question 3

Profitability ratios

Answer 3

These examine profit in relation to other figures

Relevant to profit-seeking businesses
Stakeholders’ interest

Question 4

Gross profit margin equation

Answer 4

(Gross profit / Sales revenue) x 100

Question 5

What does the gross profit margin show?

Answer 5

Shows the value of gross profit as a percentage of sales revenue

Question 6

How to improve the gross profit margin?

Answer 6

Raising sales revenue

Reducing direct costs (or Cost of goods sold)

Increase or decrease prices (depending on price elasticity)

Marketing

Question 7

How to improve a bad NPM if GPM is good?

Answer 7

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.

Question 8

Net profit margin equation

Answer 8

(Net profit before interest and tax / Sales revenue) x 100

Question 9

What does the profit margin show?

Answer 9

Shows the percentage of sales turnover remaining as a net profit

Question 10

What does the difference between GPM and NPM represent?

Answer 10

Larger difference means more difficult overhead/expences/indirect cost control

Question 11

How to improve the profit margin?

Answer 11

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

Question 12

What does the return on capital employed (ROCE) measure?

Answer 12

Measures the financial performance of a firm compared with the amount of capital invested

Question 13

What is the equation for ROCE?

Answer 13

(Net profit before interest and tax / Capital employed (less current liabilities)

Question 14

ROCE can be improved by

Answer 14

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

Question 15

ROCE should be higher than what?

Answer 15

ROCE should be higher than interest rate in banks

Question 16

Benchmark for ROCE

Answer 16

20% ROCE, but has to be put into context of the business and the industry in which it operates

Question 17

Use of liquidity ratios

Answer 17

Ability of the firm to pay its short term liabilities

Question 18

Current ratio shows what?

Answer 18

Relationship between current assets and current liabilities

Question 19

Equation of current ratio?

Answer 19

(Current assets / Current liabilities)

Question 20

Desirable ratio for current ratio

Answer 20

1.5 – 2.0

Question 21

What does it means if current ratio is over 2?

Answer 21

May mean too much stocks (inventory) or too much stagnant money (just standing there not being spent)

Question 22

What does it means if current ratio is under 1.5?

Answer 22

Too low = too little cash?, too much current liabilities
(Level of debtors does not have direct effect if they don’t default)

Question 23

How to improve current ratio?

Answer 23

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

Question 24

What does acid test ratio show?

Answer 24

Relationship between the current assets (disregarding stock) and current liabilities

Question 25

Why is acid test ratio done?

Answer 25

This is done because stock may not be a liquid asset

Question 26

Equation of acid test ratio

Answer 26

(Current assets less stocks / Current Liabilities)

Question 27

Desirable ratio for acid test ratio

Answer 27

AT LEAST 1:1

Question 28

What does it mean if acid test ratio is less than 1:1?

Answer 28

Liquidity crisis (not being able to pay short term debts

Question 29

What does it mean if acid test ratio is too high?

Answer 29

Too high indicates holding too much cash and not using it effectively

Question 30

What are the affected stakeholders?

Answer 30

The banks, creditors, and investors

Question 31

How to improve acid test ratio?

Answer 31

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

Question 32

Risks of High current ratio?

Answer 32

1. too much cost held and missed opportunities (high opportunity cost)
2. too many receivables (debtors) may lead to too much bad debt
3. too much stock (if not acid test, stock may get obsolete, high storage costs etc)