3.5 - profitability and liquidity ratio analysis

Question 1

what is a ratio

Answer 1

A ratio is one number expressed in terms of another (i.e. in a class there are 30 girls and 20 boys, so the male to female ratio is 2:3, that is for every 2 boys there are 3 girls in the class)

Question 2

what are the 3 points of a ratio analysis

Answer 2

• It is a quantitative management tool for analysing and judging the financial performance of a business. We do this by calculating the financial ratios from the organization’s final accounts.
• Current figures are normally compared with historical figures to asses if the financial performance of the company has improved.
• They are also used to compare performance with competitors

Question 3

state 4 purposes of a ratio analysis

Answer 3

1. Assess a firm’s financial position
2. Examine a firms financial performance
3. Compare actual figures with projected or budgeted figures (this is know as variance analysis)
4. Help with decision making (i.e. if investors should risk their money on the business)

Question 4

what are the 2 ways ratios are compared

Answer 4

1. Historical – compares the same ratio in two different time periods for the same business (i.e. trends that might help the managers to asses the financial performance over time)
2. Inter-firm – involved comparing the ratios of firms in the same industry (i.e. the two firms might have the same profits but their sales revenue is different). Care should be taking on comparing business in the same industry, it has to be ‘like to like’ (i.e. Coca- Cola with Pepsi)

Question 5

what are 3 things you can address about a formula

Answer 5

• How does the firm perform over time? (based on trend)
• How is the business performing? (based on financial data)
• What extra things need to be considered if they are not in the data? (business objectives)

Question 6

what are the 3 wats ratios can be expressed

Answer 6

1. Numbers in terms of another (2:3)
2. Percentages
3. number of days

Question 7

what does a profitability ratio do

Answer 7

it assesses the performance of the firm in terms of profitability. It basically examines the profit in relation to other figures (i.e. the ratio of profit to sales revenue).

Question 8

what are the 3 types of profitability ratio

Answer 8

• gross margin profit (GPM)
• net profit margin (NPM)
• return on capital employed (ROCE)

Question 9

state the formula for gross profit margin (GPM)

Answer 9

GPM = gross profit/sales revenue X 100 –> %

Question 10

If a firm has a gross profit of £120 million and a sales revenue of £200 million , that means that the firms GPM will be 60%.
what does this tell us

Answer 10

This means that for every £100 of sales £60 is gross profits (leaving the remaining £40 as cost of production.

Question 11

What does a higher GPM mean

Answer 11

The higher the GPM the better it is for the business as gross profit goes towards paying expenses

Question 12

What are 4 possible strategies to improve the GPM

Answer 12

Increase prices - Firms can increase their prices in less competitive markets or where customers are not sensitive to prices changes. Inevitably, an increase in price raises the sales Revenue. However, this could damage the image of the business and some loyal customers will feel betrayed.

Use cheaper suppliers - This will help reducing the cost of sales and help increase the GPM. However, the firm needs to be careful not to compromise the quality of their products since they can create customer dislike.

Aggressive promotional strategies - This could definite increase sales and hence increase the GPM. However, too expensive promotional strategies could also increase the costs to the point that the increase in sales will not be worth it.

Reduce direct la out costs - Basically, use less staff (select the more productive staff and literally get rid of the rest). This could apply to either employees that produce more or employees that sell more. However, the company needs to be aware of staff demotivation and maybe face the opposite effect.

Question 13

Define net profit margin (NPM)

Answer 13

This is a mesure of the profit that remains after deducting all costs from the sales revenue. It represents the percentage of the sales turnover that is turned into net profit

Question 14

What is the equation for net profit margin

Answer 14

NPM= net profit before interest and tax/sales revenue x 100

Question 15

What would a net profit margin ratio on 35% mean

Answer 15

A NPM ratio of 35% means that for every £100 of sales £35 is the net profit. This will be the amount of profit left after the production costs are accounted for.

Question 16

Is the NPM or the GPM a better measure

Answer 16

The NPM is a better measure than the GPM as it takes into account both (direct and indirect) costs. Same as with the GPM, the higher the NPM the better is for the firm.

Question 17

What represents the expenses

Answer 17

The difference between the GPM and the NPM represent the expenses.

Question 18

State 3 strategies to improve the NPM

Answer 18

Negotiate preferential payment terms with creditors and suppliers - Firms can negotiate discounts or delay payments which will improve the firm’s working capital (total current assets and total current liabilities). However, debts to suppliers need to be paid anyway.

Reduce indirect costs - Organizations can analyse “where” can they cut costs. For example, manager can fly in business instead of first class; reduce advertising, stationary etc. This could, however, demotivate staff.

Negotiate cheaper rent - This is mainly to improve cash flow. Nevertheless, it could mean that the firms will need to a location that won’t be as attractive to customers.

Question 19

Define efficiency ratio

Answer 19

Shows how well a firmes financial resources are being used. Basically, how well an organisations internally utilices it’s assets and liabilities

Question 20

State the efficiency ration equation (ROCE)

Answer 20

ROCE =net profit before interest and tax/capital employed X 100

Question 21

State the capital employed equation

Answer 21

Capital employed = non - current liabilities + equity

Question 22

State the equity equation

Answer 22

equity = share capital + retain profit

Question 23

State 3 points that a ROCE of 20% would show

Answer 23

r This means that for every £100 of capital invested the firm generates £20 as a net profit before interest and tax.
r The higher the ROCE the greater the return the firm gets form the capital employed and its an incentive for owners to put more money in the business.
r The ROCE analyses how well a firm is able to generate profits from its key sources of finance.

Question 24

What are 2 strategies for improving the ROCE

Answer 24

Reduce the amount of loan capital - This can keep the net profit unchanged but the firm will face the challenges of the ‘lack’ of cash that was probably destined to something specific (i.e. buy new machinery)

Pay additional dividends to stake holders - This will reduce the retain profits and therefore increase the ROCE (assuming the net profit remains unchanged). However, reducing retain profit can affect the future ‘internal investment’ if the firm.

Question 25

Define liquidity ratios

Answer 25

calculate how easily a firm can pay its short term financial obligations (debt) from its current assets. Basically how quickly an asset can be converted into cash.

Question 26

State the 2 main types of liquidity ratios

Answer 26

• the current ratio
• the acid test (quick) ratio

Question 27

What does the current ratio compare

Answer 27

compares the firms current assets and the current liabilities (which we can obtain from the balance Sheet).

Question 28

State the equation for current ratio

Answer 28

Current ratio = current assets/current liabilities

Question 29

If a firm had current assets of 1 mil and its current liabilities are 500,000 what is there current ratio

Answer 29

their Current ratio will be 2 which can also be expressed as 2:1, meaning that for every £1 of current liabilities the firm has £2 of current assets.

Question 30

What is a good current ratio

Answer 30

• A ratio between 1.5 and 2.5 would suggest acceptable liquidity
• A low ratio (possibly below 1) might indicate liquidity problems
• A very high current ratio (i.e. 5) is not so good since it might suggest that there is ‘too much’ assets that are not properly used (i.e. too much stock that needs to be sold, too much cash is been held and not invested)
• Of course every business is different and the ratios will vary. It is also important to compare the ratios with competitors to assess the position the firm is in.

Question 31

What are 2 possible strategies to improve current ratio

Answer 31

Reduce bank overdrafts - The firm can seek for long-term loans instead and this will reduce the current liabilities. Nevertheless, increasing long-term loans will increase the interest rate affecting its future liquidity position

Sell long term assets for cash - This will increase the available working capital for the business but when the items are needed in the long run the firm will have to face the costs (i.e. lease the asset)

Question 32

Define acid test ratio

Answer 32

this is a more accurate indicator that shows how well a firm can meet its short-term obligations since it removes the stock as part of the current assets.

Question 33

What is the acid test ratio equation

Answer 33

Acid test ratio = current assets - stock/current liabilities

Question 34

What is the acid test ratio when a firms current assets is 1 mill and it’s current liabilities is 500,000

Answer 34

the Acid test ratio will be 1.5. Which means that for every £1 of current liabilities the business has £1.5 less of current assets less stock

Question 35

What can you analyse from the acid ratio test

Answer 35

• By removing the stock the firm gets rid of the less liquid current assets and focusses on the most liquid ones (i.e. cash in the bank).
• The acid ratio shows to creditors how much of a firms short-term debit
  can be paid by selling its liquid assets at short notice.
• Same as with the current ratio an acid ratio of less than 1 might indicate liquidity problems. Ultimately that means that the firm wont be able to pay its short-term debts.
• A high acid ratio has the same repercussion as a current ratio except
  that there is no stock to be considered.

Question 36

What are 2 strategies to improve the acid ratio test

Answer 36

Sell of stock at a discount price - This will help the business raise quick cash to pay its short-term debts. However, selling stock at a lower price will reduce the sales revenue and hence reduce the profits.

Increase its credit period - This will help the firm to purchase more stock on credit but the main problem is that it will increase debt.

Question 37

What are 5 limitations of financial ratios

Answer 37

• It is difficult to generalize about whether a ratio is good or not, it all depends on the type of business.
• Different accounting practices can distort comparisons even within the same company (i.e. leasing versus buying equipment)
• A company may have some good and some bad ratios, making it difficult to tell if it’s a good or weak company.
• Seasonal factors can also distort ratio analysis. Understanding seasonal factors that affect a business can reduce the chance of misinterpretation (i.e. a retailer’s inventory may be high in the summer in preparation for the back-to-school season)

-Many large firms operate different divisions in different industries. For these companies it is difficult to find a meaningful set of industry-average ratios.