3.5 Profitability and liquidity ratio analysis

Question 1

Liquidity

Answer 1

The ability of a firm to pay its short-term debts.

Question 2

The purpose of ratio analysis:

Answer 2

• examine a firms financial position
• assess a firms financial performance
• compare actual figures with projected or budgeted figures
• aid decision-making

Question 3

Profitability ratios

Answer 3

Examine profit in relation to other figures. These ratios tend to be relevant to profit-seeking businesses rather than for not-for-profit organizations.

Question 4

Efficiency ratio

Answer 4

Indicate how well a firm’s resources have been
used, such as the amount of profit generated from the available capital used in the business.

Question 5

Gross profit margin % (formula)

Answer 5

gross profit / sales revenue x 100

Question 6

Net profit margin % (formula)

Answer 6

net profit / sales revenue x 100

Question 7

Return on capital employed (ROCE) (formula)

Answer 7

net profit before interest and tax / total capital employed x 100

Question 8

Capital employed (formula)

Answer 8

loan capital + share capital + retained profit

Question 9

Strategies to improve the profit margin ratios

Answer 9

• increase gross and net profit margin by reducing direct costs – cutting the cost of goods sold
• increase gross and net profit margin by increasing price
• increase net profit margin by reducing overhead costs

Question 10

Strategies for increasing ROCE

Answer 10

• increase net profit without increasing capital employed
  1. raise prices of existing products
  2. develop innovative products and set prices high
  3. reduce variable costs per unit
  4. reduce overheads, such as delayering or reducing promotion costs
  5. increase capital invested in new technology which could lead to an increase in net profits higher than the increase in capital employed
• reduce capital employed
  1. sell assets that contribute nothing or little to sales/profit – use the capital raised to reduce debts

Question 11

Liquidity ratios

Answer 11

Look at the ability of a firm to pay its short-term liabilities, such as by comparing working capital to short-term debts.

Question 12

Current ratio

Answer 12

current assets / current liabilities

Question 13

Acid test ratio

Answer 13

(current assets - stock) / current liabilities

Question 14

Strategies for improving liquidity ratios

Answer 14

• sell off fixed assets for cash
• sell off inventories for cash
• increase loans to inject cash into the business and increase working capital