3.5 - Profitability and liquidity ratio analysis Flashcards
What is quantitative analysis?
Quantitative financial analysis is a tool for judging the financial perfomance of the business based on financial statements. Data comes from balance sheet and proft and loss account.
What are the two types of ratios?
Profitability and liquidity
What do profitability ratios do?
Examine an organisations profit making ability:
* Gross profit margin shows the percentage of gross profit in relation to revenue
* Profit margin shows the percentage of net profit before interest and tax in relation to revenue
* ROCE shows how well capital employed is used in making profit
What is gross profit margin?
(Gross profit/revenue) * 100. The higher the GPM, the easier it is to pay expenses.
What are the strategies to improve gross profit margin?
Raise revenue by increasing or reducing prices, increase promotion or decrease costs of sales by using cheaper suppliers or cutting labour costs.
What are the advantages of rasing revenues by increasing/reducing prices?
- If you increase the price and there are not many alternatives, people will still pay the higher price
- if there are many alternatives to your product, decreasing the price will make more people buy your product because it will be cheaper than competitors
What are the disadvantages of rasing revenues by increasing/reducing prices?
Increasing/decreasing prices can impact brand image negatively:
* Increasing prices may lead to customers believing that you are taking advantage of them
* Decreasing prices may make customes doubt the quality of your product
What are the advantages and disadvantages of raising revenues by increasing promotion?
- More people will be aware about your business and product
- Advertising/promotion costs will increase
- No guarantee that if people know about your product they will buy it
What are the advantages and disadvantages to reducing cost of sales by using cheaper suppliers?
Overall lower costs but lower quality
What is the profit margin formula?
(profit before interest and tax/revenue)*100
What does a higher profit margin indicate?
The organisation has better control of its revenue.
What are the methods of improving profit margin?
- Improve working capital by: negotiating longer trade credit period, negotiating discounts
- Reduce expenses by delayering, cutting overheads
What are the disadvantages of improving profit margin through negotiating longer trade credit period?
Relationship with creditors might worsen and the costs might be higher for the business.
What are the advantages of improving profit margin through negotiating discounts?
Lower prices than usual will be paid.
What are the disadvantages of improving profit margin through negotiating discounts?
Puts pressure on the business, as early payments need to be made and cash needs to be available.
What are the advantages of improving profit margin through delayering?
Delayering(getting rid of an entire level of management)-> Managerial costs will decrease
What are the disadvantages of improving profit margin through delayering?
Span of control increases, managers will have to superwise more people and loss of control can occur
What are the advantages of improving profit margin through cutting overheads?
overheads(indirect costs). Lower costs, increased profit margin.
What are the disadvantages of improving profit margin through delayering?
possible dissatisfaction among employees.
What is the formula for ROCE(return on captial employed)
(profit before interest and tax/capital employed)*100
What does a high ROCE mean?
The higher the ROCE, the more the profit an organisation generates from invested capital
How can ROCE be improved?
Keep profits high and reduce capital employed.
* Minimise non current liabilities by reducing long term loans
* Reduce retained profits by paying more dividends
What are the disadvantages of improving ROCE by minimising non current liabilities by reducing long term loans?
Long term loans are essential to sustain long term growth of the business.
What are the disadvantages of improving ROCE by reducing retained profits by paying more dividends?
If the business does not retain profit, it will need to rely on long term sources of finance. This will have an effect on long term goals.
What is liquidity?
The extent to which it is plausible for business to convert assets into cash.
What does the liquidity ratio examine?
They examine the firms ability to pay for current liabilities.
What are liquid assets?
(current assets) assets which can be easily transformed into cash.
What is current ratio?
A ratio which compares an organisation’s current assets with its current liabilities.
What is the formula for current ratio?
current assets/current liabilities
What is the desirable current ratio range?
between 1.5:1 to 2:1
What does a current ratio of less than 1:1 mean?
Liquidity problems.
What does a current ratio of 2:1 mean?
too much either cash(depreciating asset), debtors(bad debt) and stock(unsold goods)
What are the strategies to improving the current ratio?
- increase current assets by selling non-current assets for cash
- Decrease current liabilities by using long term sources of finance rather than short term sources of finance
What are the advantages of improving current ratio by increasing current assets?
- more cash which gives flexibility in paying for short term loans
What are the disadvantages of improving current ratio by increasing current assets?
- too much cash is a depreciating asset
What are the advantages of improving current ratio by using long term SOFs?
More cash at hand, more flexible in paying for current liabilities
What are the disadvantages of improving current ratio by using long term SOFs?
The business might not have sufficient cash to pay for the daily operations
What is the acid test ratio?
It measures how sufficient the short term liquidity is to cover its short term debts.
What is the formula for acid test ratio?
(current assets-stock)/current liabilities
What does a current ratio of less than 1:1 mean?
liquidity problems.
What does a current ratio of 2:1 mean?
too much either cash(depreciating asset), debtors(bad debt)
Strategies to improve acid test ratio?
Same as current ratio but to get rid of stock but by selling it with a discount.
What are the advantages of improving acid test ratio by selling stock with a discount?
Improves liquidity as there will be more cash at hand.
What are the disadvantages of improving acid test ratio by selling stock with a discount?
Lower revenues, which means that there will be an effect on the organisations profitability in the long term
