3.5 - Profitability and liquidity ratio analysis

Question 1

What is quantitative analysis?

Answer 1

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.

Question 2

What are the two types of ratios?

Answer 2

Profitability and liquidity

Question 3

What do profitability ratios do?

Answer 3

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

Question 4

What is gross profit margin?

Answer 4

(Gross profit/revenue) * 100. The higher the GPM, the easier it is to pay expenses.

Question 5

What are the strategies to improve gross profit margin?

Answer 5

Raise revenue by increasing or reducing prices, increase promotion or decrease costs of sales by using cheaper suppliers or cutting labour costs.

Question 6

What are the advantages of rasing revenues by increasing/reducing prices?

Answer 6

1. If you increase the price and there are not many alternatives, people will still pay the higher price
2. 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

Question 7

What are the disadvantages of rasing revenues by increasing/reducing prices?

Answer 7

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

Question 8

What are the advantages and disadvantages of raising revenues by increasing promotion?

Answer 8

• 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

Question 9

What are the advantages and disadvantages to reducing cost of sales by using cheaper suppliers?

Answer 9

Overall lower costs but lower quality

Question 10

What is the profit margin formula?

Answer 10

(profit before interest and tax/revenue)*100

Question 11

What does a higher profit margin indicate?

Answer 11

The organisation has better control of its revenue.

Question 12

What are the methods of improving profit margin?

Answer 12

• Improve working capital by: negotiating longer trade credit period, negotiating discounts
• Reduce expenses by delayering, cutting overheads

Question 13

What are the disadvantages of improving profit margin through negotiating longer trade credit period?

Answer 13

Relationship with creditors might worsen and the costs might be higher for the business.

Question 14

What are the advantages of improving profit margin through negotiating discounts?

Answer 14

Lower prices than usual will be paid.

Question 15

What are the disadvantages of improving profit margin through negotiating discounts?

Answer 15

Puts pressure on the business, as early payments need to be made and cash needs to be available.

Question 16

What are the advantages of improving profit margin through delayering?

Answer 16

Delayering(getting rid of an entire level of management)-> Managerial costs will decrease

Question 17

What are the disadvantages of improving profit margin through delayering?

Answer 17

Span of control increases, managers will have to superwise more people and loss of control can occur

Question 18

What are the advantages of improving profit margin through cutting overheads?

Answer 18

overheads(indirect costs). Lower costs, increased profit margin.

Question 19

What are the disadvantages of improving profit margin through delayering?

Answer 19

possible dissatisfaction among employees.

Question 20

What is the formula for ROCE(return on captial employed)

Answer 20

(profit before interest and tax/capital employed)*100

Question 21

What does a high ROCE mean?

Answer 21

The higher the ROCE, the more the profit an organisation generates from invested capital

Question 22

How can ROCE be improved?

Answer 22

Keep profits high and reduce capital employed.
* Minimise non current liabilities by reducing long term loans
* Reduce retained profits by paying more dividends

Question 23

What are the disadvantages of improving ROCE by minimising non current liabilities by reducing long term loans?

Answer 23

Long term loans are essential to sustain long term growth of the business.

Question 24

What are the disadvantages of improving ROCE by reducing retained profits by paying more dividends?

Answer 24

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.

Question 25

What is liquidity?

Answer 25

The extent to which it is plausible for business to convert assets into cash.

Question 26

What does the liquidity ratio examine?

Answer 26

They examine the firms ability to pay for current liabilities.

Question 27

What are liquid assets?

Answer 27

(current assets) assets which can be easily transformed into cash.

Question 28

What is current ratio?

Answer 28

A ratio which compares an organisation's current assets with its current liabilities.

Question 29

What is the formula for current ratio?

Answer 29

current assets/current liabilities

Question 30

What is the desirable current ratio range?

Answer 30

between 1.5:1 to 2:1

Question 31

What does a current ratio of less than 1:1 mean?

Answer 31

Liquidity problems.

Question 32

What does a current ratio of 2:1 mean?

Answer 32

too much either cash(depreciating asset), debtors(bad debt) and stock(unsold goods)

Question 33

What are the strategies to improving the current ratio?

Answer 33

* 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

Question 34

What are the advantages of improving current ratio by increasing current assets?

Answer 34

* more cash which gives flexibility in paying for short term loans

Question 35

What are the disadvantages of improving current ratio by increasing current assets?

Answer 35

* too much cash is a depreciating asset

Question 36

What are the advantages of improving current ratio by using long term SOFs?

Answer 36

More cash at hand, more flexible in paying for current liabilities

Question 37

What are the disadvantages of improving current ratio by using long term SOFs?

Answer 37

The business might not have sufficient cash to pay for the daily operations

Question 38

What is the acid test ratio?

Answer 38

It measures how sufficient the short term liquidity is to cover its short term debts.

Question 39

What is the formula for acid test ratio?

Answer 39

(current assets-stock)/current liabilities

Question 40

What does a current ratio of less than 1:1 mean?

Answer 40

liquidity problems.

Question 41

What does a current ratio of 2:1 mean?

Answer 41

too much either cash(depreciating asset), debtors(bad debt)

Question 42

Strategies to improve acid test ratio?

Answer 42

Same as current ratio but to get rid of stock but by selling it with a discount.

Question 43

What are the advantages of improving acid test ratio by selling stock with a discount?

Answer 43

Improves liquidity as there will be more cash at hand.

Question 44

What are the disadvantages of improving acid test ratio by selling stock with a discount?

Answer 44

Lower revenues, which means that there will be an effect on the organisations profitability in the long term