3.5 Profitability and liquidity ratio analysis

Question 1

Definition of ratio analysis

Answer 1

is a quantitative management planning and decision-making tool, used to analyse and evaluate the financial performance of a business.

i.e. the firm’s financial statements, consisting of the balance sheet and income statement.

Question 1

what are the purpose of ratio analysis (4)

Answer 1

• to examine a firm’s financial position, such as its profitability as well as short-and long-term liquidity position
  -To assess a firm’s finanical performance
  -To compare actual figures with projected or budgeted figures in order to improve financial management
  -To aid decision-making, such as wether investors should risk their money by investing in tge business

Question 2

what are the three ratios of ratio analysis

Answer 2

-Gross profit margin
-Profit margin
-Return on capital employed (ROCE)

Question 3

how can a firm improve its Gross profit margin (2)

Answer 3

Raising sales revenue
Reducing direct costs

Question 4

Definition of gross profit margin

Answer 4

profitability ratio that measures an organization’s gross profit expressed as a percentage of its sales revenue. It is also an indicator of how well a business can manage its direct costs of production.

Question 5

Definition of profit margin

Answer 5

profitability ratio that measures a firm’s overall profit (after all costs of production have been deducted) as a percentage of its sales revenue.

It is also an indicator of how well a business can manage its indirect costs (overhead expenses

Question 6

How to improve profit margin (3)

Answer 6

1. Discuss preferential payment terms with trade creditors and suppliers
2. Negotiate cheaper rent
3. Reduce indirect costs

Question 7

Definition of ROCE

Answer 7

a profitability ratio that measures a firm’s efficiency and profitability in relation to its size (as measured by the value of the organization’s capital employed).

Question 8

Definition of capital employed

Answer 8

the value of the funds used to operate the business and to generate a financial return for the organisation.

Question 9

Formula for capital employed

Answer 9

Capital employed = Non-current liabilities + Share capital + Retained earnings

Capital employed = Non‐current liabilities + Equity

Question 10

Formula for ROCE

Answer 10

Return on capital employed (ROCE) = (Profit before interest and tax / Capital employed) × 100

Question 11

How to improve ROCE (3)

Answer 11

Increasing the firm’s sales revenues by using strategies such as reduced prices to attract more customers,

Reduce costs of production through methods such as using alternative suppliers, having improved stock control systems

Selling unproductive, unused, underused, and obsolete assets in order to improve operational efficiency and liquidity.

Question 12

Definition of liquidity

Answer 12

Liquidity refers to the ease with which a business can convert its assets into cash without affecting its market value,

i.e. it measures a firm’s ability to repay short-term liabilities without having to use external sources of finance.

Question 13

what are the two liquidity ratios

Answer 13

Current ratio
Acid test ratio

Question 14

Current ratio

Answer 14

The current ratio is a short-term liquidity ratio used to calculate the ability of an organization to meet its short-term debts (within the next twelve months of the balance sheet date)

Question 15

what is the generally accepted current ratio and why

Answer 15

1.5 to 2.0
it allows for a safety net because in reality it might not be possible to sell current assets quickly without losing some value.

Question 16

what does a current ratio of less than 1.0 mean

Answer 16

it means that the short-term debts of the business are greater than its liquid assets,
this could jeopardise its survival if creditors demand payment

Question 17

what if the current ratio is too high (3)

Answer 17

• too much cash in the business
• too many debtors
• too much stock

Question 18

how to improve current ratio and acid test ratio (4)

Answer 18

-Attract more customers, perhaps by changing the pricing strategy and/or improving its promotional strategies.

-Encourage customers to pay by cash, thereby improving the firm’s cash inflows.

-Use any available cash to pay off short-term debts, thereby reducing the interest (debt) burden on the business in the long run.

-Negotiate with suppliers for an extended trade credit period (e.g. from 30 days to 40 days), thereby improving its own liquidity position.

Question 19

Acid test ratio (quick test)

Answer 19

is a short-term liquidity ratio used to measure an organization’s ability to pay its short-term debts , without the need to sell any stock (inventories).

Question 20

why are stocks ignored from acid test ratio

Answer 20

because some inventories are not highly liquid such as work-in-progress or very expensive finished goods sold in niche markets.

Question 21

whats the ideal acid test ratio

Answer 21

1:1

Question 22

what happens if the acid test ratio is not 1:1

Answer 22

firm might experience working capital difficulties or even a liquidity crisis

Question 23

what does a high acid test ratio suggest

Answer 23

firm is holding onto too much cash