3.5 profitability and liquidity ratio analysis Flashcards
profitability ratios
financial ratios that show the profit of a business in relation to other financial figures
why are businesses interested in profitability ratios?
because they help the business understand how well it is using the spending on resources to generate profit
also help investors decide wether to invest or not
what does high profitability mean for shareholders
higher dividends for shareholders
gross profit margin
shows the gross profit as a percentage of sales revenue
strategies to improve sales revenue
diversification
lowering prices
increasing prices
gross profit margin formula
gross profit revenue/sales revenue x 100
diversification
benefits: different products may have higher gross profit margins. this can also reduce risk for the business
limitations: can be costly and risky
lowering prices
benefits: can increase sales and sales revenue
limitations: only works if the business achieves economies of scale to lower costs of production may not be possible for small business
increasing prices
benefits: can increase sales revenue, especially where the product has little competition and/or loyal customers
limitations: in a competitive market, increasing prices may cause sales to decline significantly, lowering sales revenue and GPM
benefits and limitations of strategies to decrease cost of sales
economies of scale
using lower cost suppliers
reducing direct labour costs
economies of scale
benefit: purchasing economies of scale would reduce the unit costs and result in higher profit margins
limitations: economies of scale may only be available to large companies. May not be possible for small businesses
using lower cost suppliers
benefits: lower cost suppliers would reduce cost of sales
limitations: could threaten the quality of products and harm revnues
reducing direct labour costs
benefits : Productivity can be improved and costs can be reduced either by hiring fewer workers who are directly involved in production, or by using non-financial motivation strategies
limitations: pressure on production workers could increase labour turnover, increasing costs of recruiting and training (and affecting other profitability ratios)
profit margin
shows the profit before income tax as a percentage of sales revenue
overheads/expenses
costs not directly related to the production of a good or service
profit margin formula
profit before interest and tax/sales revenue x 100
return on capital employed (ROCE)
is a profitability ratio, it measures the businesses profit before interest and tax in terms of the capital that has been employed or used in the business
ROCE formula
(profit before interest and tax/capital employed) x 100
capital employed formula
the value of all sources of longer term internal and external finance for a business
capital employed formula
non-current liabilities + equity
how do you analyse ROCE
compare to other industries: should be more
if ROCE is increasing over time
should be higher than interest rate
ways to improve return on capital employed
- increase sales revenue to increase profit before interest and tax
- reduce cost of sales and expenses to increase profit
- sale unused and obsolete assets
- reduce long term liabilities by paying debt
- reduce share capital and retained profit (equity)
liquidity
companys ability to convert its short term assets into cash
liquidity ratios
measure companys ability to cover its short term debt obligations without having to sell off any fixed assets
