3.5 - Profitability and Liquidity Ratio Analysis Flashcards
what is ratio analysis
analysing the profitability of a business by comparing two values of financial operating performance
what types of ratios are included in ratio analysis?
- profitability ratio
- efficiency ratio
- liquidity ratio
what is gross profit margin
a ratio showing the percentage of revenue left as profit after subtracting the cost of sales
- the higher the percentage the better
how is gross profit margin calculated
(Gross Profit/Sales Revenue) x 100
(using information from the P&L)
how to increase gross profit margin
Increase Revenue
* improve/increase marketing
* other revenue streams
* change price (when inelastic)
Decreasing Cost of Sales
* automation
* cheaper labour
* cheaper supplies
* increase productivity - train employees
whats the difference between gross profit margin and profit margin?
profit margin considers expenses whereas gross profit margin does not
what is profit margin
a measure of the overall profitability of a business after subtracting all expenses
how to calculate profit margin
(profit before interest and tax/sales revenue) x 100
how to increase profit margin
Increase Revenue
* other revenue streams
* marketing
* change price
Reduce Cost of Sales
* cheaper labour
* cheaper supplies/supplier
* increase productivity
Reduce Expenses
* reducing utilities
* reducing manager salaries
what is a liquidity ratio
the ability for a business to pay off their debts in the short-term
what is current ratio
the ability for a business to pay back its short term debts in the next 12 months
how is current ratio calculated?
- explain the ranges
(using information from the balance sheet)
(current assets/current liabilities)
The ideal range is 1.5-2
Less than 1.5 - may struggle with cashflow - not enough cash
More than 2 - loss of potential profit because holding a lot of current assets (eg. cash)
what is acid test ratio (quick test)?
it is the current ratio (ratio of current assets and current liabilities) to analyse the ability of a business to be able to pay off short term debts
but - subtracting stock from current assets because stock may not easily be turned into cash
what is the formula for acid test ratio?
explain the ranges
(current assets - stock) / (current liabilites)
a range between 1-1.5 is ideal
how to improve liquidity (liquidity ratios)? - assuming its too low
increase current assets
* sell non-current assets to get cash
decrease current liabilities
* convert short-term loans into long-term loans
- negotiate trade credit terms with suppliers and customers
what does Return on capital employed (ROCE) show?
the profits a business makes for every $100 that they invest into the business
if ROCE = 25%, the business makes $25 profit for every $100 they invest
how to calculate Return on Capital Employed (ROCE)
(profit before interest and tax) / (capital employed) x 100
capital employed = total equity + non-current liabilities
how to increase return on capital employed (ROCE)
- increase profit
- focus on capital employed
