3.5 Profitability and liquidity ratio analysis Flashcards
ratio analysis
a quantitative management tool for analysing and judging the financial performance of a business
the purpose of ratio analysis
examine a firm’s financial position
assess a firm’s financial performance
compare actual figures with projected or budgeted figures
aid decision-making
how are ratio compared?
historical comparisons
inter-firm comparisons
profitability ratios
examine profit in relation to other figures, such as the ratio of profit to sales revenue
efficiency ratios
show how well a firm’s resources have been used, such as the amount of profit generated from the available capital used by the business.
Gross profit margin (GPM)
shows the value of the gross profit as a percentage of sales revenue.
GPM formula
gross profit / sales revenue
x 100
the GPM ratio can be improved by
raising revenue
reduce direct costs
net profit margin (NPM)
shows the percentage of sales turnover that is turned into net profit.
NPM formula
net profit / sales revenue
x 100
why is NPM better than GPM as a measure of firm’s profitability?
GPM accounts for both cost of sales and expenses
the larger the difference between the two ratios, the more difficult for the business to control overheads
the NPM ratio can be improved by
negotiate preferential payment terms with creditors and suppliers
negotiate cheaper rent
reduce indirect costs
return on capital employed (ROCE)
measures the financial performance of a firm compared with the amount of capital invested
ROCE formula
net profit before interest and tax / capital employed
x 100
capital employed formula
loan capital + share capital + long-term liabilities
liquidity ratios
look at the ability of a firm to pay its short-term debts
liquid assets
assets that can be turned into cash quickly
current ratio
short-term liquidity ratio that calculates the ability of a business to meet its debts within the next twelve months
current ratio formula
current assets / current liabilities
acid test ratio (quick ratio)
a liquidity ratio that measures a firm’s ability to meet its short-term debts
acid test ratio formula
current assets - stock / current liabilities
use of ratio analysis
employees and trade unions can use ratios to assess the likelihood of pay rise and level of job security
managers and directors -
