3.5 Profitability and ratio analysis

Question 1

The acid test ratio

Answer 1

The acid test ratio is a liquidity ratio that measures a firm’s ability to meet its short-term debts. It ignores stock because not
all inventories can be easily turned into cash in a short time frame.

(Current assets - Stock) / Current liabilities

[As a general guideline, the quick ratio should be at least 1:1 otherwise the firm might experience working capital difficulties or even a liquidity crisis (a situation where a firm is unable to
pay its short-term debts).]

Question 2

Capital employed

Answer 2

Capital employed is the value of all long-term sources of finance for a business, e.g.bank loans, share capital and reserves.

Question 3

The current ratio

Answer 3

The current ratio is a short-term liquidity ratio that calculates the ability of a business to meet its debts within the next twelve months.

Current assets / Current liabilities

[It is generally accepted that a current ratio of 1.5 to 2.0 is desirable.]

Question 4

Efficiency ratios

Answer 4

Efficiency ratios indicate how well a firm’s resources have been used, such as the amount of profit generated from the available capital used in the business.

Question 5

Gross profit margin (GPM)

Answer 5

Gross profit margin (GPM) is a profitability ratio that shows the percentage of sales revenue that turns into gross profit.

GPM= Gross profit / Sales revenue x 100

Question 6

Liquid assets

Answer 6

Liquid assets are the possessions of a business that can be turned into cash quickly without losing their value, i.e. cash,
stock and debtors.

Question 7

Liquidity crisis

Answer 7

Liquidity crisis refers to a situation where a firm is unable to pay its short-term debts, i.e. current liabilities exceed current
assets.

Question 8

Liquidity ratios

Answer 8

Liquidity ratios look at the ability of a firm to pay its shortterm liabilities, such as by comparing working capital to shortterm
debts.

Question 9

Net profit margin (NPM)

Answer 9

Net profit margin (NPM) shows the percentage of sales revenue that turns into net profit,i.e.the proportion of sales revenue left over after all direct and indirect costs have been paid.

NPM = Net profit / Sales revenue x l00

[Net profits are subject to change, caused by fluctuating interest rates and tax rates (both factors are beyond the control of a business)]

Question 10

Profitability ratios

Answer 10

Profitability ratios examine profit in relation to other figures, e.g. the GPM and NPM ratios. These ratios tend to be relevant to profit-seeking businesses rather than for not-for-profit organizations.

(Managers, employees and potential
investors are interested in profitability ratios as they show how well a firm has performed in financial terms.)

Question 11

Ratio analysis

Answer 11

Ratio analysis is a quantitative management tool that compares different financial figures to examine and judge the financial performance of a business. It requires the application of figures found in the final accounts (the balance sheet and the profit and loss account).

Question 12

Return on capital employed (ROCE)

Answer 12

Return on capital employed (ROCE) is an efficiency ratio (although it also reveals the firm’s profitability) measuring the
profit of a business in relation to its size (as measured by capital employed).

Net profit before interest and tax / Capital employed x l00

Question 13

2 main ways to improve GPM (and NPM + ROCE) + how

4+2

Answer 13

1. Raising revenue by:
   - reducing the selling price of products for which there are many substitute products. > firm may gain a competitive advantage by reducing its prices

• raising the selling price of products for which there are few, if any, substitutes. If customers are not very responsive to changes in price (due to strong brand
  loyalty or a lack of substitute products available), then the firm can gain higher sales revenue by raising the price.
• marketing strategies to raise sales revenue, e.g. offering promotions (see Unit 4.5). Promotions and product extension strategies to help boost sales
• seeking alternative revenue streams to boost their sales revenue, particularly when affected by seasonal demand (see 3.2).
  2. Reducing direct costs by:
• cutting direct material costs, perhaps by using cheaper suppliers and/or cheaper materials. For example,some airlines have saved millions of dollars each year by
  cutting back on the amount of chocolates or snacks that they offer on-board. However, cost cutting can have a negative effect on the perceived quality of the good or service.
• cutting direct labour costs, i.e. reduce staffing costs by cutting the number of staff or by getting staff to do more (for the same pay). Either way, the productivity
  of staff may increase, thereby reducing unit labour costs. However, this method can cause resentment and demotivation.

Question 14

GPM and NPM difference

3p

Answer 14

1. The NPM ratio is a better measure of a firms profitability than GPM as it accounts for both cost of sales (direct costs) and expenses (indirect costs).
2. The difference between a firm’s GPM and its NPM represents the expenses, and therefore the larger the difference between these two ratios, the more difficult overhead control tends to be.
3. As with the GPM, the general rule
   is that the higher the NPM, the better it is for the firm.

Question 15

Nature of profit for high volume and low volume products

Answer 15

It is common for high volume products, such as confectionery and fast food, to have a relatively low profit margin. however, the high sales volume compensates for this.

Conversely, for low volume products, such as aircraft and luxury wines, the profit margin tends to be relatively high to compensate for the lower unit of sales.

Question 16

More ways to effect NPM; examining costs

3p

Answer 16

1. negotiate preferential payment terms with creditors and suppliers.

By delaying payment, a business may be able to improve its working capital. Alternatively, it might be possible to negotiate discounts for paying creditors on time.

2. negotiate cheaper rent.

Trustworthy and creditable businesses may be able to negotiate lower rents or delay payment of rent to improve their cash flow.

3. reduce indirect costs.

Careful examination of an organization’s expenses might reveal areas where costs
can be cut without detrimental effects to the business. For example, many businesses no longer pay senior managers to fly first class, choosing
business class or economy class
travel instead. Other overheads that might be reduced include advertising, stationery and insurance premiums.

Question 17

Exam tip I

Explain how a price reduction for a product could reduce the gross profit margin (GPM), but actually boost the net
profit margin (NPM). Use a numerical example to help explain your answer.

Answer 17

The fall in price will automatically reduce the profit margin, other things being equal. However, the price reduction has attracted more customers and since indirect costs are constant, the NPM has increased.

Question 18

Importance of ROCE;
also referred to as?
2p

Answer 18

ROCE is calculated by using net profit before tax and interest as this allows for better historical comparisons (since interest and tax rates are subject to change over time and are beyond the
control of the business).

Many people regard the ROCE as the single most important financial ratio as it measures how well a firm is able to generate profit from its sources of funds. Hence, the ROCE is often referred to as the KEY RATIO.

Question 19

Ways to improve ROCE

Answer 19

The ROCE ratio can be improved mainly by strategies to boost net profits (see above).

Mathematically, the ROCE ratio will
also increase if capital employed falls whilst net profits remain constant; although in reality this is probably not desirable.

Question 20

The current ratio can be improved by:

Answer 20

1. a combination of raising the value of current assets and reducing the value of current liabilities. For example, overdrafts can be reduced by opting for long-term loans that offer more attractive rates of interest.
   This will also free up working capital in the short term. However, this option may, of course, affect the long-term liquidity of the
   firm.

Question 21

Mathematically, the quick ratio can be improved by

2p

Answer 21

1. raising the level of current assets (cash or debtors)

or

2. lowering the amount of current liabilities.

It can be dangerous for a firm to increase debtors since this increases the likelihood of bad debts occurring. There is also a potentially large opportunity
cost in holding too much cash. Hence, it is more practical for a business to concentrate on reducing its short-term liabilities, such as overdrafts and trade creditors. For example, it might be
possible to negotiate delayed payment to creditors.

Question 22

Uses of ratio
analysis
4p

Answer 22

1. Employees and trade unions can use financial ratios to assess the likelihood of pay rises and the level of job
   security (possibly revealed by profitability and liquidity ratios).
2. Managers and directors can assess the likelihood of getting management bonuses for reaching profitability, liquidity and efficiency targets. They can also use ratios to identify areas that need improving.
3. Trade creditors look at short-term liquidity ratios to ensure that their customers (i.e. other businesses) have
   sufficient working capital to repay them.
4. Shareholders use ratios to assess the return of their investment compared with other investments, such as holding shares in other companies or in a bank account.

Question 23

Limitations of ratio

analysis

Answer 23

1. Ratios are a historical account of a firm’s performance. They do not indicate the current or future financial situation of a business (although they do give an indication of the financial health of the firm).
2. Changes in the external business environment (see Unit 1.5) can cause a change in the financial ratios without
   there being any underlying change in the performance of a business. For example, higher interest rates will reduce profitability, although sales revenues may have actually increased.
3. There is no universal way to report company accounts so this means that businesses may use different accounting
   policies. This makes inter-firm comparisons more difficult. For example, some firms use the straight-line method for depreciating assets whilst others use the reducing balance method (see Unit 3.4).
4. Qualitative factors that affect the performance of a firm are totally ignored. For example, the level of staff motivation
   and customer perceptions of quality are not considered in ratio analysis.
5. Organizational objectives differ between businesses, so comparing results from a ratio analysis could be
   meaningless. For example, there should be some reservation in comparing the financial performance of a state-owned airline with that of a private sector airline.