3.5 - Profitability Ratios Flashcards
Ratio Analysis
A method of analyzing the financial performance of a business by comparing two numbers
Numbers are often taken from:
- Profit & Loss
- Balance Sheet
Their use:
- Can see the financial performance of the business over time
- Can compare to other businesses in the industry
Look at:
- Profitability ratios
- Liquidity ratios
- Efficiency ratios
Profit Margin
How successful a company is in turning sales revenue into profit
Gross Profit Margin (%) Formula
Gross Profit / Sales Revenue x 100
E.g. 2000/4000 x 100 = 50%
Represents:
- The % profit made on just the production and sale of the product
- Here, 50% of the revenue is kept as profit (before expenses)
To increase GPM
Raising Revenue by more than the costs of sales:
- Marketing strategies
- Alternative revenue streams
- Changing the price (be careful here)
- Raise the price if inelastic
- Reduce the price if elastic
Cutting Costs of Sales:
- Cheaper suppliers, materials
- Cheaper labor (e.g. outsourcing)
- Increase productivity (e.g. automation)
- Decrease salary
Profit Margin (%) Formula
Profit before interest and tax / Sales Revenue x 100
- Measures overall profitability - after all costs have been removed
- Better indicator than GPM
- Could use Profit for Period
- Can’t compare two businesses with different levels of debt (loans), different tax rate
Increasing Profit Margin (GPM)
Raising Revenue by more than the costs of sales:
- Marketing strategies
- Alternative revenue streams
- Changing the price (be careful here)
- Raise the price if inelastic
- Reduce the price if elastic
Cutting Costs of Sales:
- Cheaper suppliers, materials
- Cheaper labor (e.g. outsourcing)
- Increase productivity (e.g. automation)
- Decrease salary
Cutting Expenses:
- Reduce utilities (e.g electricity)
- Reduce managers salaries
What about increasing the Marketing budget?
- Increase Sales
- Increase Cost of Sales
- Increase expenses (Marketing)
Liquidity Ratios
- Measures the cash flow situation for a business
- How well we can pay our debts in the next 12 months
- One measure of the bankruptcy
- Total Current Assets / Total Current Liabilities
Current Ratio
It shows to what extent the business can pay its short-term debts in the next 12 months
Ideal Ratio:
- 1.5 - 2 (General rule, though different business may differ)
If < 1.5:
- Business may struggle to have enough cash flow to pay its short - term debts
If > 2:
- Holding a high level of current assets that do not generate profit, e.g. cash
- Could indicate a lack of efficiency because the money could be put to better use
Acid Test (Quick) Ratio
- (Current Assets - Stock) / Current Liabilities
- Stock might not be easily turned into cash
- Ideally 1 - 1.5
Improving Liquidity
Assuming it is too low:
Holding more Current Assets compared to
Current Liabilities
- Hold more Cash
E.g. sell some Non-Current Assets - Reduce short-term borrowing
E.g. hold more long-term borrowing - But depends on the business & industry
E.g. a business might sell its stock very quickly, meaning it can have lower liquidity ratios
Return on Capital Employed (ROCE) (%)
- (Profit before interest and tax / Capital Employed) x 100
- Capital Employed = Total Equity + Non-Current Liabilities
- Uses both Balance Sheet and PNL
- The business makes a profit of … for every $100 invested in the business
Improving ROCE
- Increase profit to increase ROCE
- Make more efficient use of the Capital Employed
