Profitability and liquidity ratio analysis Details Flashcards
Formula for gross profit margin(GPM)
Strategies to improve gross profit and profit margins
Increasing sales revenue by:
-Diversification of products and markets
-Reducing costs
-Increasing prices
Decreasing cost of sales by:
-Purchasing economies of scale
-Using lower cost suppliers
-Reducing direct labour costs
Decreasing expenses(only applicable to profit margins)
Formula for profit margin
Why is the profit margin a better measure of profitability than the gross profit margin?
The profit margin takes into account both the direct costs of producing the products and the indirect costs and expenses
Formula for return on capital employed(ROCE)
Formula for capital employed
Capital employed = Non-current liabilities + Equity
Formula for equity
Equity = Retained earnings + Ahare capital
Strategies to improve return on capital employed(ROCE)
-Increasing sales revenue to increase profit before interest and tax
-Reducing cost of sales and expenses to increase profit before interest and tax
-Selling unused and obsolete assets(to reduce costs)
-Reducing long-term liabilities
Summary of the working capital cycle
-The business uses cash to purchase raw materials and supplies
-The money goes to trade creditors who have sold these resources to businesses
-The business then builds up stock(inventory) ready for sale
-The business sells its product to debtors, who pay the business for the product
-The inflow of cash is then used to purchase more reosurces to continue production
Formula for working capital
Working capital = Current assets - Current liabilities
Types of liquidity ratios
-Current ratio
-Acid test(quick) ratio
Formula for current ratio
Current assets ÷ Current liabilities
Strategies to improve current ratio
-Increasing current assets
-Reducing current liabilities
Methods to increase current assets
-Increasing sales
-Reducing debtors’ figures(by asking debtors to pay soner with cash)
-Selling unused fixed assets
-Reducing drawings(from owners)
Methods to reduce current liabilities
-Extending credit period
-Decreasing overheads
Reducing current liabilities(e.g. by paying overdrafts off)
Formula for acid test(quick) ratio
Why does the acid test ratio exclude stock(inventory) from the current assets?
Stock(inventory) is the least liquid of current assets
The ideal current ratio is…
1.5-2
Limitations of ratio analyses
-Do not show the current or future financial situation of the business
-Do not take external influences into account
-Do not take qualitative factors into account
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