3.5 Profitability and liquidity ratio analysis - Luka

Profitability ratios

Shows a company’s profit concerning other financial figures,

What GPM is for

Analyze how much (%) of the sale revenues are made as gross profit, and the others are lost as costs.

Strategies to improve GPM

• Diversification

• Promotional strategies

• Outsourcing

• Increasing prices

What “Profit Margin” is for

Measures the amount of profit (gross profit minus expenses) as a percentage of the sales revenue.

What the value for profit margin means

The higher the figure, the better the organization can control its overheads,

How to improve profit margins

• Decrease direct costs

• Increase price

• Reduce overhead costs

ROCE (Return On Capital Employed)

“Are we making a return on the investment we have made?”

Capital Employed

Long term liabilities + Share capital + Retained profit

What ROCE is always compared to

Interest rates (“what would have happened if we left the money in the bank?”)

How to improve ROCE

• Invest in technology

• Reduce variable (direct) costs

• Sell capital

Liquidity Ratios

Measures a company’s ability to cover its short-term debts

Liquidity

Ability to convert current assets to cash

Insolvent

Situation where the business is unable to pay debts

Lease back

Selling an asset and hiring another instead

Acid test (quick) ratio

Business’s ability to pay its short-term debts

Strategies to improve ratio(s)

• Increase sales

• Lengthen creditors

• Shorten (or no) debtors

Problem if there is a drastic difference between GP and PM

Expenses are too high

Current ratio and/or Acid test ration need to be:

• More than 1

• Accountants advise for current rations to be between 1.5 and 2.0

If ratio < 1, then:

You have more liabilities than assets (you are insolvent)