3.5 Profitability and Ratio Analysis

Vocabulary flashcards covering profitability, liquidity, and efficiency ratios based on the provided lecture transcript.

Ratio analysis

A collection of analytical instruments used by accountants to examine and evaluate the financial health of a business.

Liquidity ratios

Calculations used to determine a company’s ability to pay off its short-term debts, including the current ratio and the acid test ratio.

Gross Profit Margin (GPM)

A profitability ratio assessed by comparing direct costs and sales revenue; it is typically evaluated against previous years or competitors' results.

Net Profit Margin (NPM)

A profitability ratio calculated using net profit before interest and tax, which reflects a company's ability to manage indirect costs relative to revenue.

Current Ratio

A liquidity ratio expressed as $X : 1$ that compares current assets to current liabilities; a value between $1.5$ and $2$ is often considered ideal.

Acid Test Ratio

Also known as the quick ratio, this liquidity measure excludes stock from current assets because stock is the least liquid asset and requires demand to be turned into cash.

Return on Capital Employed (ROCE)

An efficiency ratio, often called the key ratio, that measures a firm's financial performance relative to the total amount of capital invested.

Capital Employed

The total value of all assets minus current liabilities, representing the total amount of investment in the business.

Direct costs

Costs specifically linked to production, such as direct labor or materials, that are reduced to improve the Gross Profit Margin.

Indirect costs

Operating expenses such as rent, insurance premiums, and advertising that are managed or reduced to improve a business's Net Profit Margin.