Business 3.5 & 3.6

Profitability ratios

help show how well a business is doing focusing on profit, capital employed, and total revenue

What is the formula for gross profit?

Sales revenue - COGS (opening balance + purchases - closing balance)

Is a higher gross profit preferable to lower ones?

Yes, a higher gross profit is preferable to lower ones. This is because a higher gross profit means that a company is earning more revenue after deducting the cost of goods sold. It indicates that the company is efficient in managing its production costs and pricing strategy, which can lead to higher profits and better financial stability.

how to improve gross profit margin

• Increase prices
• Reduce cost of goods sold
• Negotiate better supplier contracts
• Reduce waste and spoilage
• Analyze and adjust pricing strategy

What is a net profit margin?

measures the percentage of profit a company earns from its revenue after deducting all expenses, including taxes and interest. its better when higher

how to improve net profit margin?

• Increase revenue
• Reduce operating expenses
• implement new pricing strategies

what is return on capital employed

profitability and efficiency in relation to its size , compares profit made by business with amount of money invested. better high.

how to improve return on capital employed

• Increase revenue
• Reduce operating expenses
• Improve inventory management
• Invest in research and development

Liquidity ratios

determine whether it is in a position where its current assets will be able to to pay any immediate bills that arise.

current ratio

ability for a business to meet short term debts within a year . 1:1 ratio means they have just enough current assets to pay off current liabilities. 2:1 means they are not using their current assets efficiently. 1.5:1 is the best.

how to improve current ratio

• Increase current assets
• Decrease current liabilities

Acid test ratio

ability to pay short term debts within a year without having to sell stock. important because stock is not guaranteed to be sold. aim to have it at around 1.

how to improve acid test ratio

• Increase current assets value
• decrease current liabilities value by paying off debts

efficiency ratio analysis

how efficiently a business employs its resources

stock turnover (days)

how quickly a business uses or sells its stock

stock turnover, high, low

higher means the profit earned on stocks is quick which will allow businesses to operate on lower profit margins, lower stock turnover may be because of stockpiling.

how to improve stock turnover

• Implement just-in-time (JIT) inventory system
• get rid of obsolete stock

Creditor days

how quickly a business pays its debts to suppliers and other short term creditors

should creditor days be high or low

a high creditor days ratio means the business takes longer to pay back its suppliers and short term creditors, although this may be beneficial for the business because it improves their cash flow, they have to be careful not damage relations with suppliers.

how to improve creditor days ratio

• Negotiate longer payment terms with suppliers
• Increase sales to generate more cash flow

Debtor days

average number of days it takes to collect debts from customers

why should debtor days be low?

the lower, the better because it will mean they collect their debts faster giving them accessibility to use their money

how to improve debtor days?

• Impose surcharges on late payments
• give debtors incentives to pay earlier such as giving discounts to those who pay before the due date

Gearing ratio

shows relationship between loan capital and share capital to see how much it relies on internal and external sources

what does it mean when gearing ratio is high or low?

when its high it means they are high geared relying mostly on loan capital, when its low it means they rely mostly on share capital. too high or too low is not good, needs to be in between

how to improve gearing ratio

• for higher GR: depend on external sources of finance
• for low GR: repay creditors