3.5 profitability and liquidity ratio

ratio analysis

involves extracting information from financial accounts to assess business performance

profit margins

measures the proportion of revenue that is converted into profit. Can be used to compare to previous years to understand performance over years, higher and increasing profit margins are better. (more revenue is being converted into profit)

gross profit margin

shows the proportion of revenue that is turned into gross profit, the larger the number the better

gross profit / sales revenue x100

strategies to improve gross profit margin

raise revenue

• increasing selling price of products with few substitutes

• decreasing selling price for products with more substitutes

• seek alternative revenue streams

reduce cost of sales

• reduce direct material costs by sourcing new suppliers

• reduce direct labour costs

profit margin

shows the proportion of revenue that is turned into profit before interest and tax

profit before interest and tax / sales revenue x100

return on capital employed (RoCE)

known as the primary ratio. it compares the profit made by a business to the amount of capital invested in the business. shows how effectibe a business uses their capital

profit before interest and tax / capital employed x100

statergies to improve profit margin and ROCE

controlling expenses

• reduce indirect labour costs

• seek cheaper rental premises

• find alternative suppliers for insurance policies

• use cheaper forms of advertising

limitations of strategies used to improve profitability ratios

may increase

Liquidity

refers to the cash and other current assets businesses have available to quickly pay bills and meet short-term business/financial obligations

current ratio

a method to measure liquidity. It is effective for businesses that hold little stock.

current assets / current liabilities

If the result is 2, for every $2 of current assets, there is $1 of short-term debt

acid test / liquid capital ratio

a method to measure liquidity. It deducts the least liquid asset (stock) to give a more realistic measure of liquidity.

(current assets - stock) / current liabilities

If the answer is $2, then the business has $2 of most liquid current assets to cover each £1 of short-term debt

bench mark for ratios

current ratio - 1.5:1

acid test ratio - 1:1

strategies to improve liquidity ratios

raise value of current assets - (encourage purchases by offering discounts for immediate payments, invest in stock control systems to reduce the amount of stock held)

reduce value of current liabilities - (cut overdrafts and use long-term loans with lower interest rates, avoid late payment penalties)