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