3.5 Profitability & Liquidity Ratios

Ratio Analysis

The use of financial data to measure performance, comparing profitability, efficiency, returns, growth, and risk to support decision-making.

Profitability Ratios

2 types of ratios that measure a firm's ability to generate profit:

1. Gross profit margin

2. Profit margin (net)

3. ROCE

(Profitability) Gross Profit Margin

% of sales kept after COGS.

High → efficient production/sourcing.

Low → high costs of goods, poor pricing, or inefficiency.

Strategies to Improve Gross Profit Margin

- Increase prices in less competitive/price-sensitive markets

- Use effective, not costly, promotional strategies

- Source cheaper materials without reducing quality

- Reduce direct labour costs by boosting productivity

(Profitability) Profit Margin

% of sales kept after all expenses (net).

High → strong overall cost control & profitability.

Low → overheads/interest too high, efficiency issues

Strategies to Improve Profit Margin

- Cut unnecessary indirect costs (e.g., luxury perks)

- Negotiate with stakeholders for lower rent or supplier discounts

- Combine cost reduction with revenue-raising measures

(Profitability) Return on capital employed (ROCE)

Profit/returns earned from capital employed.

High → capital used effectively, good return for investors.

Low → poor use of assets/capital, unattractive to investors.

Strategies to Improve ROCE

- Reduce long-term loans while keeping profits stable

- Pay higher dividends to lower retained profit and raise ROCE

-Balance with future investment needs and asset requirements

Liquidity Ratios

2 types of ratios that measure a firm's ability to pay short-term debts:

1. current ratio

2. acid test ratio

Current ratio

Measures ability to pay short-term debts using all current assets.

Above 2 → too much idle cash/assets.

Below 1 → liquidity risk, may struggle to pay short-term debts.

Ideal ≈ 1.5-2:1.

Strategies to Improve current ratio

Replace overdrafts with long-term loans → lowers current liabilities, but raises interest and gearing.

Sell long-term assets → boosts working capital, but may require costly leasing later.

Acid test ratio

Measures ability to pay short-term debts using only liquid assets (excluding stock).

Above 1 → strong ability to pay immediate debts.

Below 1 → potential liquidity issues if stock can't be sold quickly.

Ideal ≈ 1:1.

Strategies to Improve acid test ratio

Sell stock for cash → increases liquidity, but may reduce profit.

Extend credit to debtors → boosts sales, but risk of bad debts.