3.5 profitability and liquidity ratios

what are the three main profitability ratios?

the gross profit margin

the profit margin

return on capital employed

what are the two main liquidity ratios?

the current ratio

the acid test ratio

How can profit margins determine the success of a business

it is the amount by which the sales revenue exceeds the costs

higher and increasing profit margins are preferable (it means more revenue is converted into profit)

How to calculate gross profit margin

Gross profit/Sales revenue x 100

How to calculate profit margin

profit before interest and tax / sales revenue x 100

What is ROCE (return on capital employeed)

compares profit made by a business to the amount of capital invested in the business to generate profit

formula = profit before interest and tax / capital employed x 100

capital employed= non current liabilities + equity

How to improve gross profit margin?

increase sales revenue

reduce direct costs

How to increase sales revenue

increase value of sales

raise prices

sell premium products

increase column of sales

use price tactics

increase marketing activities

How to reduce direct costs

reduce variable costs

purchasing in bulk, purchasing cheaper/alternative resources

ensure doesn't have an effect on the quality of products

buying stock in greater quantities may require investment in increased storage space

reduce wastage of raw materials and components

How to improve profit margin

increase gross profit margin

reduce overhead costs

How to reduce overhead costs

reducing staff levels

relocating to cheaper prmises

changing utility companies

however might affect productivity

relocation costs can outweigh some benefits moving to cheaper location

replacing inefficient or outdated equipment may require staff training

How to judge business using ROCE?

the higher the rate the better as it indicates that the business is profitable and using its capital efficiently

at least 20 per cent is usually a good sign

What can a business achieve if you increase ROCE

Increase the level of profit generated without introducing new capital into the business

Maintain the level of profit generated whilst reducing the amount of capital in the business

Which two ratios to use to measure the liquidity of a business?

Current ratio and acid test ratio

What is current ratio and how to calculate?

The result indicates how many £s of current assets it has available to cover each £1 of short term debt

Current assets/ current liabilities

What is the acid test ratio and how to calculate?

he acid test ratio provides a more realistic measure of the businesses ability to meet short-term debts quickly

since stock is deducted as it might take some time to sell

formula: current assets - stock / current liabilities

What are ways to improve liquidity?

- reduce the credit period offered to customers

- ask suppliers to extend repayment period

- make use of overdraft

- sell off excess stock

- sell assets

- introduce new capital, sell shares