3.5 IB BUSINESS: Profitability and Liquidity Ratio Analyst

Definition of each term and description

What is Profitability Ratios?

It is when Gross Profit and Profit margin are used to asses how successful the management of a business has been at converting sales Revenue in both Gross Profit and profit before interest and tax.

How are Profitability Ratios used?

It is used to measure the performance of a company and it’s Management team.

How do you measure Profitability Ratios?

You measure the percentage of Gross Profit or profit before tax and interest a firm earns on each dollar it makes.

What does Gross Profit Margin do?

It identifies the profit a firm archives from trading and buying and selling of goods.

What does the Gross Profit Margin show in the management of a business?

It shows how efficient and effective managers are for “adding value” to the cost of sales.

How does Gross Profit Margin evaluate if the management team is effective?

Selling prices and purchase prices almost always remain constant over a trading period, if the ratio starts to falter the management team may be at fault.

What is Profit Margin?

It serves as a signal as to the capacity the firm has to generate profits after overhead and indirect costs (Expenses) have been taken into account.

What happens when Profit margin isn’t constant?

The ratio should be constant overall, if it starts to falter then overhead costs are rising faster than sales.

How would you calculate Profit Margin?

(Profit before tax and Interest) / Sales Revenue x 100

In what ways can you improve Profit Margin?

Increasing sales through advertising and promos, Reducing direct costs,Increasing selling price,Reducing Indirect Costs (Overhead).

What is Liquidity Ratios?

They assets the ability of the firm to pay its short term debts.

What happens if Working Capital is low?

The business will not be able to meet its short-term debts.

How is Current Ratio expressed?

2:1 - rounded if possible

How do you calculate Current Ratio?

Current Assets / Current Liabilities

What is the Acid Test Ratio?

it is a quick way to measure the liquidity as stocks of unsold goods (inventory) are not included in the current assets. (Quick Ratio)

Why is the Acid Test used?

It gives a clearer picture of the firm’s ability to pay short term debts.

How could you improve Liquidity?

Selling off Fixed Assets for cash and lease, Increase cash in a business through a loan,A publicly held company could increase cash by selling new shares.

How could you Improve Liquidity if an Asset is still needed by a business?

You could add leasing charges to the overhead, Reducing profit margin.

What is Profitability/ Efficiency Ratio?

It is the most commonly used means of a assessing the profitability of a business.

How do you calculate Return On Capital Employment (ROCE)?

(Profit before tax and interest) / Capital Employment x 100

How do you calculate Capital Employment?

Non-Current Liabilities + Equity

How is Return On Capital Employment (ROCE) used?

It looks at how efficient an organization uses it's Capital or Total Assets to create goods and services that are turned into profit.

What are the limitations of a Ratio Analysis?

It is a singular ratio, Other Businesses (Inter Firm Comparisons), Other time periods (Trend Analysis).Companies have different management styles, Ratios show the financial problem but cant solve the business problem.