❤️‍🔥 3.5 Profitability and ratio analysis

Ratio analysis

Quantitative management planning and decision-making tool, used to analyze and evaluate the financial performance of a business.

Purpose of ratio analysis

• Evaluate financial performance by exposing financial strengths and weaknesses

• Make historical and inter-firm comparisons by analyzing past data of the business, and those of other businesses in the same (or even different) industries for benchmarking purposes.

Profitability

Firm’s profit in relation to another variable such as its sales revenue.

Purpose of profitability ratios

• Examine the level and value of a firm’s profits, enabling different stakeholders to measure their financial returns on their investments.

• Express firm’s profits as a percentage of its sales revenue.

Gross profit margin

Profitability ratio that measures an organization’s gross profit expressed as a percentage of its sales revenue.

Indicator of how well a business can manage its direct costs of production.

Gross profit margin ratio equation

= (Gross profit/Sales revenue) x 100

How to improve the GPM ratio?

• Increase sales revenues and reducing direct costs

  • Change the firm’s promotional strategies to persuade more customers to buy the firm’s goods and/or services.

  • Launch new good and services that have a higher GPM

  • Reduce prices of products sold in highly competitive markets to attract more customers, especially those that are highly price elastic.

  • Outsourcing production to third party suppliers, so that the business can benefit from specialized services offered in a cost-effective way.

Profit margin

• Measures a firm’s overall profit (after all costs of production have been deducted) as a percentage of sales revenue

• How well a business can manage its indirect costs (overhead expenses)

Profit margin ratio equation

= (Profit before interest and tax/Sales revenue) x 100

PM ratio and GPM ratio relationship

• Low profit margin ratio, despite a high GPM ratio, indicates poor financial management and the lack of control of overheads.

How to improve the profit margin ratio?

• Reduce any type of excessive and unnecessary expenses.

Why does the profit margin ratio use profit before interest and tax?

• Historical benchmarking: comparing the profit margin ratio is meaningless as interest charges and tax deductions are expenses beyond the control of the business.

• Inter-firm benchmarking: tax and interest rates differ in overseas markets.

Return on capital employed ratio

• Measures a firm’s efficiency and profitability in relation to its size (as measured by the value of the organization’s capital employed).

Capital employed

• Value of the funds used to operate the business and to generate a financial return for the organization.

• = Non current liabilities + Share capital + Retained earnings

• = Non current liabilities + Equity

ROCE ratio equation

• = (Profit before interest and tax/ Capital employed) x 100

How to improve its ROCE ratio?

• Increasing sales revenue by reducing prices to attract more customers, using new sales promotions, offer a wider distribution network, and launching new and improved products.

• Reduce costs of production by using alternative suppliers, improved quality management systems, or improved stock control systems.

• Selling unproductive or obsolete assets to improve operational efficiency and liquidity, decreasing is cash outflows.

Liquidity ratios

Financial ratios that examine an organization’s ability to pay for its short-term liabilities and debts.

Liquidity

Ease with which a business can convert its assets into cash without affecting its market value.

Repaying short-term liabilities without having to use external sources of finance

Liquidity crisis

Situation arises when the organization is unable to pay its short-term debts.

Current ratio

Short-term liquidity ratio used to calculate the ability of an organization to meet its short-term debts within the next twelve months of the balance sheet date.

Current ratio equation

Current ratio = Current assets/Current liabilites

Minimum figure for the current ratio of any organization

• 1:1 firm has just enough liquid assets to pay off its short-term liabilites.

Improve current ratio

• Increase its current assets and/or reduce its current liabilities

  • Attract more customers by changing the pricing strategy or improving the promotional strategy

  • Encourage customers to pay by cash, improving the firm’s cash inflows

  • Use any available cash to pay off short-term debts, reducing the interest (debt) burden on the business in the long-term.

  • Negotiate with suppliers for an extended trade credit period, improving its own liquidity position.

Acid test ratio (quick ratio)

• Short-term liquidity ratio used to measure an organization’s ability to pay its short-term debts within the next twelve months of the balance sheet date, without the need to sell any stocks (inventories)

Why are stocks ignored in the acid test ratio?

• Some inventories are not highly liquid, such as work-in-progress or very expensive finished goods. Hence, it is difficult to convert stock into cash in a short period of time.

Acid test ratio formula

= (Current assets - Stock)/Current liabilities

How to improve the acid test ratio

• Raise cash inflows for the business or reduce its cash outflows

• Improve its stock control management system in order to reduce cash outflows associated with poor stock control management. Value of acid test ratio improves as its level of stocks falls.