BM Unit 3.5 Profitability and liquidity ratio analysis

Terms for unit 3.5 from the book Business Management 5th edition by Paul Hoang.

Acid test ratio

Also known as the quick ratio, this short-term liquidity ratio measures an organization's ability to pay its short-term debts without having to sell any stock (inventories).

Capital employed

This is the value of the funds used to operate the business and to generate a financial return for the organization. It is the sum of non-current assets and equity finance.

Current ratio

A 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).

Gross profit margin (GPM)

A profitability ratio that measures an organization's gross profit expressed as a percentage of its sales revenue. It is also an indicator of how well a business can manage its direct costs of production.

Liquidity

Refers to the ease with which a business can convert its assets into cash without affecting its market value, i.e., it measures a firm's ability to repay short-term liabilities without having to use external sources of finance.

Liquidity ratios

These are financial ratios that examine an organization's ability to pay its short-term liabilities and debts, namely the current and acid test ratios.

Profit

The financial surplus after all costs, including expenses, have been paid.

Profit margin ratio

A profitability ratio that measures a firm's overall profit (after all costs of production have been deducted) as a percentage of its sales revenue. It is also an indicator of how well a business can manage its indirect costs (overhead expenses).

Ratio analysis

A quantitative management planning and decision-making tool, used to analyse and evaluate the financial performance of a business. These can be further categorised as profitability, liquidity, and efficiency ratio analysis.

Return on capital employed (ROCE)

A profitability ratio that measures a firm's efficiency and profitability in relation to its size (as measured by the value of the organization's capital employed).

Purpose of Ratio Analysis

* Examine a firms financial position, e.g. its short- and long-term liquidity position

* Assess a firms financial performance, e.g. its ability to control expenses

* Compare actual figures with projected or budgeted figures (known as variance analysis)

* Aid decision-making, e.g. whether investors should risk their money by investing in the business.

Ways to compare ratios

Historical comparisons

Inter-firm comparisons

Historical comparisons of ratios

Comparing the same ratio in two different time periods for the same business

Inter-firm comparisons

Comparing the same ratios of businesses in the same industry

GMP (formulae)

Gross profit/Sales Revenue * 100

Ways to raise sales revenue

* Reducing the selling price of products for which there are

many substitute products.

* Raising the selling price of products for which there are

few if any substitutes

* Using improved marketing strategies to raise sales revenue

* Seeking alternative revenue streams

Ways to reduce directs costs

Cutting direct material costs

Cutting direct labour costs

Profit margin (Formulae)

Profit before interest and tax/Sales revenue*100

Ways to improve Profit margin

Reduce expenses

- Payment terms

- Negotiate cheaper rent

- Reduce indirect costs

Raise sales revenue

- Reduce selling price

- Increase selling price

- Improve marketing

ROCE formula

Profit before interest and tax/Capital employed x 100

Capital employed formula

Non-current liabilities + Equity

Current Ratio Formula

Current assets - Current liabilities

Reasons for too high current ratio

Too much cash in busienss

Too many debtors

Too much stock

Ways to improve current ratio

Reduce current liabilities and choose long-term loans.

Sell some fixed assets to generate cash.

Acid test ratio formula

(Current Assets - Stock) / Current Liabilities