3.5 Profitability and liquidity ratio analysis

Ratio Analysis

A quantitative management tool comparing two or more financial figures from final accounts to evaluate business performance.

Gross Profit Margin (GPM)

A profitability ratio comparing gross profit to sales revenue, expressed as a percentage: (Gross Profit / Sales Revenue) x 100.

Profit Margin (PM)

A profitability ratio showing operating profit (profit before interest and tax) as a percentage of sales revenue: (Profit Before Interest & Tax / Sales Revenue) x 100.

Return on Capital Employed (ROCE)

A profitability ratio measuring how efficiently a business generates operating profit from its long-term capital: (Profit Before Interest & Tax / Capital Employed) x 100.

Capital Employed

The total value of long-term capital invested in a business; calculated as Non-Current Liabilities + Equity.

Liquidity Ratios

Financial metrics that measure a company's ability to settle short-term obligations without selling fixed assets.

Working Capital Cycle

The continuous flow of cash used to purchase materials, create inventory, sell to debtors, and receive cash back.

Current Ratio

A liquidity ratio measuring short-term asset coverage over short-term liabilities: Current Assets / Current Liabilities.

Acid Test (Quick) Ratio

A strict liquidity ratio excluding inventory from current assets to assess immediate debt paying ability: (Current Assets - Stock) / Current Liabilities.

Liquid Assets

Assets that can be converted into cash quickly without significant loss of value (e.g., cash and trade debtors).

Insolvency

A financial state where a business is unable to meet its short-term financial obligations when they fall due.

Overheads

Indirect expenses incurred in running a business that are not directly tied to production (e.g., rent, admin salaries).

Trade Creditors

Suppliers to whom the business owes money for goods or services bought on credit (Current Liabilities).

Trade Debtors

Customers who have purchased goods or services on credit and owe money to the business (Current Assets).

Ideal Current Ratio Range

A standard accounting benchmark of 1.5 to 2.0, indicating sufficient liquidity without excess tied-up cash.

Ideal Acid Test Ratio Target

A standard accounting benchmark of 1.0, meaning $1 of liquid assets for every $1 of short-term debt.

Strategy to Improve GPM

Raising sales prices, sourcing cheaper raw materials, or achieving purchasing economies of scale.

Strategy to Improve PM

Reducing overhead expenses such as rent, utility usage, marketing, or administrative costs.

Strategy to Improve ROCE

Increasing operating profit through higher revenues/lower costs, or selling off unused non-current assets.

Strategy to Improve Liquidity

Encouraging early debtor payments, extending creditor payment terms, or selling off surplus fixed assets.