BM Topic 3.5: Profitability & Liquidity Ratio Analysis

Define ‘ratio analysis’

quantitative management planning & decision-making tool used to analyse & evaluate the financial performance of a business (i.e. the firm’s financial statements consisting of the balance sheet & income statement). such analysis helps decision-makers & other stakeholders to evaluate a business organisation’s financial performance by exposing various financial strengths & weaknesses.

• helps make meaningful historical & inter-firm comparisons by analysing past data of the business & those of other businesses in the same (& even different) industries for benchmarking purposes

Define ‘profitability’

measure of profit in relation to another variable

Purpose of ‘profitability ratios’ & 3 different kinds

examine the level & value of a firm’s profits, thereby enabling different stakeholders to measure the financial returns on their investments. also express a firm’s profits as a percentage of its sales revenue.

1. Gross profit margin (GPM)

2. Profit margin ratio

3. Return on capital employed (ROCE)

‘Gross profit margin (GPM)’ as a profitability ratio

measures an organisation’s gross profit expressed as a percentage of its sales revenue. an indicator of how well a business can manage its direct costs of production

• gross profit margin = (gross profit ÷ sales revenue) x 100

‘Profit margin’ as a profitability ratio

measures a firm’s overall profit (after all costs of production have been deducted) as a percentage of its sales revenue. an indicator of how well a business can manage its indirect costs (overhead expenses). indicates the percentage of sales revenue that is turned into profit.

• profit margin = (profit before interest & tax ÷ sales revenue) x 100

the higher the profit margin ratio figure, the better the organisation’s control over its expenses & hence the higher its profitability tends to be → also indicates greater efficiency in managing the firm’s overheads

the higher the profit margin ratio, the more profitable the firm has been

Define ‘profit’

the financial surplus after all costs, including expenses, have been paid

Ways to improve the ‘profit margin ratio’

reduce any type of excessive & unnecessary expenses. typical business expenses include the following:

• insurance

• lease payments for capital equipment & other fixed (non-current) assets

• mortgage payments

• phone & internet services

• rent on commercial buildings/land

• salaries for management & administrative personnel

• utility bills

Define ‘capital employed’

values of the funds used to operate the business & to generate a financial return for the organisation. the sum of non-current liabilities & equity finance.

‘Return on capital employed’ as a profitability ratio

profitability ratio that measures a firm’s efficiency & profitability in relation to its size (as measure by the value of the organisation’s capital employed)

• return on capital employed (ROCE) = (profit before interest & tax ÷ capital employed) x 100

Ways to improve ‘ROCE ratio’

a business can improve its ROCE ratio by using any combination of strategies that improve its profit before interest & tax, such as:

• increasing the firm’s sales revenues by using strategies such as reduced prices to attract more customers, using new sales promotions, offering a wider & more efficient distribution network and/or launching new & improved products

• reduce costs of production through methods such as using alternative suppliers, having improved stock control systems, seeking additional opportunities for economies of scale, improved quality management systems to reduce the cost of wastage

• selling unproductive, unused, underused & obsolete assets in order to improve operational efficiency & liquidity. being more efficient also helps the firm reduce its cash outflows