Profitability and Liquidity Ratio Analysis

These flashcards review key concepts and definitions related to the profitability and liquidity ratio analysis, essential for understanding a firm's financial performance.

Profitability ratios

Used to assess a firm's performance in terms of profit-generating, including ratios like gross profit margin and net profit margin.

Gross profit margin

The percentage of revenue that exceeds the cost of goods sold, calculated as GPM = (Gross Profit / Sales Revenue) × 100.

Net profit margin

A measure of the profit that remains after all costs are removed from revenue, calculated as NPM = (Net Profit Before Interest and Tax / Sales Revenue) × 100.

Return on capital employed (ROCE)

Measures the efficiency and profitability of a firm’s invested capital, calculated as ROCE = (Net Profit Before Interest and Tax / Capital Employed) × 100.

Liquidity

The ability of a business to convert its current assets into cash.

Current ratio

Measures a firm's current assets to its current liabilities, calculated as Current Ratio = Current Assets / Current Liabilities.

Acid test (quick) ratio

A more accurate indicator of a firm’s ability to meet short-term obligations, calculated as Acid Test Ratio = (Current Assets - Stock) / Current Liabilities.

Working capital cycle

The process of turning current assets into cash that can be used to purchase resources needed to produce a product, defined as Current Assets - Current Liabilities.

Efficiency ratios

Ratios that assess how well a firm uses its assets and liabilities to generate profit.

Methods to improve Gross Profit Margin

Increase prices, lower production costs, aggressive marketing, or reduce direct labor costs.

Importance of Current Ratio

It indicates whether a firm has enough working capital to pay off short-term debts.

Importance of Acid Test Ratio

It provides a more precise measure of a firm's short-term liquidity position.