3.5 Ratio Analysis

Profitability Ratios

A class of financial metrics that examine profit in relation to other figures, such as profit relative to sales revenue to assess how effectively a business generates profit compared to revenue, costs, assets, or equity.

Timeframe of Profitability Ratios

Based on data from a specific point in time.

Applicability of Profitability Ratios

More relevant to profit-seeking businesses than to non-profit organizations.

Gross Profit Margin (GPM)

A profitability ratio that shows gross profit as a percentage of sales revenue to measure how efficiently a business produces goods or services by showing how much revenue remains after direct costs.

Formula for Gross Profit Margin

(Gross Profit / Sales Revenue) * 100

Meaning of a High GPM

Indicates strong profitability, as more revenue is left to cover other expenses after direct costs.

Profit Margin (PM)

A profitability ratio that shows profit before interest and tax as a percentage of sales revenue to measure how much of the sales revenue remains after deducting indirect costs from gross profit.

Formula for Profit Margin

(Profit before Interest & Tax / Sales Revenue) * 100

Meaning of a High PM

Indicates strong overall profitability, giving the firm more funds for dividends and retained earnings. And when compared to GPM, shows the indirect cost

Return on Capital Employed (ROCE)

A profitability ratio that measures a firm's financial performance relative to the capital invested to assess how efficiently a firm uses its capital to generate profit.

Formula for ROCE

(Profit before Interest & Tax / Capital Employed) * 100

Definition of Capital Employed

The total of non-current liabilities and equity, representing the funds used to operate the business.

Meaning of a High ROCE

Indicates efficient use of capital, showing strong profitability from the funds available.

Raise Revenue to Improve GPM

- Increase the selling price for products with few substitutes.

- Decrease the selling price for products with many substitutes to boost sales volume.

- Use marketing strategies to increase sales revenue.

- Produce and sell products with a higher gross profit margin.

- Seek alternative revenue streams to diversify income.

Reduce Cost of Sales to Improve GPM

- Reduce direct material costs by sourcing alternative raw materials or new suppliers.

- Cut direct labor costs by improving workforce efficiency or reducing the workforce.

Control expenses to improve PM and ROCE

Reduce indirect labor costs by outsourcing or streamlining operations, Seek cheaper rental premises to lower fixed costs, Install energy-efficient machinery and equipment to cut energy costs, Find alternative suppliers for insurance policies to reduce premiums, Use cheaper forms of advertising to lower marketing expenses

Liquidity Ratios

Ratios that measure a firm's ability to pay its short-term liabilities and reveal the level of working capital available to meet everyday financial obligations.

Current Ratio

A liquidity ratio that measures a firm's ability to cover its short-term liabilities with its liquid assets to assess whether a firm can use its liquid assets to cover its short-term debts.

Formula for Current Ratio

Current Assets / Current Liabilities

Ideal benchmark for Current Ratio

The ideal range for current assets to current liabilities is between 3:2 and 2:1.

Quick Ratio (Acid Test)

A liquidity ratio that measures short-term liquidity by excluding stock from current assets to assess whether a firm can meet its short-term obligations without relying on inventory.

Formula for Quick Ratio

(Current Assets - Stock) / Current Liabilities

Reason for excluding stock in Quick Ratio

Stock may not be easily converted into cash, especially during periods of low demand.

Ideal benchmark for Quick Ratio

A 1:1 ratio is considered financially healthy.

Effect of exceeding current ratio benchmark

May indicate that the firm's cash balance is too high. When the cash balance is too high, the firm is missing the opportunity to reinvest surplus cash to grow the business.

Effect of exceeding quick ratio benchmark due to debtors

May indicate that the debtor balance is too high. When the debtor balance is too high, too many outstanding payments from customers increases the risk of bad debts.

Effect of exceeding quick ratio benchmark due to stock

May indicate that the stock balance is too high. When the stock balance is too high, unsold inventory may not be converted into cash if it becomes perishable, unfashionable, or obsolete.

How to increase current assets to improve liquidity

Encourage cash purchases by offering discounts for immediate or early payment, Invest in stock control systems to reduce stock levels and increase cash holdings.

How to reduce current liabilities to improve liquidity

Replace overdrafts with long-term loans that have lower interest rates, Repay creditors on time to avoid late payment penalties, Use early payment discounts and consult tax specialists to reduce tax liabilities