3.5 Profitability and Liquidity Ratio Analysis

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).