3.5 Profitability and Liquidity Ration Analysis

Ratio Analysis

Financial analysis tool used in the interpretation and assessment of a firm’s financial statements. It helps evaluate a company’s financial performance by determining certain trends and exposing its various strengths and weaknesses.

The Two Types of Ratio Analysis

1) Profitability Ratios

2) Liquidity Ratios

Profitability Ratios

These are ratios that assess the performance of a company in terms of its profit-generating ability. There are two types of profitability ratios

The Two Types of Profitability Ratios

1) Gross Profit Margin

2) Profit Margin

Gross Profit Margin

Calculated by dividing the gross profit by the sales revenue, expressed as a percentage.

Strategies to Improve Gross Profit Margins

• A company can increase prices for products in markets where there is less competition or markets where consumers are less sensitive to price changes. Raising prices here could increase sales revenue because the quantity purchased may not alter significantly when the price changes. The major drawback is that this could damage a company’s image to its consumers.

• A business can source cheaper suppliers of materials in order to cut down on its purchase costs. This will help reduce the cost of sales and help increase the gross profit margin.

• A company may adopt. more aggressive promotional strategies to make customers buy more.

• A business can aim to reduce direct labor costs by being more productive or sell more units.

Profit Margin

Calculated by dividing the net profit before interest and tax by the sales revenue, expressed as a percentage.

Strategies to Improve Profit Margin

• A firm can carefully check the indirect costs to see where unnecessary expenses may be avoided.

• A company could negotiate with key stakeholders to cut costs.

Return on Capital Employed (ROCE)

Assess the returns a firm is making from its capital employed. Capital employed is found by adding a firm’s non-current liabilities to its equity.S

Strategies to Improve ROCE

• A company should try to reduce the amount of long-term loans while still ensuring that profit before interest and tax remains unchanged.

• A company could declare and pay dividends to shareholders. This will have the effect of reducing the retained profit, thereby increasing the ROCE.

The Two Types of Liquidity Ratios

1) Current Ratio

2) Acid Test Ratio

Current Ratio

A ratio that compares a company’s current assets to its current liabilities.

Strategies to improve Current Ratio

• A company could reduce bank overdrafts and choose instead to seek long-term loans, reducing current liability.

• Another strategy would be to sell existing long-term assets for cash. This increases the available working capital for the business.

Acid Test Ratio

Stringent ratio that subtracts stock from the current assets and compares this to the firm’s current liabilities.

Strategies to Improve the Acid Test Ratio

• A company could sell off stock at a discount for cash, this will help to improve the liquidity position of the business and make more working capital available to pay off its short-term debts.

• A company could increase the credit period for debtors to enable them to purchase more stock on credit. This could lead to increased bad debts in the business if the debtors do not pay.