3.5 profitability ratios and 3.6 debt ratios

GPM

the percentage of revenue that remains after deducting cost of sales

Can be increased by increasing sales revenue or reducing costs

high gross profit margin means a company keeps a large portion of its revenue after paying for the direct costs of producing its goods or services

Profit margin (operating)

how much money a business earns from its core, day-to-day operations before subtracting interest and taxes

ROCE

Shows how icy profit the business makes for every unit of money invested in it

It is a measure how effectively a business uses the capital invested in the business to generate profit

Higher percentage is better

To improve, increase profits of reduce capital employed

Current ratio

shows whether a company has enough sort term assists to pay off its short term debts due within the next year

Ratio above 1.0 : The company has more current assets than current liabilities.

Ratio below 1.0: The company has more short-term bills than easily accessible assets.

Very high ratio: can mean the company is failing to use its cash or assets efficiently to grow the business

Acid test ratio

Whether a company has enough sort term assets to pay off its debts without selling inventory

Ratio above 1.0 : The company has more current assets than current liabilities.

Ratio below 1.0: The company has more short-term bills than easily accessible assets.

Very high ratio can mean the company is failing to use its cash or assets efficiently to grow the business

Improving liquidity

Reduce credit period offered to customers

Ask suppliers for longer

Use an overdraft

Sell excess stock/assets

Stock turnover

shows how well a business converts its stock into sales

Number of times a business sells all of its stock during a period: Businesses aim for a high or increasing ratio, More stock sold means that it is generating profit more efficiently

Number of days taken to sell all of its stock: Businesses aim for a low or falling ratio, Selling stock quickly means profit is achieved swiftly

To improve: hold less stock or reduce cos of sales

Gearing ratio

shows the balance of non-current liabilities to shareholder capital used to fund a business - want this to be low

• If the outcome is less than 50% the business is low-geared

  • The business is largely funded by shareholder capital

• If the outcome is more than 50% the business is highly-geared

  • The business is largely funded by loan capital - can be problematic if interest rates increase, reduces chance of further loans, makes it harder to attract investors, high interest rates on future borrowings

Debtor days

measures the average number of days it takes for a business to collect money from its debtors

Businesses aim for a low or reducing ratio to improve cash flow

Improved by: sending clear invoices promptly, perform credit checks on customers, offer various payment methods, provide incentives for early payback

Creditor days

measures the average number of days a business takes to pay its creditors

• Businesses generally aim for a high or increasing ratio

  • This indicates skills of negotiation in arranging extended credit terms with suppliers

  • Delaying payments to suppliers can improve cash flow

taking longer may have negative consequences

• Relationships with important suppliers may worsen

  • They are less likely to extend further trade credit 

  • Penalties for late payment 

  • Orders may be delayed until payment is received

• Creditworthiness may worsen

Improve by; employ a credit controller to manage negotiations about payments

Insolvency

the inability of a business to pay debts and continue trading

For a sole traders or partnership: this may/will lead to bankruptcy

For a company: they could enter into administration - attempts to settle debts and continue trading. If this fails they may liquidate - the selling of assets to settle outstanding debts and dissolve a company

Bankruptcy

occurs when a business ceases to trade and the value of its possessions are distributed to its creditors