Unit 3.5: Profitability and Liquidity Rate Analysis

Ratio Analysis

Quantitative management tool that compares different financial figures toe examine and judge the financial performance of a business 

• Uses figures in the final accounts (balance sheet and P&L account)

Purpose Ratio Analysis

• Examine financial position

  • Profitability, short or long term liquidity position

• Asses performance 

• Compare actual figures to the projected/ budget ones

  • Variance Analysis

• Aid with decision-making  

  • for both the business and stakeholder

Variance Analysis

• Compare actual figures to the projected/ budget ones

Application of Ratio Analysis

• HIstorical Comparisons: Compare ratios to historical figures

  • Looks at the same rations of a business but from different time periods

• Inter-firm Comparison: Compare rations to rival businesses 

What businesses are used for inter-firm comparisons

• Value of this analysis only comes from comparing Profitability Ratiosbusinesses 

Profitability Ratios

Examines the profit in relation to other figures - Shows how well the firm has performed in financial terms

• only applicable to for-profit or profit-oriented businesses

Profit

Financial surplus earning of an organization once all costs have been deducted from sales revenue

The main profitability Ratios

1. Gross Profit Margin (GPM):

2. Profit Margin

3. Return on Capital Employed (ROCE): Key ratio

Gross Profit Margin (GPM)

Represented in percentage figure

Higher GPM is

Better for the business: Gross profit goes towards their expenses → they’re actually able to pay themselves now

Improving GPM

1. Raising Sales Revenue

   • Reducing the selling price of elastic products

   • Raising the price of products that have less substitutes (inelastic) 

   • Improving marketing strategies 

   • alternative revenue streams

2. Reducing Direct Costs

   • Cutting direct material costs/ labor costs

Profit Margin

• Calculated with the profit before interest and tax - makes it more easily comparable to historical profits 

• Better measure of the profit as it accounts for both cost of sales and its expenses (Direct and indirect costs)

expenses

GPM - Profit Margin

• when expenses is higher that means there is larger different between the two ratio = overhead control is harder

Reducing expenses

1. Discuss preferential payment terms with the trade creditors → Helps with cash flow

2. Negotiate cheaper rent

3. Reduce indirect costs 

Return on Capital Employed (ROCE): Key ratio

Measures the financial performance of a firm based on their amount of capital invested

Capital employed

 = Owners equity + Noncurrent liabilities

Analysis of ROCE

• ROCE ratio will increase if capital employed falls whilst net profit remains constant - this is not desirbale as more profit isn’t being made

• HIgher the ROCE value the better of the business 

  • Eg, 20% ROCE means that when 100 dollars are invested 20 dollars are expected in profit 

• ROCE of a business should be higher than the interest rate offered at commercial banks 

  • if not put it in the bank to make profit

Liquidity Ratios

The ability of a firm to pay its short-term liabilities → Helps asses likelihood of financial lenders receiving their money back

Liquid Assets

Assets that can be quickly turned into cash without losing their value

Eg, Cash, stocks, debtors

Two main Liquidity ratios

1. Current Ratio:

2. Acid Test Ratio: Quick Ratio

Current Ratio:

• Deals with the firm’s liquid assets and current liabilities

  • Determines whether a firm can use liquid assets to cover short-term debts (within 12 months of the balance sheet)

Analysis of current ratio

• THe firm has (current ratio) of current liquid assets for every 1 dollar of current liabilities

  • If the value is negative: They will have trouble paying back their debts

  • If the value is high: 

1. TOo much cash in the business 

2. Too many debtors - More likely to have customers defaulting on what they owe

3. Too much stock - Increase storage and insurance costs

• General Rule: Have a current ratio of 1.5-2.0 so there is safety net 

  • Sufficient working capital 

Working capital

= Current assets - current liabilities

Acid Test Ratio

It ignores the value of the stocks when measuring the short-term liquidity position of a business - since stocks aren’t always easily converted to cash

General Rule of Acid test ratio

Should have a 1:1 ratio otherwise there will be working capital difficulties

• High value means they’re holding onto the cash that could be used more effectively 

Liquidity crisis

firm is unable to pay its short-term debts

Improvements for a low acid test ratio

• By raising the level of current assets 

• Lowering the amount of current liabilities 

• Increase debtors 

  • Risky since it could lead to increases rate of bad debts occurring 

Application of Ratio Analysis to different stakeholders (6)

• Employees and trade unions use the ratios to assess the likelihood of pay rises/ job security 

• Managers and directors can assess the likelihood of getting bonuses - identify areas of improvement

• Trade creditors use short term liquidity ratios to ensure customers (businesses) have enough working capital 

• Shareholders: Assess the return of their investments compared to others

• Financiers: Consider if the business has enough funds to repay the loans they could get

• Local Community: use the range to gauge job opportunities for the local residents 

Limitations of ratio analysis

• Ratios are historical accounts - do not indicate the future financial situation 

• Changes in external environmen

• No universal final accounts report 

• No consideration of qualitative factors - eg staff motivation, quality of the products 

• Organizational objectives could be different