3.5 - Profitability and liquidity ratio analysis

What is ratio analysis and what is it used for?

It is a tool for analyzing the financial performance of a business. This is useful as it can be compared to other businesses, and used to understand company trends

What are profitability ratios?

These are ratios which compare profit to other figures, such as the ratio of profit to sales revenue.

These are:

• Gross profit margin (GPM)

• Profit margin (PM)

• Return on capital employed (ROCE)

How do you calculate the gross profit margin?

It is the value of gross profit as a percentage of sales revenue:

(Gross profit / sales revenue) x 100

E.g., If the GPM is 65%, that means that for every $100 of sales revenue, $65 of that will be gross profit

How can you increase the gross profit margin?

• By increasing sales revenue (e.g., charge higher prices)

• Reducing cost of sales (e.g., moving to an area with cheaper rent)

How do you calculate profit margin?

Profit margin shows the profit before interest and tax as a percentage of sales revenue

(Profit before interest and tax / sales revenue) x 100

E.g., if the PM is 25%, that means that for every $100 of sales revenue, $25 of that will be profit before interest and tax

How can you increase the profit margin?

• Increasing sales revenue

• Decreasing cost of sales

• Decreasing expenses

How do you calculate return on capital employed?

ROCE measures the profit before interest and tax as a percentage of the amount of capital invested.

(profit before interest and tax / capital employed) x 100

E.g., an ROCE of 45% means that for every $100 invested into the firm, $45 of that is profit

What is capital employed?

It is non-current liabilities + equity (because these are the long-term fundings of the business, the money put into it)

What is liquidity?

It is how quickly assets can be converted into cash.

What do liquidity ratios show?

They show the company’s ability to pay for current liabilities (short-term debts), through their current assets

What are the two types of liquidity ratios?

Current ratio and quick ratio

What is the current ratio?

It show how able a company is to use current assets to pay for current liabilities

current ratio = current assets / current liabilities

So, if the ratio is 0.9:1, that means that for every $1 of current liabilities, it can be paid with 0.9$ if current assets

What is the quick ratio?

It shows how able a company is to pay for current liabilities in an emergency. This still includes paying with current assets, but without stock, as it can’t always be converted quickly into cash

quick ratio = (current assets - stock) / current liabilities

So, if the ratio is 1.5:1, that means that for every $1 of current liabilities, the company has $1.5 of cash and debtors to pay for it

What is the best value for a liquidity ratio to have?

Between 1.5 - 2, as you don’t want current assets to be too high?

Why is it bad if current assets are too high?

• If you have too much stock, it may go to waste

• If you have too much cash, not enough may have been invested into the business

• If you have too many debtors, the business may have to chase up the payments they are owed

How can you improve liquidity ratios?

By raising current assets (increasing cash by increasing sales, investing in stock control to reduce stock to increase quick ratio)

By reducing current liabilities (decreasing amount of trade creditors you owe by paying on time)