3.5

3.5 - PROFITABILITY AND LIQUIDITY RATIO ANALYSIS


Ratio analysis is a quantitative financial analysis tool for judging the financial performance of the business based on financial statements

Types of Ratios : 

Profitability ratios examine an organisation's profit-making ability. The three types of profitability ratios are gross profit margin, profit margin and return on capital employed (ROCE).

Gross profit margin shows the percentage of gross profit in relation to revenue. You will need a profit and loss account to obtain data for calculation of profit margin. The formula of gross profit margin is:

Gross profit margin = gross profit ÷ revenue ⨉ 100

The higher the gross profit margin is, the better. For example, gross profit of $150 from sales revenue of $250 is 60%. It means that for every $100 of sales, $60 is gross profit.

Strategies to improve Gross Profit margin - 

Adjust Pricing

  • Lower Prices: May increase demand, raising revenue; however, it may negatively impact brand image as it could seem inferior.

  • Raise Prices: Can increase revenue if demand is inelastic (e.g., few alternatives), but risks being perceived as unethical.

Increase Promotion

  • Benefits: More potential customers become aware of the product, potentially increasing demand.

  • Drawbacks: Increased marketing costs, and awareness doesn’t guarantee sales.

Reduce Cost of Sales (Cheaper Suppliers)

  • Pros: Lower cost of sales could boost gross profit margin.

  • Cons: Risk of inferior quality, which may affect product reputation.

Reduce Cost of Sales (Lower Labor Costs)

  • Pros: Reduces expenses, improving margins.

  • Cons: May reduce employee motivation and incur severance costs for layoffs.




Profit margin shows the percentage of net profit before interest and tax in relation to revenue. You will need a profit and loss account to obtain data for calculation of profit margin. The formula of gross profit margin is:

Profit margin = profit before interest & tax ÷ revenue ⨉ 100

The higher the profit margin, the better the organisation controls its expenses. For example, the profit margin of $100 from sales revenue of $250 is 40%. It means that for every $100 of sales, $40 is profit margin.

Strategies to improve Profit margin - 

Improve Working Capital by Extending Trade Credit Period

  • Method: Negotiate a longer trade credit period to delay payments, improving cash flow for daily operations.

  • Pros: Increases cash on hand, boosting working capital.

  • Cons: Suppliers may react negatively, potentially straining relationships or raising prices.

Negotiate Early Payment Discounts with Suppliers

  • Method: Agree to pay earlier than usual in exchange for discounts.

  • Pros: Frees up cash due to lower supply costs.

  • Cons: May create pressure to generate revenue quickly, potentially affecting product quality or employee motivation.

Reduce Expenses (Delayering)

  • Method: Remove unnecessary management levels to cut costs.

  • Pros: Reduces expenses, directly increasing net profit.

  • Cons: May reduce control over employees, potentially impacting productivity.

Cut Overhead Costs (e.g., Rent, Supplies)

  • Method: Lower expenses on non-essential items (e.g., rent, stationery, coffee).

  • Pros: Reduces overall operating expenses.

  • Cons: Could lower staff morale if accustomed benefits, like free coffee, are removed.


Return on capital employed (ROCE) shows how well capital employed is used in making profit. You will need both a profit and loss account and balance sheet to obtain data for calculating ROCE. The formula for ROCE is:

ROCE = profit before interest & tax ÷ capital employed ⨉ 100

Capital employed = non-current liabilities + equity

The higher the ROCE, the more profit the organisation generates from invested capital. For example, 25% ROCE shows that for every $100 invested, $25 profit is generated. ROCE benchmarks are different in different industries but usually a benchmark of an acceptable ROCE is around 20%.

Strategies to improve ROCE - 

Reduce Non-Current Liabilities (e.g., Long-Term Loans)

  • Method: Lower reliance on long-term loans, which reduces liabilities.

  • Pros: Improves ROCE by decreasing the capital employed.

  • Cons: Limited funds for growth as long-term loans often fund asset purchases essential for expansion, potentially hindering long-term growth.

Reduce Retained Profits by Increasing Dividend Payments

  • Method: Pay higher dividends to reduce retained profits, thereby lowering capital employed.

  • Pros: Boosts ROCE by reducing the capital base without impacting profits.

  • Cons: Lower retained profits limit self-funding for growth, potentially increasing dependency on loans, linking back to drawbacks from reduced long-term borrowing.


Liquidity ratios examine an organisation's ability to pay for its current liabilities. Liquidity is defined as the state of being liquid. In the business world, water is cash, i.e. cash is the most liquid asset. 

So, liquidity refers to the availability of liquid assets to an organisation. In the balance sheet, liquid assets are in the current assets section and are usually cash, debtors and stock. 

Types of Liquidity Ratios : 

Current ratio compares organisation’s current assets to current liabilities. The formula of current ratio is:

Current ratio = current assets ÷ current liabilities

Desirable ratio depends on the industry, but it is usually between 1,5:1 to 2:1. If the current ratio is lower than 1:1, it indicates that the organisation is experiencing liquidity problems. If the ratio is more than 2:1, it means too much of one or some of the following:

  • Cash : Cash is a depreciating asset. Its value decreases over time due to inflation, so it is not a good idea to hold too much cash.

  • Debtors : If an organisation holds too many debtors, it means that it sells a lot of its product on credit, i.e. it means that debtors receive products, but pay for them later. It might result in bad debt — a situation when debts cannot be repaid. This should be avoided.

  • Stock : (unsold goods). This indicates that there is too much unsold goods that take up storage space and do not generate any value. This situation is also undesirable.






Strategies to improve Liquidity Ratio - 

Increase Current Assets by Selling Non-Current Assets for Cash

  • Method: Sell non-current assets to boost cash reserves.

  • Pros: Increases cash, directly improving the current ratio.

  • Cons: Holding too much cash is undesirable as it’s a depreciating asset. Balance is crucial to avoid excess cash or liquidity shortages.

Decrease Current Liabilities by Shifting to Long-Term Financing

  • Method: Use long-term financing instead of short-term loans to reduce current liabilities.

  • Pros: Improves current ratio and reduces frequent payment obligations.

  • Cons: Risk of liquidity issues if cash is insufficient for immediate expenses, like wages or utilities.


Acid test (quick) ratio compares organisation’s current assets less stock to current liabilities. The formula of acid test ratio is:

Acid test ratio = (current assets – stock) ÷ current liabilities

This ratio is very similar to the current ratio, but it excludes stock from calculation, which makes this ratio more strict. It is more suitable for organisations, whose stock is not very liquid and yet is very high in value.

Strategies to improve Acid Test Ratio - 

Increase Cash by Selling Non-Current Assets

  • Improves cash reserves and the acid test ratio, though excessive cash should be avoided as it’s a depreciating asset.

Reduce Current Liabilities by Using Long-Term Financing

  • Enhances the acid test ratio by reducing short-term obligations but requires careful cash management to avoid liquidity issues.

Quickly Liquidate Inventory through Discount Sales

  • Method: Sell inventory at a discount to convert it to cash.

  • Pros: Increases cash, thus improving the acid test ratio.

  • Cons: Discounts reduce revenue, potentially impacting profitability negatively.

 TERMS/IMPORTANT STUFF : 

Acid Test Ratio (Quick Ratio): A liquidity ratio that measures a firm's ability to meet its short-term debts, ignoring stock, as not all inventories can be easily turned into cash in a short time frame.

Capital Employed: The value of all long-term sources of finance for a business, consisting of noncurrent liabilities plus equity.

Current Ratio: A short-term liquidity ratio that calculates the ability of a business to meet its debts within the next twelve months.

Gross Profit Margin (GPM): A profitability ratio that shows the value of a firm's gross profit as a percentage of its sales revenue.

Liquid Assets: The possessions of a business that can be quickly converted into cash without losing value, such as cash, stocks, and debtors.

Liquidity Crisis: A situation in which a firm is unable to pay its short-term debts, meaning current liabilities exceed current assets.

Liquidity Ratios: Ratios that assess a firm's ability to pay its short-term (current) liabilities, including the current ratio and the acid test (quick) ratio.

Profit Margin: A ratio showing the percentage of sales revenue that turns into profit, representing the proportion of sales revenue left after all direct and indirect costs are paid.

Profitability Ratios: Ratios that examine profit in relation to other figures, including the gross profit margin (GPM), profit margin, and return on capital employed (ROCE) ratios.

Ratio Analysis: A quantitative management tool that compares different financial figures to assess and evaluate the financial performance of a business.

Return on Capital Employed (ROCE): A profitability ratio that measures a firm’s financial performance based on the amount of capital invested.