3.5 Profitability and Liquidity

Profitability:

Gross profit margin (from profit or loss statement):

Gross profit/sales revenue x 100%

The higher the number, the more efficient management is in generating profit for every dollar of the cost involved.

Increase the GPM = Increase gross profit = Increase revenue

Increase prices in less competitive/sensitive markets.

  • It may increase sales revenue, but the market may have very few or even lack substitutes.

  • Damage the image of the business with loyal consumers.

Cheaper materials to cut down the costs.

  • Reducing the cost of sales.

  • Customer resentment is it changes the quality.

Net profit margin:

(gross profit – expenses)/sales revenue x 100%

A higher net profit margin means that a company is more efficient at converting sales into actual profit.

Avoid unnecessary expenses.

  • Demoralize people who got used to them.

Negotiate with key stakeholders.

  • Cut costs.

  • This could lead to a firm moving to a poorer location.

Efficiency ratio:

Return on capital employed (ROCE):

Net profit before interest and tax/capital employed x 100%

Measures the return of the profit generated by the organization.

Capital employed = money invested = Non-current liabilities + Equity

Reduce loan capital.

  • Loan capital may be needed to purchase essential fixed assets.

Pay additional dividends to shareholders.

  • Reduce the retained profit.

  • Less ploughed-back profit for future investment.

Liquidity:

Current ratio – a company's ability to pay short-term obligations. >1 can meet its financial obligations ON TIME.

Higher is better.

Reduce bank overdrafts and seek long-term loans.

  • Reduce the current liabilities.

  • Increasing interest with long-term loans affects efficiency.

Sell fixed assets for cash.

  • Increases available working capital.

  • Risky to sell essential assets, may face the cost of leasing them.

 

Acid test ratio - the ability of a company to pay its bills as they come due, can a business meet its financial obligation NOW. You need time to sell stocks so we don’t take them into account.

>1 = can pay NOW; <1 = wait for maturity

Sell off stock at a discount for cash.

  • More available cash.

  • Reduce revenue.

Increase the credit period for debtors.

  • Leading to increased bad debts.