3.5 — Profitability and Liquidity Ratio Analysis

PART A: INTRODUCTION TO RATIO ANALYSIS

What is Ratio Analysis?

Ratio analysis is the technique of analysing financial statements by calculating ratios — relationships between different financial figures — to assess a business's performance, financial health, and efficiency.

Why Use Ratios?

Purpose	Explanation
Simplifies data	Converts complex accounts into meaningful numbers
Enables comparison	Compare with previous years, competitors, industry
Identifies trends	Track performance over time
Highlights problems	Reveals areas needing attention
Informs decisions	Supports investment, lending, management decisions
Benchmarking	Measure against standards or targets

Types of Ratios

Category	What It Measures	Key Ratios
Profitability	How effectively the business generates profit	Gross profit margin, Profit margin, ROCE
Liquidity	Ability to meet short-term obligations	Current ratio, Acid test ratio
Efficiency	How well resources are used	Stock turnover, Debtor days, Creditor days
Gearing	Level of debt financing	Gearing ratio, Interest cover
Investor	Returns to shareholders	EPS, Dividend yield, P/E ratio

This unit focuses on Profitability and Liquidity ratios

Using Ratios Effectively

Comparison	Description
Historical	Compare with previous years (trend analysis)
Inter-firm	Compare with competitors
Industry	Compare with industry averages
Targets	Compare with planned/budgeted figures

Important: A single ratio in isolation has limited meaning. Context is essential.

PART B: PROFITABILITY RATIOS

Overview

Profitability ratios measure how effectively a business generates profit from its activities. They show the relationship between profit and other financial figures.

1. Gross Profit Margin

Definition: The percentage of revenue that remains after deducting the cost of goods sold; shows the profit from trading before operating expenses.

Formula

$Gross\ Profit\ Margin = \frac{Gross\ Profit}{Revenue\ (Sales)} \times 100%$

Example Calculation

Item	Amount
Revenue	$500,000
Cost of Goods Sold	$300,000
Gross Profit	$200,000

$Gross\ Profit\ Margin = \frac{200,000}{500,000} \times 100% = 40%$

Interpretation: For every $1 of sales, $0.40 remains after covering direct costs.

What It Shows

Aspect	Explanation
Trading efficiency	How well the core buying/selling or production is managed
Pricing power	Ability to mark up products
Cost control	Effectiveness of managing direct costs
Product mix	Impact of selling different products

Factors Affecting Gross Profit Margin

Factor	Impact on Margin
Price increases	Higher margin (if volume maintained)
Price reductions	Lower margin (unless offset by volume)
Supplier costs rise	Lower margin
Better purchasing	Higher margin
Production efficiency	Higher margin
Wastage/theft	Lower margin
Product mix shift	Varies by product profitability
Competition	May force prices down

Industry Variations

Industry	Typical GP Margin	Why
Supermarkets	20-30%	High volume, low margin strategy
Luxury goods	50-70%	Premium pricing, brand value
Software/SaaS	70-90%	Low marginal cost
Restaurants	60-70%	High markup on food
Manufacturing	25-40%	Significant production costs

Strategies to Improve Gross Profit Margin

Strategy	How It Works
Increase prices	Higher revenue per unit
Negotiate with suppliers	Lower COGS
Reduce waste	Lower COGS
Improve production efficiency	Lower cost per unit
Change product mix	Focus on higher-margin products
Source cheaper materials	Lower COGS (watch quality)
Reduce theft/shrinkage	Lower COGS
Add value	Justify higher prices

2. Profit Margin (Net Profit Margin)

Definition: The percentage of revenue that remains as profit after all operating expenses, interest, and tax; shows overall profitability.

Note: Different versions exist depending on which profit figure is used.

Formula (Using Operating Profit / PBIT)

$Profit\ Margin = \frac{Operating\ Profit\ (PBIT)}{Revenue\ (Sales)} \times 100%$

Alternative (Using Net Profit After Tax):

$Net\ Profit\ Margin = \frac{Net\ Profit}{Revenue} \times 100%$

Example Calculation

Item	Amount
Revenue	$500,000
Operating Profit (PBIT)	$75,000

$Profit\ Margin = \frac{75,000}{500,000} \times 100% = 15%$

Interpretation: For every $1 of sales, $0.15 remains as operating profit.

What It Shows

Aspect	Explanation
Overall profitability	How much profit is generated from sales
Operating efficiency	Control of all operating costs
Business model	Viability of the business approach
Pricing and costs	Combined effect of all factors

Relationship: Gross Margin vs Profit Margin

Scenario	What It Suggests
High GP margin, low profit margin	High operating expenses; overheads problem
Low GP margin, low profit margin	Problems with both trading and overheads
Both margins stable	Consistent performance
Both margins declining	Serious concerns about competitiveness
GP margin falling, profit margin stable	Operating costs reduced to compensate

Factors Affecting Profit Margin

Factor	Impact
All GP margin factors	Flows through to profit margin
Operating expenses	Higher expenses = lower margin
Marketing spend	Higher spend may lower margin (but boost volume)
Administrative efficiency	Better control = higher margin
Depreciation	Higher depreciation = lower margin
One-off costs	Can distort in specific period
Interest (if included)	Higher debt = lower margin
Scale	Larger businesses may achieve lower costs

Strategies to Improve Profit Margin

Strategy	How It Works
All GP margin strategies	Improve trading profit
Reduce overheads	Lower operating expenses
Increase efficiency	More output from same resources
Automation	Reduce labour costs
Renegotiate contracts	Lower rent, insurance, etc.
Review marketing	Better ROI on marketing spend
Delayering	Reduce management costs
Outsourcing	Convert fixed to variable costs
Energy efficiency	Reduce utility costs

3. Return on Capital Employed (ROCE)

Definition: The percentage return generated on the total capital invested in the business; measures how efficiently a business uses its capital to generate profit.

Often called: The primary ratio; most important profitability ratio

Formula

$ROCE = \frac{Operating\ Profit\ (PBIT)}{Capital\ Employed} \times 100%$

What is Capital Employed?

Capital Employed represents the total long-term investment in the business.

Formula:

$Capital\ Employed = Total\ Equity + Non\text{-}Current\ Liabilities$

Or equivalently:

$Capital\ Employed = Total\ Assets - Current\ Liabilities$

Example Calculation

Item	Amount
Operating Profit (PBIT)	$75,000
Total Equity	$300,000
Non-Current Liabilities	$100,000
Capital Employed	$400,000

$ROCE = \frac{75,000}{400,000} \times 100% = 18.75%$

Interpretation: For every $1 invested in the business, $0.1875 of operating profit is generated.

What It Shows

Aspect	Explanation
Overall efficiency	How well all capital is used to generate profit
Investment return	What investors/lenders are getting for their money
Management effectiveness	Ability to generate returns from resources
Comparison standard	Can compare to cost of capital, alternative investments

Interpreting ROCE

ROCE Level	Interpretation
Higher than cost of capital	Creating value; worthwhile investment
Equal to cost of capital	Just covering costs; no value added
Lower than cost of capital	Destroying value; investment not justified
Higher than competitors	More efficient use of capital
Declining trend	Deteriorating efficiency

Typical benchmark: Should exceed the cost of borrowing (interest rates) and shareholders' required return.

Factors Affecting ROCE

Factor	Impact
Operating profit	Higher profit = higher ROCE
Capital employed	Higher capital = lower ROCE (if profit unchanged)
Asset efficiency	Better use of assets = higher ROCE
Financing structure	Mix of debt and equity affects capital employed
Asset revaluations	Higher asset values = lower ROCE
Investments	New investments may initially lower ROCE

Strategies to Improve ROCE

Strategy	How It Works
Increase operating profit	All profit margin strategies
Reduce capital employed	Sell underutilised assets
Improve asset utilisation	Generate more sales from same assets
Avoid overinvestment	Don't hold excessive assets
Manage working capital	Reduce unnecessary current assets
Review investments	Divest underperforming divisions
Lease vs buy	Leasing keeps assets off balance sheet

ROCE and the Du Pont Analysis

ROCE can be broken down into two components:

$ROCE = Profit\ Margin \times Asset\ Turnover$

Where:

Profit Margin = Operating Profit / Revenue
Asset Turnover = Revenue / Capital Employed

This shows two routes to improving ROCE:

Increase profit margin (make more profit per $ of sales)
Increase asset turnover (generate more sales per $ of assets)

Profitability Ratios — Summary

Ratio	Formula	What It Measures
Gross Profit Margin	(GP / Revenue) × 100%	Trading efficiency
Profit Margin	(PBIT / Revenue) × 100%	Overall operating profitability
ROCE	(PBIT / Capital Employed) × 100%	Return on investment

PART C: LIQUIDITY RATIOS

Overview

Liquidity ratios measure a business's ability to meet its short-term financial obligations — to pay bills as they fall due without having to sell long-term assets.

Why Liquidity Matters

Reason	Explanation
Survival	Business cannot survive if it can't pay bills
Creditor confidence	Suppliers, banks need assurance of payment
Operational continuity	Cash needed for day-to-day operations
Opportunity	Liquid businesses can seize opportunities
Avoiding insolvency	Many profitable businesses fail due to cash problems

Key insight: Profit ≠ Cash. A profitable business can fail if it lacks liquidity.

1. Current Ratio

Definition: The ratio of current assets to current liabilities; measures whether a business has enough short-term assets to cover short-term debts.

Also called: Working capital ratio

Formula

$Current\ Ratio = \frac{Current\ Assets}{Current\ Liabilities}$

Expressed as: X:1 (e.g., 2:1 means $2 of current assets for every $1 of current liabilities)

Example Calculation

Item	Amount
Current Assets	$150,000
Current Liabilities	$75,000

$Current\ Ratio = \frac{150,000}{75,000} = 2:1$

Interpretation: The business has $2 of current assets for every $1 of current liabilities.

What It Shows

Aspect	Explanation
Short-term solvency	Ability to pay short-term debts
Working capital	Adequacy of working capital
Financial cushion	Buffer against unexpected demands
Operational efficiency	How well short-term resources are managed

Interpreting Current Ratio

Ratio	Interpretation
< 1:1	Current liabilities exceed current assets; potential liquidity problem
1:1 to 1.5:1	Tight liquidity; may be acceptable depending on industry
1.5:1 to 2:1	Generally considered healthy
> 2:1	Strong liquidity; but may indicate inefficient use of assets
Very high (e.g., 5:1)	Excessive current assets; poor asset utilisation

Traditional benchmark: 2:1 was historically considered ideal, but this varies significantly by industry.

Industry Variations

Industry	Typical Current Ratio	Why
Supermarkets	0.5:1 - 1:1	Fast inventory turnover; cash sales; pay suppliers slowly
Manufacturing	1.5:1 - 2.5:1	Need to hold inventory and receivables
Utilities	0.5:1 - 1:1	Predictable cash flows; can operate with lower ratio
Construction	1.2:1 - 1.8:1	Long project cycles
Service businesses	1:1 - 2:1	Little inventory

Limitations of Current Ratio

Limitation	Explanation
Includes inventory	Inventory may be slow to convert to cash
Quality of assets	Receivables may include bad debts
Timing	Snapshot; may not reflect typical position
Industry differences	No universal "good" ratio
Composition	Doesn't show what makes up current assets

2. Acid Test Ratio (Quick Ratio)

Definition: The ratio of liquid current assets (excluding inventory) to current liabilities; a more stringent test of liquidity.

Also called: Quick ratio, Liquid ratio

Why Exclude Inventory?

Reason	Explanation
Least liquid	Inventory is the slowest current asset to convert to cash
Uncertain value	May not sell for book value
Takes time	Must be sold, then receivable collected
May be obsolete	Some inventory may have little value

Formula

$Acid\ Test\ Ratio = \frac{Current\ Assets - Inventory}{Current\ Liabilities}$

Or:

$Acid\ Test\ Ratio = \frac{Receivables + Cash}{Current\ Liabilities}$

Expressed as: X:1

Example Calculation

Item	Amount
Current Assets	$150,000
Inventory	$60,000
Current Liabilities	$75,000

$Acid\ Test\ Ratio = \frac{150,000 - 60,000}{75,000} = \frac{90,000}{75,000} = 1.2:1$

Interpretation: The business has $1.20 of liquid assets for every $1 of current liabilities.

What It Shows

Aspect	Explanation
Immediate liquidity	Ability to pay debts without selling inventory
Cash position	Strength of most liquid assets
Dependency on inventory	How reliant on selling stock
True short-term position	More realistic view than current ratio

Interpreting Acid Test Ratio

Ratio	Interpretation
< 0.5:1	Serious liquidity concerns
0.5:1 to 1:1	May be acceptable depending on industry
1:1	Can cover all current liabilities without selling inventory
> 1:1	Comfortable liquidity position
Very high	May indicate excess cash or receivables

Traditional benchmark: 1:1 often considered minimum, but varies by industry.

Current Ratio vs Acid Test — Comparison

Business	Current Ratio	Acid Test	Interpretation
A	2.5:1	2.0:1	Good liquidity; low inventory dependence
B	2.5:1	0.5:1	Current ratio misleading; high inventory; liquidity concerns
C	1.5:1	1.4:1	Acceptable; little inventory (service business?)
D	1.0:1	0.3:1	Risky; heavily dependent on selling inventory

Key insight: The gap between current ratio and acid test shows inventory's significance.

Strategies to Improve Liquidity Ratios

Strategy	Effect	Considerations
Collect receivables faster	Increases cash; improves both ratios	May strain customer relationships
Sell excess inventory	Converts to cash; improves acid test more	May sell at discount
Extend payables (within terms)	Doesn't reduce current liabilities directly but preserves cash	Don't damage supplier relationships
Reduce inventory levels	Reduces current assets but improves acid test	Risk of stockouts
Convert short-term to long-term debt	Reduces current liabilities; improves both ratios	May be costly
Inject equity capital	Increases cash; improves both ratios	Dilutes ownership
Sell fixed assets	Increases cash; improves both ratios	Lose productive assets
Delay capital expenditure	Preserves cash; improves both ratios	May harm future capacity
Negotiate supplier credit	Extends payment terms	Need good relationships
Factor receivables	Immediate cash from invoices	Costly; reduces margin

Liquidity Ratios — Summary

Ratio	Formula	What It Measures
Current Ratio	Current Assets / Current Liabilities	Overall short-term solvency
Acid Test Ratio	(Current Assets − Inventory) / Current Liabilities	Immediate liquidity

PART D: USING RATIOS TOGETHER

Building a Picture

Analysis	Ratios Used Together
Profitability	GP margin + Profit margin + ROCE
Liquidity	Current ratio + Acid test
Overall health	All ratios together

Example Combined Analysis

Ratio	Year 1	Year 2	Year 3	Trend
GP Margin	45%	43%	40%	Declining ↓
Profit Margin	15%	14%	12%	Declining ↓
ROCE	20%	18%	15%	Declining ↓
Current Ratio	2.0:1	1.8:1	1.5:1	Declining ↓
Acid Test	1.2:1	1.0:1	0.8:1	Declining ↓

Interpretation:

All profitability measures declining — competitive pressure or cost issues
Liquidity tightening — may face cash flow problems
Acid test below 1:1 — dependent on selling inventory
Urgent need to investigate causes and take action

Ratio Interrelationships

Relationship	Explanation
GP margin → Profit margin	GP minus operating expenses = Operating profit
Profit margin → ROCE	ROCE = Margin × Asset turnover
Liquidity → Profitability	Poor liquidity may force costly decisions
High inventory → Current ratio	Boosts current ratio but drags acid test
Fast growth → Liquidity pressure	Growth consumes cash (overtrading)

PART E: LIMITATIONS OF RATIO ANALYSIS

Important Caveats

Limitation	Explanation
Historical data	Based on past; may not predict future
Point in time	Balance sheet is snapshot; may not be typical
Accounting policies	Different methods produce different ratios
Window dressing	Accounts can be manipulated
Industry differences	Ratios vary hugely by industry
Size differences	Hard to compare different-sized businesses
Non-financial factors	Customer satisfaction, employee morale, reputation not captured
Inflation	Distorts historical comparisons
Intangibles	Valuable assets may not be on balance sheet
One-off items	Can distort ratios in specific period
Context needed	Ratios alone don't explain why
Benchmarks	"Good" ratio varies; no universal standard

Window Dressing Examples

Technique	Effect on Ratios
Delay purchases until after year-end	Lower inventory; better acid test
Collect receivables before year-end	Higher cash; better liquidity
Delay paying suppliers	Higher cash (temporarily)
Sale and leaseback	Removes assets; changes ROCE
Capitalising expenses	Higher profit; higher assets
Timing of asset revaluation	Affects capital employed and ROCE

PART F: EXAM APPLICATION

Potential Exam Questions

"Analyse what the gross profit margin and profit margin ratios reveal about a business's performance." (10 marks)
"Evaluate the usefulness of ROCE as a measure of business performance." (10 marks)
"Discuss the strategies a business might use to improve its liquidity ratios." (10 marks)
"Examine the difference between the current ratio and acid test ratio." (10 marks)
"To what extent does ratio analysis provide a complete picture of business performance?" (10 marks)
"Analyse the limitations of using financial ratios to compare two different businesses." (10 marks)

Key Definitions to Memorise

Term	Definition
Gross Profit Margin	Gross profit as a percentage of revenue
Profit Margin	Operating profit (PBIT) as a percentage of revenue
ROCE	Operating profit as a percentage of capital employed
Capital Employed	Total equity plus non-current liabilities
Current Ratio	Current assets divided by current liabilities
Acid Test Ratio	Current assets minus inventory, divided by current liabilities
Liquidity	Ability to meet short-term financial obligations
Profitability	Ability to generate profit from activities

Key Formulas

Ratio	Formula
Gross Profit Margin	(Gross Profit / Revenue) × 100%
Profit Margin	(PBIT / Revenue) × 100%
ROCE	(PBIT / Capital Employed) × 100%
Capital Employed	Total Equity + Non-Current Liabilities
Current Ratio	Current Assets / Current Liabilities
Acid Test	(Current Assets − Inventory) / Current Liabilities

Evaluation Frameworks

When discussing profitability ratios:

"Profitability must be assessed in context — industry, trends, competitors..."
"Different ratios reveal different aspects — GP margin shows trading; ROCE shows overall efficiency..."
"High profitability ratios are generally good but must be sustainable..."
"Improving ratios requires understanding the underlying causes..."

When discussing liquidity ratios:

"Liquidity is essential for survival; profitable businesses can fail without it..."
"The acid test is more stringent than the current ratio..."
"Optimal liquidity varies by industry and business model..."
"Too much liquidity can indicate inefficient use of resources..."

When evaluating ratio analysis:

"Ratios are tools, not answers — they raise questions to investigate..."
"Comparison over time and with benchmarks adds meaning..."
"Non-financial factors are not captured in ratios..."
"Window dressing can make ratios misleading..."