Profitability and Liquidity Ratio Analysis

Profitability and Liquidity Ratio Analysis Notes

Overview of Ratio Analysis

  • Definition: Financial tool to interpret and assess organization’s final accounts.

  • Purpose: Evaluate financial performance and facilitate comparisons for benchmarking.

Profitability Ratios

  • Purpose: Measure the value of a firm’s profits for investment assessment.

  • Key Ratios: Gross Profit Margin (GPM), Profit Margin, Return on Capital Employed (ROCE).

1. Gross Profit Margin (GPM)

  • Definition: Gross profit as a percentage of sales revenue.

  • Formula: GPM = (Gross Profit / Sales Revenue) x 100.

  • Example: GPM = ($45m / $100m) x 100 = 45%.

  • Strategies: Change promotions, launch higher-margin products, adjust prices, outsource.

2. Profit Margin

  • Definition: Overall profit as a percentage of sales revenue.

  • Formula: Profit Margin = (Profit / Sales Revenue) x 100.

  • Example: Profit Margin = ($20m / $100m) x 100 = 20%.

  • Strategies: Cut expenses, optimize salaries.

3. Return on Capital Employed (ROCE)

  • Definition: Efficiency and profitability relative to capital employed.

  • Formula: ROCE = (Profit Before Interest and Tax / Capital Employed) x 100.

  • Strategies: Increase sales, reduce production costs.

Liquidity Ratios

  • Purpose: Assess ability to pay short-term liabilities.

  • Key Ratios: Current Ratio, Acid-Test Ratio.

1. Current Ratio

  • Definition: Ability to meet short-term debts with liquid assets.

  • Formula: Current Ratio = Current Assets / Current Liabilities.

  • Example: Current Ratio = $25m / $15m = 1.67:1.

  • Strategies: Increase current assets, negotiate credit periods.

2. Acid-Test Ratio

  • Definition: Ability to pay short-term debts without selling inventory.

  • Formula: Acid-Test Ratio = (Current Assets - Inventory) / Current Liabilities.

  • Example: Acid Test Ratio = ($18m - $2m) / $12m = 1.33:1.

  • Strategies: Manage inflows, improve stock control.