- Profitability and liquidity ratio analysis
- A management tool of analyzing and judging the financial performance of a business
- Numbers are taken from the final accounts
- Purpose
- To analyze the firm’s position (e.g. short-term liquidity, long-term liquidity, etc.)
- Assess financial performances (i.e. ability to control expenses)
- Compare actual with projected or budgeted figures (variance analysis)
- Aid in decision-making (to invest or not)
- Ratio comparison can be:
- Historical comparison (2 different time periods to show trends)
- Inter-firm comparisons (same industry)
- Profitability ratios
- These examine profit in relation to other figures
- Relevant to profit-seeking businesses
- Stakeholders’ interest
- Absolute profit – tell little on a firm’s performance
- Gross profit margin
- Shows the value of gross profit as a percentage of sales revenue
- GPM = (Gross profit / Sales revenue) x 100
- Improve the ratio by
- Raising sales revenue
- Increase or decrease prices (depending on price elasticity)
- Marketing
- Reducing direct costs
- Net profit margin
- Shows the percentage of sales turnover turned into net profit
- NPM = (Net profit before interest and tax / Sales revenue) x 100
- Differences between GPM and NPM represent expenses
- Larger difference means more difficult overhead control
- Improve the ratio by
- Same as GPM but costs can be examined further
- Negotiate preferential payment terms with creditors and suppliers to improve working capital
- Negotiate cheaper rent
- Reduce indirect costs
- Return on capital employed (ROCE)
- Measures the financial performance of a firm compared with the amount of capital invested
- ROCE = (Net profit before interest and tax / Capital employed)
- Figures show profit as a % of the capital used to generate it
- ROCE should be higher than interest rate in banks
- Benchmark: 20% ROCE, but has to be put into context of the business and the industry in which it operates
- ROCE is the key/primary ratio
- Using your net profit before tax and interest as this allows better comparisons – can’t control interest and tax rates
- Measures how well a firm is able to generate profit from its funds
- ROCE can be improved by
- Employ strategies to improve net profits
- Technically decreasing capital employed will improve the ratio, but this is not desirable
- Liquidity ratios
- Ability of the firm to pay its short term liabilities
- Current ratio
- Relationship between current assets and current liabilities
- Current ratio = (Current assets / Current liabilities)
- Reveals if a firm is able to use its liquid assets to cover its short term debts
- Desirable ratio: 1.5 – 2.0
- > 2: may mean too much stocks (inventory) or too much stagnant money (just standing there not being spent)
- Too low = too many debtors or current liabilities
- How to improve current ratio
- Raising the value of current assets
- Reducing the value of current liabilities
- Acid test ratio
- Relationship between the current assets (disregarding stock) and current liabilities
- This is done because stock may not be a liquid asset
- Acid test ratio = (Current assets less stocks / Current Liabilities)
- Desirable Ratio is AT LEAST 1:1
- < 1:1 ratio = liquidity crisis (not being able to pay short term debts
- Too high indicates holding too much cash and not using it effectively
- Affected stakeholders are the banks, creditors, and investors
- How can it be improved
- Raise level of current assets
- Lower current liabilities
Kim De Leon3.5. Profitability and Liquidity Ratio Analysis
