3.5. Profitability and Liquidity Ratio Analysis

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