Profitability and liquidity ratio analysis (Liquidity ratios (Acid test…
Profitability and liquidity ratio analysis
Return on capital employed (ROCE)
Demand could be price elastic.
This can only be a long-term strategy.
Cheaper materials could reduce quality
May not be effective in increasing profit in the short run and may have drawbacks e.g. less promotion could reduce sales
Finance will be needed and increase in net profits may be relatively less than increase in capital employed.
assets may be needed in the future e.g. for expansion of business
Strategies to increase ROCE
Increase net profit w/o increasing capital employed e.g.:
Raise prices of existing products
Develop innovative products and set prices high
Reduce variable costs per unit
Reduce overheads, such as delayering or reducing promotion costs
Increase capital invested in new technology which could lead to an increase in net profits hgiher than the increase in capital employed.
Reduce capital employed e.g.:
Sell assets that contribute mothing or little to sales/profit - use the capital raised to reduce debts
Return on capital employed (%)
= (net profit/capital employed) x 100
- (non-current assets + current assets) -current liabilities or non-current liabilities + shareholders' equity. The total capital invested in the business
Most commonly used means of assessing the profitability of a business; often reffered to as the
primary efficiency ratio
Profit margin ratios :-
Gross profit margin
net profit margin
ratios are used to assess how successful the management of a business has been at converting sales revenue into both gross and net profit.
Gross profit margin (%)
= (gross profit/sales revenue) x 100
Net profit margin (%)
= (net profit/sales revenue) x 100
Strategies to increase profit margins
1. Increase gross and net profit margin by reducing direct costs - cutting cos of goods sold
a. Use cheaper materials for soles on shoes
b. Cut labour costs by relocating production to low- labour-cost countries
c. Cut labour cots by increasing productivity through automation in production
d. Cut wage costs by reducing workers' pay
2. Increase gross and net profit margin by increasing price
a. Raise the price of the product with no significant increase in variable costs
b. Petrol companies increase prices by more than the price of oil has risen.
3. Increase net profit margn by reducing overhead costs
Cut overhead costs, such as rent, promotion costs or management costs, but maintain sales levels, for example by:
a. moving to a cheaper head office location
b. reducing promotion costs
c. delayering the organisation
the ability of a firm to pay its short-term debts
= current assets/current liabilities
Acid test ratio
also known as
a stricter test of a firm's liquidity. it ignores the least liquid of the firm's current assets - stocks, which have not yet been sold and there is no certainty that they will be sold in the short term. By eliminating the value of stocks from the acid test ratio, the users of accounts are given a clearer picture of the firm's ability to pay short-termd debts.
acid test ratio
= liquid assets/current liabilities
Strategies for improving liquidity ratios
1. Sell off fixed assets for cash - could lease these back if still needed by the business
Land and property could be sold to a leasing company
2 Sell off invntories for cash -
: this will improve the acid test ratio, but not the current ratio
Inventories of finished goods could be sold off at a discount to raise cash.
Just-in-time (JIT) inventory management will achieve this objective
3. Increase loans to inject cash into the business and increase working capital
Long-term loans could be taken out if the bank is confident of the company's prospects.