Please enable JavaScript.
Coggle requires JavaScript to display documents.
3.5 PROFITABILITY AND LIQUIDITY RATIO ANALYSIS (LIQUIDITY RATIOS (ACID…
3.5 PROFITABILITY AND LIQUIDITY RATIO ANALYSIS
PROFITABILITY RATIO
RETURNED ON CAPITAL EMPLOYED (ROCE)
Formula :
net profit per capital employed times 100% (also shown in percentage)
Capital employed is the value of all the assets employed in a business, and can be calculated by adding fixed assets to working capital or by subtracting current liabilities from total assets
Also referred as the primary efficiency ratio
Higher the ratio of ROCE, the greater the return on each dollar
Is used to assess the profitability of a business
Strategy to improve
Reduce variable cost per unit
Cheaper material could reduce quality
Reduce overhead
Not effective in increasing profit
Raise price of existing products
Demand could be price elastic
Sell assets
Assets may be needed in future
PROFIT MARGIN RATIOS
Net Profit Margin
Formula :
net profit per sales revenue times 100%
Net profit is affected by overheads / indirect costs
Net profit margin also shown in percentage
Is used to see the improve or worsen of a company performance
Gross Profit Margin
Formula :
gross profit per sales revenue times 100%
Gross profit margin is a good indicator of how effectively managers have added value to the cost of sales
Is used to assess how successful the management of a business in converting sales revenue into gross profit
Gross profit margin in shown in percentage
Strategy to improve
Reduce indirect costs/overheads
raise product price with no increase in variable cost
moving to cheaper area would damage the image, cutting promotional would let the sales fall, fewer managers means less efficency
Increase price
cut overhead thru rent, promotion cost, management cost
i.e:
move to cheaper head office, reduce promotion cost
total profit fall if consumer switch to competitors, long term image may be damaged
Reduce direct costs
use cheaper material, cut labour cost; relocating production or automation production, cut wage costs
consumer's perception on quality, purchase machinery would increase overheads, motivation of labour falls
LIQUIDITY RATIOS
ACID TEST RATIO
Ignores the least liquid of the firm current assets to give a clearer picture of the firm ability to pay back
Formula :
liquid assets per current liabilities
A stricter test of a firm liquidity
Results below 1 means that the business has a liquidity problem
Also known as quick ratio
CURRENT RATIO
Current ratio is current assets per current liabilities
The safe ratio in current ratio is about 1.5-2
A result in depends on the in industry the firm operates in and the recent trend in the current ratio
Current ratio over 2 might suggest that too many funds are tied up in unprofitable inventories meanwhile low current ratio leas to corrective management action to increase cash held by the business
Result can be expressed as ratio or just a number
STRATEGY TO IMPROVE LIQUIDITY
Sell inventories for cash
Goods could be sold at a discount
Will reduce the gross profit margin, consumers may doubt the image of the brand if the inventories are sold cheaply
Increase loans
Long term loans could be taken out if the bank is confident of the company's prospects
These will increase the gearing ratio and interest costs
Sell fixed assets for cash
Land and property could be sold to a leasing company
Leasing charges would be add to overheads, if assets are sold quickly, the price would be sold at low value
TERMS TO CONSIDER
Liquidation:
When a firm ceases trading and its assets are sold for cash
Insolvent:
When a firm cannot meet its short term debts
Liquidity:
Ability of a firm to pay its short term debts