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3.5 PROFITABILITY AND LIQUIDITY RATIO ANALYSIS (PROFITABILITY RATIOS…
3.5 PROFITABILITY AND LIQUIDITY RATIO ANALYSIS
INTRODUCTION
Numbers are taken from the final accounts
PURPOSE
To analyse the firm’s position (e.g. short 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)
a management tool of analyzing and judging the financial performance of a business
PROFITABILITY RATIOS
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 cost 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)
Measure the financial performance of a firm compared with the amount of capital invested = how well a firm is able to generate profit from its funds
ROCE
= (net profit before interest and tax / capital employed)
use net profit before tax and interest as this allows better comparisons - can't control interest and tax rates
figures show profit as a % of the capital used i 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 can be improved by
employ strategies to improve net profits
technically decreasing capital employed will improve the ratio, but this is not desirable
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
increasing or decreasing prices (depending on price elasticity)
marketing
reducing direct costs
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