Profitability and liquidity ratio analysis 3.5/3.6

Profitability

Gross profit margin: Measures the performance of a business.

Net profit margin : Assesses how successful a business was in converting sales revenue into both gross and net profit (%)

ROCE (return on capital employed): Assesses the profitability of a business.
Capital employed = (Non-current assets + current assets) - (Current liabilities + shareholders equity)

  • The higher the value the greater the return on each €
  • The method is not universally agreed thus, cannot be compared ith businesses abroad/ that don't use it

Liquidity

Current ratio: A ratio representing the ability to repay short-term debts / 1€. It is recommended for that amount to be between €1.5 to €2.

  • Very low current ratios are not surprising for food retailers as there is a constant inflow and outflow of cash.
  • Results under €1 suggests the business will not be able to pay the short term debts as for every €1 owed there is less than a €1 available to repay. To fix this the business can review their overheads, takt out long term loans or sell redundant assets.
  • It is also, bad to have more than €2 as it may suggest there are too many funds attached to the business and not being invested in it.

Acid test: It is the same as the current ratio test but is stricter. It ignores the least liquid of the firm's current assets - stocks: not yet sold and not guaranteed to be sold.

  • Results bellow €1 are bad (like current ratio).
  • A full assessment can be done by reviewing and comparing previous years.
  • Firms with high inventories such as, furniture retailers will have different current ratios and acid tests however, this is to be expected and not an issue whereas, for computer firms it would be as stock can lose its value fast.

Liquidity: The ability of a business to pay its short-term debts

How to improve:

How to improve liquidity:

Sell fixed assets for cash - These could be leased back

  • If assets are sold too fast they might not be sold at their true value
  • If assets are still needed then leasing charges will cause an increase in the netprofit margin

Sell inventories for cash - Will improve acid test but not current ratio

  • This will reduce the gross profit margin if inventories are sold at a discount
  • Consumers may doubt the reputation of the brand if sold cheaply
  • Inventories may be needed to meet changing customer needs and wants.

Increase loans = more cash in the firm and increase working capital

  • This will increase the gearing ratio
  • This will increase interest costs as well.

How to improve:

Raise prices of existing products = D could be price elastic

Develop innovative products at high prices = only long-term + investment needed

Reduce variable costs / unit = Cheaper materials reduce quality

Reduce overheads (delayering or promotion costs) = May have drawbacks and ineffective in the short-run.

Reduce overhead costs: rent, promotion/management costs but maintain sales = lower rent means a cheaper area - damage image and not the same customer reach, efficiency may fall due to lower promotion costs and could lead to sales falling by more than the fixed costs.

Reducing direct costs (cutting the costs of the goods sold) = Quality may be at risk, consumers may think the product is bad, machinery will be expensive - increase in overheads and motivation may fall for workers

Increase price - of the product or process = Total sales revenue may fall if customers switch to competitors and bad reputation due to the idea that it is a profiteering decision

Insolvency: Unable to pay the debts owed - bankruptcy or insolvent state