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Profitability and liquidity ratios - Coggle Diagram
Profitability and liquidity ratios
Profitability ratio
Gross profit margin
The gross profit margin shows the value of a firm's gross profit
expressed as a percentage of its sales revenue.
(Gross profit / Sales revenue) x 100
The higher the better
How to increase
Increase sales revenue
Redue cose
Profit margin
The profit margin shows the percentage of sales turnover that
is turned into overall profit.
((Profit before interest and tax) / sales revenue) x100
higher the better
ways to improve- same as GPM
Return of capital employed (ROCE)
That measures the financial performance of a firm based on the
amount of capital invested.
(Profit before interest and tax) / capital employed x 100
Should atleast exceed the interest rate charged by bank
Liquidity ratio
Current ratio
The current ratio deals with a firm's liquid assets and current
liabilities.
Current asset / current liability
Should be between 1.5 to 2
less than 1.5 means too many debts
More than 2 means too many unused asset
Acid test ratio
it ignores the value of stock when measuring the
short-term liquidity position of a business.
(Current asset - stock) / current liability
should be 1:1
high means firm is holding too much cash
low means the firm is facing liquidity crisis
Uses of financial ratios
assess the likelihood of pay rises and the level of job security
Managers and directors can assess the likelihood of getting management bonuses for reaching profitability, liquidity and efficiency targets.
Trade creditors look at short term liquidity ratios to ensure that their customers (i.e. other businesses) have sufficient working capital to repay them.
Shareholders use financial ratios to assess the return of their
investment compared to other investments
Limitations of financial ratios
Can not predict future
No universal way
external factors may affect it