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3.5 Profitability & Liquidity Ratio Analysis

Ratio Analysis

A ratio is one number expressed in terms of another.

For example, a company with 20 men and 30 women gives a ratio of 2:3, indicating that for every 2 men, there are 3 women.

In this case, ratio analysis is a quantitative management tool for businesses. It allows the business to assess their financial performance in a given time period. This is usually done by comparing historical data to final closing data (comparing last year's results to the current year's results)

The purpose of ratio analysis

This is done to:

Assess the business's financial position
Asses the business's financial performance
Compare actual data to historical or predicted values (known as
Assist in decision-making

Ratios can be compared in two ways:

Historical Comparison - comparing two data sets from different periods of time
Inter-firm Comparison - comparing data sets from different companies within the same industry

Profitability and Efficiency Ratios

Profitability ratios

Examines profits in relation to other figures, such as sales revenue.

As a ratio for profits, this is commonly applied to for-profit businesses, meaning charitable firms are excluded.

This shows how well a firm performed financially.

Ratios:

Gross Profit Margin
Net Profit Margin
Return on Capital Employed

Efficiency ratios

Examines how efficient the business is in terms of resource usage. For example, profits can be compared to how much capital was invested.

For example:

Two businesses generated $100 profits. Business A invested $200 and Business B invested $250. The efficiency ratio for A is 50%, but for B is 40%. Therefore, despite making the same profits, business A is more efficient.

Ratios:

Return on Capital Employed

Profit

Key objective for most businesses and acts as a measure of a firm's success
Surplus of earnings

Gross Profit Margin

Value of gross profit as a percentage of sales revenue

GPM = (Gross Profit/Sales Revenue) x 100

Improving GPM Ratio:

Raising revenue by:
- reducing selling price of products with many substitute products
- raising selling price of products with few substitutes
- marketing strategies
- seeking alternative revenue streams
Reducing costs by:
- cutting direct material costs (might have a negative effect)
- cutting direct labour costs

Net Profit Margin

Percentage of sales turnover that is turned into net profit

NPM = (Net Profit/Sales Revenue) x 100

better measure of firm's profitability
accounts for both direct and indirect costs
a larger difference between GPM and NPM means that overheads are more difficult to control
NPM > GPM is better

Improving NPM ratio:

negotiate preferential payment terms with creditors and suppliers
improve working capital
negotiate cheaper rent
reduce indirect costs

Return on Capital Employed (ROCE)

Measures the financial performance compared to the amount of capital invested

ROCE = (Net profit before interest and tax/Capital employed) x 100

Capital Employed = loan capital + share capital + retained profit

ROCE shows profit as a percentage of the capital used too generate it
ROCE > Interest rate in other banks
Must be high enough to create an incentive for investors

Liquidity Ratios

Looks at the ability of a firm to pay its short-term liabilities, by comparing working capital to short-term debts

Businesses can be profitable but not liquid
- Bad asset management (cashflow)
Liquid Assets - assets that can be quickly turned into cash

Current Ratio:

Current Ratio = Current Assets/ Current Liabilities

ratio of 1.5 to 2.0 is desirable
high ratio means too much cash, too many debtors or too much stock

Acid Test Ratio (Quick Ratio)

Acid Test Ratio = ((Current Assets - Stock) / Current Liabilities)

doesn't include stock as it is not easily converted into cash
ratio should be 1:1
high ratio might mean too much cash in hand which could be used elsewhere

Uses and Limitations of Ratio Analysis

Uses:

Employees and trade unions use this to assess the likelihood of pay raise and job security
Managers and directors assess the likelihood of getting management bonuses and identify areas that need improvement
Trade creditors look at short term liquidity ratios to ensure that their customers have sufficient working capital to repay them
Shareholders can assess the return of their investment compared with other investments
Financiers consider if the business has a sufficient funds and profitability to repay loans that may be approved
Local community to gauge job opportunities

Limitations:

Historical account does not indicate the current or future financial situation of a business
Changes in external business environment can cause a change in financial situation without affecting business performance
No universal way to report company accounts
Qualitative factors that affect performance of a firm are ignored
Organizational objectives differ between businesses

Other quantitative and qualitative factors to assess performance:

Historical comparisons
- determine deterioration or improvement in firm's performance
Inter-firm comparisons
- ratios should be compared with close rivals to assess relative performance
The nature of the business and its aims and objectives (profit-seeking or non-profit)
The state of the economy
Social factors

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