3.6 - Profitability & Liquidity Ratio Analysis
The purpose of ratio analysis
Ratio analysis serves as a financial tool to evaluate a business's performance. It enables comparisons of financial data over different time periods, helping stakeholders assess trends and make informed decisions.
Key aspects of ratio analysis
- Historical comparisons - Ratios allow businesses to compare their performance across various periods, identifying improvements or declines.
- Profitability assessment - These ratios measure the level of profits relative to sales or investments, showing returns for stakeholders.
- Liquidity evaluation - Ratios assess a firm's ability to meet short-term debts using current assets, helping to avoid liquidity crises.
- Overall benefits - By expressing figures as percentages or ratios, they provide clear insights into efficiency, profitability, and financial health.
Profitability ratios including gross profit margin
Profitability ratios examine the profits generated by a business, often expressed as a percentage of sales revenue. They help stakeholders gauge the return on investments and the efficiency of operations.
Gross profit margin
Gross profit margin (GPM) indicates the gross profit as a percentage of sales revenue. Gross profit is calculated as sales revenue minus cost of goods sold (COGS).
Where:
- Gross profit = Sales revenue - COGS (£)
- Sales revenue = Total income from sales (£)
A higher GPM suggests better profitability from core operations.
Methods to improve gross profit margin
- Enhancing promotion - Implementing better marketing strategies to attract more customers and increase sales volume.
- Product innovation - Launching new items with higher margins to boost overall profitability.
- Price adjustments - Lowering prices in competitive markets to gain market share and volume.
- Supplier negotiation - Finding suppliers offering lower prices for raw materials, which reduces COGS.
Worked example - Calculating gross profit margin
An electronics retailer has sales revenue of £5 million and cost of goods sold of £2.5 million. Calculate the gross profit and gross profit margin.
Step 1: Identify the values
- Sales revenue = £5 million
- Cost of goods sold = £2.5 million
Step 2: Calculate gross profit
Gross profit = £5 million - £2.5 million = £2.5 million
Step 3: Apply the gross profit margin formula
Net profit margin and return on capital employed
These profitability ratios provide deeper insights into overall efficiency after accounting for all costs and the use of invested capital.
Net profit margin
Net profit margin (NPM) shows net profit (after deducting all costs) as a percentage of sales revenue. Net profit is the remaining surplus after paying production costs and expenses.
Where:
- Net profit before interest and tax = Gross profit - Expenses (£)
- Sales revenue = Total income from sales (£)
A higher NPM reflects efficient expense management and greater returns from sales.
Methods to improve net profit margin:
- Cost control - Cutting unnecessary daily expenses to increase net profit.
- Relocation strategies - Moving to locations with lower rent or operational costs.
Return on capital employed
Return on capital employed (ROCE) assesses profitability relative to the capital invested in the business. Capital employed is fixed assets plus working capital, or equivalently, equity plus long-term liabilities.
Where:
- Net profit before interest and tax = Profit after expenses but before deductions (£)
- Capital employed = Total assets - Current liabilities (£)
Methods to improve return on capital employed:
- Boosting revenue - Using promotions, price reductions, broader distribution, or product enhancements to increase sales.
- Cost reduction - Implementing better stock control, quality management, or achieving economies of scale.
- Asset management - Selling off underused assets to improve liquidity and reduce capital employed.
Worked example - Calculating net profit margin
A café chain has sales revenue of £7 million, cost of goods sold of £3.5 million, and expenses of £2.1 million. Calculate the net profit and net profit margin.
Step 1: Identify the values
- Sales revenue = £7 million
- Cost of goods sold = £3.5 million
- Expenses = £2.1 million
Step 2: Calculate net profit
Net profit = £7 million - £3.5 million - £2.1 million = £1.4 million
Step 3: Apply the net profit margin formula
Liquidity ratios including current ratio
Liquidity ratios evaluate a business's capacity to settle short-term debts using current assets. They are essential for maintaining financial stability and preventing situations where debts cannot be paid.
Current ratio
The current ratio measures the ability to cover debts due within the next 12 months using current assets.
Where:
- Current assets = Assets convertible to cash within a year (£)
- Current liabilities = Debts due within a year (£)
Results are expressed as a ratio, such as 2:1. A minimum of 1:1 is needed, with 2:1 ideal for most sectors. However, excessively high ratios may indicate inefficient use of assets.
Methods to improve current ratio:
- Increasing cash inflows - Attracting more cash-paying customers.
- Cash management - Placing surplus cash in high-interest accounts or using it to reduce short-term debts.
- Credit terms - Negotiating longer payment periods with suppliers.
- Financing adjustments - Replacing short-term debts with long-term liabilities.
Potential drawbacks of a high current ratio:
- Excess stock - Ties up working capital unnecessarily.
- Idle cash - Should be invested in business growth instead.
- High debtors - Can strain working capital if payments are delayed.
Worked example - Calculating current ratio
A consulting firm has current assets of £5.2 million and current liabilities of £3.25 million. Calculate the current ratio.
Step 1: Identify the values
- Current assets = £5.2 million
- Current liabilities = £3.25 million
Step 2: Apply the current ratio formula
Step 3: Interpretation
This means the firm has £1.60 in current assets for every £1 of current liabilities.
Acid test ratio
The acid test ratio, also known as the quick ratio, assesses liquidity by excluding stock from current assets, as stock may not be easily convertible to cash quickly.
Where:
- Current assets - stock = Liquid assets excluding inventory (£)
- Current liabilities = Debts due within a year (£)
A ratio below 1:1 signals potential liquidity issues. It is particularly useful for firms with slow-selling or hard-to-liquidate stock.
Methods to improve acid test ratio:
- General strategies - Apply the same approaches as for the current ratio, such as better cash management or extended credit terms.
- Stock control - Enhance inventory management to reduce excess stock and improve liquidity.
Worked example - Calculating acid test ratio
A retail chain has current assets of £6 million, stock of £1.5 million, and current liabilities of £3 million. Calculate the acid test ratio.
Step 1: Identify the values
- Current assets = £6 million
- Stock = £1.5 million
- Current liabilities = £3 million
Step 2: Calculate liquid assets
Liquid assets = £6 million - £1.5 million = £4.5 million