Unit 3: FINANCE AND

ACCOUNTS
3.5 Profitability and Liquidity
Ratio Analysis
By: Miss Kath Estrella
Outline:
✓Profitability ratios: (AO2, AO4)
-gross profit margin
- profit margin
- return on capital employed (roce)
✓Possible strategies to improve profitability ratios
(AO3)
✓Liquidity ratios (AO2. AO4)
- current ratio
- quick acid test ration
✓Possible strategies to improve liquidity ratios (AO3)
Ratio analysis
 Ratio analysis
✓Ratio analysis is a quantitative management tool for
analysing and judging the financial performance of a
business.
✓Ratios can be compared in two ways:
- Historical comparisons - involve comparing the
same ratio in two time periods for the same firm.
- Inter-firm comparisons - involve comparing the
ratios of businesses in the same industry.
Profitability ratios
 Profitability ratios
✓Profitability ratios examine profit in relation to other
figures, such as ratio of profit to sales revenue.
✓These ratios tend to be relevant to profit-seeking
businesses rather than not-for-profit organizations.
 Gross profit Margin (GPM)
✓Gross profit margin (GPM) shows the value of gross
profit as a percentage of sales revenue.
 Interpreting Gross profit Margin (GPM)
Yoga studio
✓The higher the
GPM result, the • Gross profit margin:
better it is for a • 45%
• Interpretation:
firm as it will have • For every $100 of sales revenue
more gross profit generated, $45 of that will be gross profit.
to go towards Restaurant
paying for its • Gross profit margin:
expenses. • 65%
Which business is the better • Interpretation:
performing firm, the yoga studio • For every $100 of sales revenue
or the restaurant? generated, $65 of that will be gross profit.
Strategies to improve Gross profit Margin (GPM)
• Raise revenue by:
• If the yoga studio has very few competitors,
increase the selling price.
• If the yoga studio has many competitors, decrease
the selling price.
• Market the yoga studio to attract more customers.
• Offer personal yoga training which have higher
profit margins.
• Sell yoga related merchandise (e.g. yoga clothing,
mats, blocks and straps).
• Reduce cost of sales by:
• Hire less experienced, but cheaper, yoga teachers.
• Eliminate complimentary towel services (if
relevant).
Strategies to improve Gross profit Margin (GPM)
 Profit margin
✓Profit margin (PM) shows the value of net profit as a
percentage of sales revenue
 Interpreting Profit margin
✓The higher the Yoga studio

PM result, the • Profit margin:

better it is for a • 20%
• Interpretation:
firm as it will have • For every $100 of sales revenue generated, $20
of that will be profit before interest and tax.
more profit to go
towards dividends Restaurant
and retaining
• Profit margin:
profit. • 18%
Which business is the better • Interpretation:
performing firm, the yoga studio • For every $100 of sales revenue generated, $18
or the restaurant? of that will be profit before interest and tax.
Exercise:
1. Calculate
the GPM and
the profit
margin ratios
for JKL Ltd.
in both years
(show all your
working).
[4 marks]
 Exercise: Answer
GPM Year 1-
500/850*100=58.82%
GPM Year 2-
500/1000*100=50%

PM Year 1-
360/850*100= 42.35%
PM- Year 2-
400/1000*100=40%
 Return on capital employed (ROCE)
✓ROCE is a profitability ratio that measures the financial
performance of a firm compared with the amount of
capital invested (i.e. sources of funds).
 Interpreting ROCE
✓The higher the Yoga studio

ROCE result, the • ROCE:

better it is for the • 10%
• Interpretation:
firm as it has been • For every $100 invested into the firm, $10
more efficient at of that will be generated as profit.
generating profit Restaurant
from the funds
• ROCE:
available. • 8%
Which business is the better • Interpretation:
performing firm, the yoga studio • For every $100 invested into the firm, $8 of
or the restaurant? that will be generated as profit.
Exercise:
1. Calculate
the ROCE
ratio for JKL
Ltd. for both
years.
Exercise: Answer
ROCE Year 1-
360/800*100=45%

ROCE Year 2-
400/1000*100=40%
Strategies to improve profit margin and ROCE
✓Profit margin and return on capital employed can
both be improved by controlling expenses
✓Examples of how to control expenses
▪Reduce indirect labour costs
▪Seek cheaper rental premises
▪Install energy efficient machinery and equipment
▪Find alternative suppliers for insurance policies
▪Use cheaper forms of advertising
 Limitations of strategies used to improve
profitability ratios
✓Identify the Strategy
Strategy Drawback
Drawback

drawback(s) for A firm

A firm decides
decides
improve
to
to improve
its GPMmoreby
its GPM by spending This will increase their expenses
each strategy in the spending
on more
advertising on
their which will decrease their PM.
advertising
products.their
table. products.
Although this will reduce their
A firm decides to improve
A PM
firmand
decides to expenses, the redundancies will
its ROCE by
improve its20%
PM of
and create a climate of fear and
making itsROCE
by makingredundant.
20% of its demotivation among the firm’s
employees
employees.
employees redundant.
The time and money spent on
searching for a new location, real-
A firm decides to relocate
A firm decides to estate agent fees, moving costs and
its business to a cheaper
relocatelocation.
its business to a informing customers of the new
cheaper location. location undo the benefits of this
strategy.
Liquidity ratios
 Liquidity ratios
✓Liquidity ratios look at the ability of a firm to pay its
short-term liabilities.
✓These are important ratios as they reveal the level of
working capital with which firms can meet their everyday
financial obligations.
Liquidity ratios
Current ratio
Acid test (quick) ratio
 Current Ratio
✓The current ratio deals with the liquid assets (cash or
assets that can be turned into cash quickly) and short-term
liabilities of a firm i.e. its working capital.
Exercise:
1. Calculate
the current
ratio for JKL
Ltd. for both
years.
Exercise: Answer
Year 1-
500/200=2.5:1

Year 2-
700/300=2.3:1
 Interpreting Current ratio
Yoga studio
✓The ideal
benchmark for the • Current ratio:
• 0.9 : 1
current ratio is 1.5 to • Interpretation:
2 : 1. • For every $1 of current liabilities, the yoga
✓This means for every studio has $0.90 of current assets to pay
The restaurant’s liquidity position is
$1 of current for it. favourable as it is within the current
Restaurant
ratio benchmark of 1.5 to 2 : 1. The
liabilities, a firm has yoga studio is heading towards a
$1.50 to $2 of • Current ratio: liquidity crisis as it does not have

current assets to pay • 1.9 : 1 enough working capital to pay for its
current liabilities.
• Interpretation:
for it. business is the better
Which
• For every $1 of current liabilities, the yoga
performing firm, the yoga studio
or the restaurant? studio has $1.90 of current assets to pay for
it.
 Quick (Acid test) ratio
✓The quick ratio is like the current ratio except that it
ignores stock when measuring the short-term liquidity of a
business
Exercise: Answer

Acid test ratio

Year 1-
500-250/200=1.25:1
Year 2-
700-350/300=1.16:1
 Interpreting Quick ratio
✓The ideal Yoga studio

benchmark for the • Quick ratio:

current ratio is 1 : 1. • 0.3 : 1
• Interpretation:
✓This means for every • For every $1 of current liabilities, the firm
$1 of current has $0.30 cash or debtors to pay for it.
liabilities, a firm has The restaurant’s liquidity position is
$1 of cash or debtors Restaurant
favourable as it is within the quick ratio
benchmark of 1 : 1. The yoga studio is
to pay for it. • Quick ratio: facing a severe liquidity crisis as it does not
have enough liquidity to pay for its current
• 1.05 : 1 liabilities.
Which business is the better • Interpretation:
performing firm, the yoga studio • For every $1 of current liabilities, the firm has
or the restaurant? $1.05 cash or debtors to pay for it.
 Exceeding liquidity ratio benchmarks

Reason for exceeding

Benchmark Consequences of exceeding benchmark
benchmark

Cash balance is too The firm is wasting the opportunity to use

high the surplus cash to grow the business

• Current ratio 1.5 If there are too many outstanding payments

Debtor balance is too
to 2 : 1. from customers, there is a higher risk of bad
high
• Quick ratio 1 : 1. debts

Unsold inventory may never be converted

Stock balance is too
into cash as it is perishable, unfashionable
high
or obsolete
 Strategies to improve liquidity ratios

• Raise value of current assets Reduce value of current liabilities

• Examples include: • Examples include:

• Encourage cash purchases by • Cut overdrafts and use long-term
offering discounts for immediate loans with lower interest rates.
cash payments or early • Avoid late payment penalties from
repayments if they have trade creditors by paying on time.
credit. • Take advantage of cash payment
• Invest in stock control systems to discounts.
reduce the amount of stock held • Use the services of a specialist tax
(which will increase the cash accountant who can advise on
balance). how to reduce tax liabilities.
Limitations of strategies used to improve liquidity
ratios
Strategy
Strategy Drawback
Drawback

• Identify the A firm decides to increase the

A firm decides to increase the value Paying for a stock control system will
drawback(s) for value of its current assets by
of its current assets by investing in eventually require cash to pay for it,
investing in a stock control
each strategy in the a stock control system.
system.
thus reducing the liquidity of the firm.
table.
This will reduce the number of
AA firm
firm decides
decides toto reduce
reduce the
the value
creditors of the firm. However, it will
value
of its of its current
current liabilities
liabilities by
by taking
also reduce the cash balance which
taking advantage
advantage of immediate
of immediate cash
will reduce the available liquidity of
cashsettlement
settlementdiscounts.
discounts.
the firm.

This will reduce the value of creditors

A firm decides to reduce its
A current
firm decides to reduce its current at the firm. However, it will also
liabilities by paying its
liabilitiesas
creditors bysoon
paying creditorsanas reduce the cash balance which will
itsreceives
as it
soon as it invoice.
receives an invoice. reduce the available liquidity of the
firm.
Summary of ratios
Activity: Worksheet on Ratio analysis
• Posted in MB