3.5 Profitability & Liquidity
Ratio Analysis
Topic 3: Finance and Accounts
The Purpose of Ratio Analysis
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The profitability of a company is not the
whole story of its financial health.
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Does the company do a good job managing “cost
of goods”?
Does the company do a good job of managing
overhead costs?
Does the company have enough money to pay its
liabilities?
Does the company have too much long-term debt?
Does the company do a good job of using its
assets to generate profit?
Ratio Analysis
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Ratios 3 main categories in the IB
Syllabus:
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Profitability Ratios
Liquidity Ratios
Financial Efficiency Ratios (HL ONLY)
We will examine 2 of them.
Ratio Analysis
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Profitability Ratios
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Liquidity Ratios
Profitability Ratios - Margins
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Purpose: Measures the ability to
convert sales revenue into profit.
Gross Profit Margin
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% of gross profit to total sales revenue
Net Profit Margin
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% of net profit to total sales revenue
Gross Profit Margin
Sales
Revenue
Cost of
Goods
Sold
Current
Assets
Current
Liabilities
Stocks
(Inventory)
Accts
Recvble
Net Profit
Gross
Profit
ABC, Inc.
250
125
XYZ Corp.
3200
800
Purpose: How well are we generating profits before overhead expenses?
Are we controlling Cost of Goods?
(Gross Profit / Sales Revenue) X 100 = Gross Profit Margin %
ABC Inc:
125/250 X 100=50%
XYZ Corp:
800/3200 X 100 = 25%
Which company is maximizing its profit at the GROSS profit level?
(Sales – Cost of Goods Sold) = Gross Profit
Net Profit Margin
Sales
Revenue
Cost of
Goods
Sold
Current
Assets
Current
Liabilities
Stocks
(Inventory)
Accts
Recvble
Net Profit
Gross
Profit
ABC, Inc.
250
50
125
XYZ Corp.
3200
500
800
Purpose: How well are we generating profits after overhead expenses?
Are we controlling overhead expenses?
(Net Profit / Sales Revenue) X 100 = Net Profit Margin %
ABC Inc:
50/250 X 100=20%
XYZ Corp:
500/3200 X 100 = 16%
Which company is maximizing its profit at the Net profit level?
(Sales – Cost of Goods Sold – Overhead Expenses) = Net Profit
Strategies to improve
Profit Margin Ratios
Strategy
Example
Evaluation
Increase Gross
and Net profit
margins by
reducing cost of
goods sold (direct
costs)
1.
2.
Use cheaper materials
Cut labor costs;
outsource
Cut labor costs by
improving productivity
Cut wages
1. Perception of quality by customers may fall and
hurt company’s reputation.
2. Quality maybe put at risk.
3. Expensive equipment investment as well
training costs. Overhead costs increase.
4. Motivation levels, productivity, and quality may
fall.
Increase Gross
and Net profit
margin by
increasing price
Raise the price of the
product with no increase in
direct costs
Total profit could fall as customers may switch to a
different product.
Increase Net profit
margin reducing
overhead costs
Cut overhead costs such as
rent, insurance, promotion
costs, or salaries while
maintaining sales levels
Moving to a lower rent district could damage
company’s reputation.
3.
4.
Customers may consider this “profiteering” and
cause long term image damage to the company.
Cutting promotion costs could lead to falling sales.
Reducing salaries by eliminating positions could
result in inefficient of running of the business.
Profitability Ratios- RoCE
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Purpose: Measures the ability of using capital
employed effectively to earn a profit
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The higher the % the greater return on your investment
It can be compared with past performance to see if the
ability to earn a profit is improving
Can be compared with interest earned from other
investments
Should be compared with the interest rate of borrowing
money. If it is less than the interest rate, borrowing money
will further reduce returns to shareholders.
Return on Capital Employed (RoCE)
(Primary efficiency ratio)
Sales
Revenue
Cost of
Goods
Sold
Current
Assets
Current
Liabilities
Stocks
(Inventory)
*Capital
Employed
Net Profit
ABC, Inc.
400
50
XYZ Corp.
5000
500
Gross
Profit
*capital employed = non-current liabilities + shareholders equity
Purpose: How effective is the capital invested in the company at earning a
profit? Could I earn a higher rate of return elsewhere?
(Net Profit / Capital Employed) X 100 = Return on Capital Employed
ABC Inc:
50/400 X 100=12.5%
XYZ Corp:
500/5000 X 100 = 10%
Which company is maximizing its capital resources to generate a profit?
(What are capital resources…long term loans, debentures, cash generated by
sale of stock, retained earnings “ploughed back” into the company)
Strategies to improve RoCE
Strategy
Increase Net profit without
increasing capital employed:
1. Raise prices of products
2. Develop innovative products
and set prices high
3. Reduce variable costs per unit
4. Reduce overheads
5.
Increase capital invested in
technology if it will lead to
higher profits
Reduce Capital Employed:
1. Sell assets that do not contribute
to sales/profits and use raised
capital to reduce debt
Limitation
1.
2.
Demand could be elastic
This can only be a long term strategy
3.
4.
Cheaper materials could reduce quality
May not be effective in the short term and may have
drawbacks – less promotion reduces sales
Finance will be needed and increase in net profits may
be less than the increase in capital employed
5.
1. These assets may be needed in the future
Ratio Analysis
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Profitability Ratios
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Liquidity Ratios
What do we mean by “liquid”?
Liquidity is the ability of a firm to pay its
short-term debts. (Cash or cash-like)
Liquidity Ratios
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Purpose: Measures the ability to payoff
current debt.
Current Ratio
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Current assets to current liabilities
Acid Test Ratio
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Liquid assets to current liabilities
Current Ratio
Sales
Revenue
Cost of
Goods
Sold
Current
Assets
Current
Liabilities
ABC, Inc.
60
30
XYZ Corp.
240
240
Stocks
(Inventory)
Accounts
Recvble
Net Profit
Gross
Profit
Purpose: Do we have the ability to payoff our current debts?
Current Assets / Current Liabilities
ABC Inc:
60/30 = 2
XYZ Corp:
240/240 = 1
A healthy current ratio is 1.5-2.0
For every $1.50 - $2 of assets I can
pay off $1 of liabilities.
Which company has the larger capacity to payoff debts?
(Cash + Accts Receivable + Inventory) / Accts Payable
Current Ratio
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Purpose: Measures the capacity to payoff
current debt
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Most firms are advised to have a ratio of 1.5-2.0
to be in a safe position
Low ratios may not be unusual for high-volume
cash businesses like grocery stores, fast food
restaurants, or gas stations
Results over 2 might suggest that too much
money is tied up in inventory or long credit terms
to debtors (Accounts Receivables)
Acid Test Ratio
Sales
Revenue
Cost of
Goods
Sold
Current
Assets
Current
Liabilities
Stocks
(Inventory)
ABC, Inc.
60
30
30
XYC Corp.
240
240
60
Accounts
Recvble
Net Profit
Gross
Profit
Purpose: Do we have the CASH to payoff our current debts?
Liquid Assets = Current Assets - Inventory Stocks
Liquid Assets / Current Liabilities
A healthy current ratio is 1 or above
ABC Inc:
30/30 = 1
XYZ Corp:
180/240 = .75
For every $1 – liquid assets I can
pay off $1 of liabilities.
Which company has the larger capacity to payoff debts?
(Current assets - inventory) / Accts Payable
Acid Test Ratio
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Purpose: Measures the capacity to payoff
current debt with liquid assets
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Results below 1 are viewed with caution as there
might not be enough cash to short-term debt.
View the ratio results in context with last
year….are we improving or declining?
What is the natural inventory level expectations
for your type of business? This will affect your
ratio so it must be viewed in context with your
type of business.
Strategies to improve
Liquidity Ratios
Strategy
Example
Evaluation
Sell off fixed
assets for cash –
could lease back if
needed
Land and property could be
sold to a leasing company.
If assets are sold quickly, they may not bring their
full value.
Sell off inventories
for cash
Finished goods inventory
can be sold at a discount to
raise cash.
Note: this
improves the acid
test ratio but the
current ratio
If the asset is still needed and leased back, leasing
charges will increase overheads and reduce net
profit margin.
JIT (just-in-time) inventory
strategies will limit
inventory stock naturally.
This will reduce the gross profit margin if inventory
is sold at a discount.
May damage brand image if inventory is sold at a
reduced price.
Inventory may be needed for higher customer
demand levels in the near future.
JIT strategies are not “right” for all industries.
Increase loans to
inject cash into the
business to
increase working
Long-term loans could
utilized if bank is confident
of the ability of repayment.
These will increase the gearing ratio (HL)
These will increase interest costs.