3.5 Profitability and Liquidity Ratios
Profitability Ratios:
• profitability ratios show a company’s overall efficiency and performance, they are divided into two type, margins and
returns
• indicators of the extent to which the firm’s effective use of its resources enables it to crate an excess of revenue.
• Examples: Gross profit margin, net profit margin and return on capital employed.
Gross profit margin:
Net Profit Margin:
• shows the gross profit as a percentage of sales revenue
• it indicates the profitability of the business’ core business • shows the net profit as a percentage of sales revenue
activities • shows how well managers can control overheads
• Gross profit margin = (gross profit / revenue) x 100 (indirect costs)
• Improving gross profit margin: • net profit margin = (net profit before interest and tax /
• change the price - reducing the price of a good can revenue) x100
encourage increased sales, whilst increasing the price • Improving net profit margin
would increase sales revenue providing COGS remained • Increase revenue - increasing revenue by
the same. Changing the price depends on the price decreasing the cost of goods sold to improve the
elasticity of demand (PED) gross profit margin. A larger gross profit margin has
• reduce the price by establishing economies of scale - an increased capacity to absorb operating
bulk purchasing economies of scale would reduce the expenses, resulting in a larger net profit margin
unit cost resulting in a decreased cost of goods sold. • lowering the cost of goods sold - this will raise the
• reduce the price by finding cheaper suppliers - this gross profit margin to then increase the net profit
would enable the firm to reduce its price and still be margin
profitable, but a change in suppliers could compromise • reducing operating expenses - negotiating lower
quality rent, strict monitoring of electricity usage, reducing
• promotion - buy-one-get-one-free promotion encourage spending of top management on travel etc
sales
ROCE (Return on Capital Employed): Liquidity Ratios:
• measures how efficiently a company can generate profits • firm’s ability to convert current assets into cash
from it capital employed • measure of the company’s ability to settle its short-
• the higher the better term debt
• ROCE = (net profit before interest and tax / capital • Examples: current ratio and acid test ratio
employed) x100
• capital employed = long-term liabilities +share capital
+retained profits
• Improving ROCE: Current Ratio:
• reduce long-term liabilities - pay off debt or restructure
loans to have a longer repayment period • shows a firm’s ability to pay off its short-term debts
• reduce equity and retained profit - this is not desirable using its current assets, usually with cash or liquid
assets
• current ratio = current assets / current liabilities
• Improving current ratio
Acid test ratio: • reduce current liabilities - paying overdrafts and
short-term loans
• more immediate indicator of a firm’s ability to pay off its • improve the business’ credit control system -
short-term debt. It excludes the stick figure from the current gives a more realistic idea of debtors that are liquid
assets as stocks are not as liquid to retrieve debts owed on a shorter term
• Acid test ratio = (current assets - stock) / current liabilities • sale of unused fixed assets - increase the cash
• Improving acid test ratio: component of the current assets and increase
• increase sales - increased revenue so more cash, but working capital
this could increase promotional expenses • negotiate longer payment terms with suppliers -
• reduce current liabilities - pay off short-term loans reduces outflow so more cash is available to pay off
• reduce drawing - reduction in cash withdrawals from the short term debt
business for the owner’s personal use • decrease overheads - reduce outflows
• sale of unused assets - increase liquidity
Profitability Ratios:
• profitability ratios show a company’s overall efficiency and performance, they are divided into two type, margins and
returns
• indicators of the extent to which the firm’s effective use of its resources enables it to crate an excess of revenue.
• Examples: Gross profit margin, net profit margin and return on capital employed.
Gross profit margin:
Net Profit Margin:
• shows the gross profit as a percentage of sales revenue
• it indicates the profitability of the business’ core business • shows the net profit as a percentage of sales revenue
activities • shows how well managers can control overheads
• Gross profit margin = (gross profit / revenue) x 100 (indirect costs)
• Improving gross profit margin: • net profit margin = (net profit before interest and tax /
• change the price - reducing the price of a good can revenue) x100
encourage increased sales, whilst increasing the price • Improving net profit margin
would increase sales revenue providing COGS remained • Increase revenue - increasing revenue by
the same. Changing the price depends on the price decreasing the cost of goods sold to improve the
elasticity of demand (PED) gross profit margin. A larger gross profit margin has
• reduce the price by establishing economies of scale - an increased capacity to absorb operating
bulk purchasing economies of scale would reduce the expenses, resulting in a larger net profit margin
unit cost resulting in a decreased cost of goods sold. • lowering the cost of goods sold - this will raise the
• reduce the price by finding cheaper suppliers - this gross profit margin to then increase the net profit
would enable the firm to reduce its price and still be margin
profitable, but a change in suppliers could compromise • reducing operating expenses - negotiating lower
quality rent, strict monitoring of electricity usage, reducing
• promotion - buy-one-get-one-free promotion encourage spending of top management on travel etc
sales
ROCE (Return on Capital Employed): Liquidity Ratios:
• measures how efficiently a company can generate profits • firm’s ability to convert current assets into cash
from it capital employed • measure of the company’s ability to settle its short-
• the higher the better term debt
• ROCE = (net profit before interest and tax / capital • Examples: current ratio and acid test ratio
employed) x100
• capital employed = long-term liabilities +share capital
+retained profits
• Improving ROCE: Current Ratio:
• reduce long-term liabilities - pay off debt or restructure
loans to have a longer repayment period • shows a firm’s ability to pay off its short-term debts
• reduce equity and retained profit - this is not desirable using its current assets, usually with cash or liquid
assets
• current ratio = current assets / current liabilities
• Improving current ratio
Acid test ratio: • reduce current liabilities - paying overdrafts and
short-term loans
• more immediate indicator of a firm’s ability to pay off its • improve the business’ credit control system -
short-term debt. It excludes the stick figure from the current gives a more realistic idea of debtors that are liquid
assets as stocks are not as liquid to retrieve debts owed on a shorter term
• Acid test ratio = (current assets - stock) / current liabilities • sale of unused fixed assets - increase the cash
• Improving acid test ratio: component of the current assets and increase
• increase sales - increased revenue so more cash, but working capital
this could increase promotional expenses • negotiate longer payment terms with suppliers -
• reduce current liabilities - pay off short-term loans reduces outflow so more cash is available to pay off
• reduce drawing - reduction in cash withdrawals from the short term debt
business for the owner’s personal use • decrease overheads - reduce outflows
• sale of unused assets - increase liquidity
