2.6 Profitability and Liquidity Ratio Analysis

Profitability Ratios

Gross Profit Margin

• Measures an organization's gross profit as a percentage of sales revenue.
• Remember: Gross profit = revenue (profit) after deducting the direct costs.
• Firms aim to have a high gross profit margin as it indicates good profitability.
• To improve ratio: increase sales revenue or decrease direct costs.
• Formula:

(Net) Profit Margin

• Measures the overall profit after all costs have been deducted as a percentage of sales revenue; businesses aim to have a high percentage as it indicates good control of costs.
• Indicator of how well a business manages its indirect costs.
• To improve ratio: find ways of reducing costs (both direct and indirect) or increase sales revenue.
• Formula:

Return on Capital Employed (ROCE)

• Measures a firm's efficiency of using capital invested into the business to generate profit; firms aim to have a high percentage as it indicates capital efficiency.
• Remember: capital employed = non-current liabilities + equity.
• It measures the percentage of profit before interest and tax that the capital employed generates.
• To improve ratio: increase level of profit without introducing capital into business, maintain level of profit whilst reducing amount of capital in business, and decreasing costs and expenses.
• Formula:

Liquidity Ratios

Ratios that measure an organization's ability to pay its short-term debts and liabilities.

• Liquidity = ease of selling an asset and converting it into cash.
• Working capital = current assets – current liabilities.

Current Ratio

• Measures a business' ability to meet its short-term debts.
• A too high ratio indicates inefficiency as a business is keeping too much current assets.
• A ratio below 1 means a business is not able to pay off their short-term obligations with their current assets.
• To improve ratio: increase current assets (e.g. improve cash flow) or decrease liabilities (e.g. negotiate interest terms with suppliers).
• Formula:

Acid Test Ratio

• Used to measure the ability of an organization to pay off its short-term liabilities without the need to sell any stock.
• Stocks are ignored in this ratio as they are not highly liquid.
• To improve ratio: increase current assets (e.g. improve cash flow) or decrease liabilities (e.g. negotiate interest terms with suppliers).
• Formula: