3.5: Profitability,liquidity ratio analysis

Ratio analysis and its purpose

Ratio analysis is a quantitative tool used to evaluate a business's financial performance by comparing different financial figures. It involves calculating ratios using data from the balance sheet and income statement.
Purpose of ratio analysis:
Financial position: Assess liquidity, profitability, and capital structure.
Financial performance: Evaluate efficiency and expense control.
Decision-making: Aid investment decisions and strategic planning.
Types of ratio comparisons:
Historical comparisons: Compare current ratios to past performance.
Inter-firm comparisons: Compare ratios to industry competitors.
Key financial ratios:
Profitability ratios: Measure the ability to generate profit.
Gross profit margin: Measures the profitability of sales.
Profit margin: Measures overall profitability.
Return on capital employed (ROCE): Measures the efficiency of using capital to generate profit.

The profitability ratios measure the financial performance of a business by comparing profit to other figures like sales revenue or capital employed. These ratios are crucial for profit-oriented businesses and are of interest to managers, employees, and investors.
Key profitability ratios:
Gross Profit Margin (GPM): Compares gross profit to sales revenue.
Formula: (Revenue-Cost of Goods sold/Revenue) x 100
Profit Margin: Compares net profit to sales revenue.
Formula: (Profit For the year/Revenue) x 100
Return on Capital Employed (ROCE): Compares profit to capital invested.
Formula: (Profit for the year/ Capital Employed) x 100
Improving profitability ratios:
Increase sales revenue: Reduce prices for elastic products, raise prices for inelastic products, improve marketing, or seek alternative revenue streams.
Reduce costs: Cut direct costs (materials, labor) or indirect costs (expenses).
ROCE analysis:
ROCE measures how efficiently capital is used to generate profit.
Higher ROCE indicates better financial performance.
ROCE should exceed interest rates on bank deposits.
Improving ROCE involves increasing profit or decreasing capital employed.
Understanding profitability ratios is essential for businesses to assess their financial health and make informed decisions.

Liquidity ratios measure a company's ability to pay its short-term debts using its current assets. Creditors, investors, and shareholders are interested in these ratios.
Key liquidity ratios:
Current ratio: Compares current assets to current liabilities.
Formula: (Current Assets/Current Liabilities):1
Acid test ratio (quick ratio): Excludes inventory from current assets.
Formula: (Current Assets-Inventories/Current Liabilities):1
Ideal ratios:
Current ratio: Generally between 1.5 and 2.0.
Acid test ratio: At least 1:1.
Improving liquidity:
Increase current assets: Sell inventory, collect receivables.
Decrease current liabilities: Reduce overdrafts, negotiate with creditors.
Liquidity ratios are essential for assessing a company's short-term financial health and its ability to meet obligations.

Ratio analysis is a valuable tool but has limitations:
Historical focus: Ratios reflect past performance, not future trends.
External factors: Economic changes can affect ratios without underlying changes in performance.
Lack of standardization: Different accounting practices can make comparisons difficult.
Qualitative factors: Non-financial factors like employee motivation and social impact are not considered.
Limited scope: Ratios provide a partial view of a business's performance.
To effectively assess a business's performance, it's essential to consider both financial ratios and other qualitative factors.