3.

5 Profitability and
ratio analysis
 Profitability and liquidity ratios
• LO: Use ratios to analyse the performance of a business
Starter
• Explain the difference between current and fixed assets
• Explain the difference between gross and net profit
Extension
• Research the financial performance of a company of your choice. Use their profit and
loss account and balance sheet to back up any conclusions that you have.
All : Calculate Profitability and liquidity ratios (level 1-2)
Most : Interpret the meaning of results (level 3-5)
Some : Assess the value of ratio analysis (level 6-7)
 Ratio analysis

• Ratios are like a collection

of doctors instruments.

• Accountants (like you!!) use them

to analyse the health of a business.
 Profitability ratios
• Gross Profit Margin
• Net Profit Margin
Activity
Which stakeholders will care about the profitability
of an organization
Extension
Explain why
 Gross Profit Margin
In order to assess this figure we need to compare
it to
• Previous years GPM
• Competitors GPM
How to improve GPM
Raise sales revenue
Reduce direct costs 1- give specific examples of how to increase sales
revenue
2- give specific examples of how to reduce direct
costs.
 Gross Profit Margin
In order to assess this figure we need to compare it to
• Previous years GPM
• Competitors GPM

How to improve GPM

Raise sales revenue – Reduce selling price (if there are lots of available
substitutes), Raise selling price (if there are few substitutes), Improve
marketing, seek alternative revenue streams.
Reduce direct costs – Use cheaper suppliers, cutting direct labour costs
(redundancies)
Net profit before
interest and tax
Net Profit Margin
In order to assess this figure we need to compare it to
• Previous years NPM
• Competitors NPM

How to improve NPM

1- which net profit figure should we use? and why?
Increase sales revenue 2- give specific examples of how to reduce indirect
Reduce indirect costs costs
Net profit before
interest and tax
Net Profit Margin
In order to assess this figure we need to compare it to
• Previous years NPM (why before tax?)
• Competitors NPM

How to improve NPM

Increase sales revenue
Reduce indirect costs – Negotiate cheaper rent, reduce wages, cut
advertising, reduce insurance premiums, reduce light and heating bill.
 NPM Vs GPM
• Which method is better in order to
assess the profitability of a business?
• If there is a large gap between GPM
and NPM what does this mean?
• What is happening in the table on the
right? Explain how GPM can get worse
but NPM can improve?
(iii) Explain two reasons for this change. [4 marks]
 Liquidity ratios
• Current ratio
• Acid test (quick) ratio
Liquidity ratios look at a company’s
ability to pay its short term debts.
Put the following current assets in order from
most liquid to least liquid;
Bank
Debtors
Cash
Stock
 Current Ratio

Activity
Calculate the current ratio for the 2009 and 2010.
Extension
Expressed as X:1 What does the answer mean??
 Q1 - Why would a
Current Ratio business not want to have
• The perfect ratio for current ratio is a current ratio of 0.9:1?
between 1.5 and 2 How could this be
improved?
If a business has a current ratio of 2:1 this
Q2 – Why would a
means that the business has $2 available in
business not want to have
liquid assets for every $1 of current liabilities
a current ratio of 3:1?
This allows for a margin of safety because How could this be
some assets might lose value if attempted to improved?
be sold quickly (Debtors & Stock)
What should we compare the What types of businesses
current ratio of a company with? Current ratio would it be acceptable to have
a current ratio of over 2?

If the Current Ratio is below 1.5 – the business will struggle to cover short term debts.
This could jepordise the short term future of the company or force the company to
consider short term sources of finance. In order to improve the Current Ratio the
business could; increase current assets, decrease current liabilities
If the Current Ratio is above 2 – the business is holding too many current assets. Holding
cash presents an opportunity cost (training, advertising, R&D), Having too many debtors
increases likelihood of bad debts occurring and too much stock increases storage and
insurance costs in addition to the opportunity cost. . In order to improve the Current
Ratio the business could; decrease current assets, increase current liabilities
 Acid Test Ratio

Activity
Calculate the acid test ratio for the company A and
company B?
Expressed as X:1 Extension
What does the answer mean??
 Acid test ratio (quick ratio)

• The perfect ratio for acid test is at least 1:1

This is a seen as a better measure of a firm’s liquidity because stock is the least
liquid current asset and requires demand for the product to be turned into cash.
Work-in-progress stock also does not have much added value and therefore
cannot easily be sold.
Highly expensive stock also can particularly difficult to sell (boeing aircraft)
1. Comment on the liquidity position of CM? (4 marks)
 Efficiency ratio
Return on capital employed (ROCE)

Net Profit Net Profit

$200,000 $500,000
Activity
Which company is more attractive to invest in
Extension
What additional information would you like to have before making your
decision
Return on capital employed
The ROCE ratio measures the financial
performance of a firm compared with the
amount of capital invested.
 Return on capital employed
• ROCE measures the financial performance of a company relative to the capital invested.
This allows us to compare businesses of different sizes.
• The ROCE figure should exceed the interest rate offered by banks in order to incentivize
investors to take the risk of investing their money.
• Most people regards ROCE as the single most important ratio and it is therefore often
referred to as the key ratio.
In order to improve ROCE;
 Improve Net Profit
 Reduce capital employed while keeping profits constant (this is not desirable)
(iii) Comment on the liquidity and profitability of BBT (6
marks)
 Uses of ratio analysis

Who actually cares about these ratios?

 Uses of ratio analysis
• Employees and trade unions – likelihood of pay rises and job security.
• Managers and directors –Identify areas of improvement. Assess the likelihood of
receiving bonuses.
• Trade creditors – Can the business repay short term debts.
• Shareholders – assess the potential return on investment.
• Financiers – Can the business repay any loans.
• The local community – Gauge potential job opportunities for residents. Seek
sponsorship for local events.
 Ratio limitations
• Ratios only provide a historical account of a firms performance
• Changes in the external business environment will cause changes in the ratios
even if the performance of the business doesn't change (interest rates)
• Different accounting policies may make it difficult to compare companies
(depreciation method)
• Qualitative factors not considered (staff motivation, brand awareness/loyalty)
• Organisational objectives may differ (growth over profit maximization) (private
vs state owned companies)
• Complete picture is not provided unless you also look at; historical performance,
inter-firm competition, nature of the business, state of the economy, social factors
 You know it’s good for you.

Additional past paper questions