3.5. Profitability and liquidity ratios
Syllabus Content
- The following profitability and efficiency ratios: gross profit margin, net profit margin & ROCE
- Possible strategies to improve these profitability & efficiency ratios
- The following liquidity ratios: current ratio & acid-test/quick ratio
- Possible strategies to improve these liquidity ratios
- Triple A Learning - ratio analysis
Ratio analysis is an accounting tool, which can be used to measure the solvency, the profitability, and the overall financial strength of a business, by analysing its financial accounts (specifically the balance sheet and the profit and loss account).
Accounting ratios are very easy to calculate and they enable a business to highlight which areas of its finances are weak and therefore require immediate attention.
There are three main categories of accounting ratio on the IB course:
- Profitability (or ‘performance’) ratios, these analyse the profit made over the last year.
- Liquidity ratios, these measure the solvency of the business and its ability to meet short-term debts.
- Financial efficiency (or ‘activity’) ratios, these analyse the efficiency of the business in terms of the use of its resources in generating sales.
The following profitability and efficiency ratios: gross profit margin, net profit margin & ROCE
3.5. Profitability Ratios
There are three main ratios that can be used to measure the profitability of a business:
1: Gross Profit Margin
Gross profit margin is a profitability ratio that calculates the percentage of sales that exceed the cost of goods sold. In other words, it measures how efficiently a company uses its materials and labor to produce and sell products profitably. You can think of it as the amount of money from product sales left over after all of the direct costs associated with manufacturing the product have been paid. These direct costs are typically called cost of goods sold or COGS and usually consist of raw materials and direct labor.
The gross profit ratio is important because it shows management and investors how profitable the core business activities are without taking into consideration the indirect costs. In other words, it shows how efficiently a company can produce and sell its products. This gives investors a key insight into how healthy the company actually is. For instance, a company with a seemingly healthy net income on the bottom line could actually be dying.
Formula
The gross profit formula is calculated by subtracting total cost of goods sold from total sales.
Both the total sales and cost of goods sold are found on the income statement. Occasionally, COGS is broken down into smaller categories of costs like materials and labor. This equation looks at the pure dollar amount of GP for the company, but many times it’s helpful to calculate the gross profit rate or margin as a percentage.
The gross profit percentage formula is calculated by subtracting cost of goods sold from total revenues and dividing the difference by total revenues. Usually a gross profit calculator would rephrase this equation and simply divide the total GP dollar amount we used above by the total revenues. Both equations get the result.
Example
Monica owns a clothing business that designs and manufactures high-end clothing for children. She has several different lines of clothing and has proven to be one of the most successful brands in her space. Here’s what appears on Monica’s income statement at the end of the year.
- Total sales: $1,000,000
- COGS: $350,000
- Rent: $100,000
- Utilities: $10,000
- Office expenses: $2,500
Monica has an upcoming meeting with investors and wants to know how to find gross profit and what method to use. First, we can calculate Monica’s overall dollar amount of GP by subtracting the $350,000 of COGS from the $1,000,000 of total sales like this:
As you can see, Monica has a GP of $650,000. This means the goods that she sold for $1M only cost her $350,000 to produce. Now she has $650,000 that can be used to pay for other bills like rent and utilities.
Monica can also compute this ratio in a percentage using the gross profit margin formula. Simply divide the $650,000 GP that we already computed by the $1,000,000 of total sales.
Analysis
The gross profit method is an important concept because it shows management and investors how efficiently the business can produce and sell products. In other words, it shows how profitable a product is.
The concept of GP is particularly important to cost accountants and management because it allows them to create budgets and forecast future activities. For instance, Monica’s GP was $650,000. This means if she wants to be profitable for the year, all of her other costs must be less than $650,000. Conversely, Monica can also view the $650,000 as the amount of money that can be put toward other business expenses or expansion into new markets.
Investors are typically interested in GP as a percentage because this allows them to compare margins between companies no matter their size or sales volume. For instance, an investor can see Monica’s 65 percent margin and compare it to Ralph Lauren’s margin even though RL is a billion-dollar company. It also allows investors a chance to see how profitable the company’s core business activities are.
Investors want to know how healthy the core business activities are to gauge the quality of the company. They also use a gross profit margin calculator to measure scalability. Monica’s investors can run different models with her margins to see how profitable the company would be at different sales levels. For instance, they could measure the profits if 100,000 units were sold or 500,000 units were sold by multiplying the potential number of units sold by the sales price and the GP margin.
Source - http://www.myaccountingcourse.com/financial-ratios/gross-profit-margin
2: Net Profit Margin/Operating Profit Margin
The net profit margin, also known as the operating profit margin, is a profitability ratio that measures what percentage of total revenues is made up by operating income. In other words, the operating margin ratio demonstrates how much revenues are left over after all the variable or operating costs have been paid. Conversely, this ratio shows what proportion of revenues is available to cover non-operating costs like interest expense.
This ratio is important to both creditors and investors because it helps show how strong and profitable a company's operations are. For instance, a company that receives 30 percent of its revenue from its operations means that it is running its operations smoothly and this income supports the company. Conversely, a company that only converts 3 percent of its revenue to operating income can be questionable to investors and creditors. The auto industry made a switch like this in the 1990's. GM was making more money on financing cars than actually building and selling the cars themselves. Obviously, this did not turn out very well for them. GM is a prime example of why this ratio is important.
Formula
The operating margin formula is calculated by dividing the operating income by the net sales during a period.
Operating income, also called income from operations, is usually stated separately on the income statement before income from non-operating activities like interest and dividend income. Many times operating income is classified as earnings before interest and taxes. Operating income can be calculated by subtracting operating expenses, depreciation, and amortization from gross income or revenues.
The revenue number used in the calculation is just the total, top-line revenue or net sales for the year.
Analysis
A higher operating margin is more favorable compared with a lower ratio because this shows that the company is making enough money from its ongoing operations to pay for its variable costs as well as its fixed costs. For instance, a company with an operating margin ratio of 20 percent means that for every dollar of income, only 20 cents remain after the operating expenses have been paid. This also means that only 20 cents are left over to cover the non-operating expenses such as interest and taxation.
Example: If Christie's Jewelry Store sells custom jewelry to celebrities all over the country. Christie reports the follow numbers on her financial statements:
Net Sales: $1,000,000
Cost of Goods Sold: $500,000
Rent: $15,000
Wages: $100,000
Other Operating Expenses: $25,000
Here is how Christie would calculate her operating margin.
As you can see, Christie's operating income is $360,000 (Net sales – all operating expenses). According to our formula, Christie's operating margin .36. This means that 64 cents on every dollar of sales is used to pay for variable costs. Only 36 cents remain to cover all non-operating expenses such as interest, taxation, depreciation and amortization.
Source - http://www.myaccountingcourse.com/financial-ratios/operating-margin-ratio
3: Return on Capital Employed (ROCE)
Return on capital employed or ROCE is a profitability ratio that measures how efficiently a company can generate profits from its capital employed by comparing net operating profit to capital employed. In other words, return on capital employed shows investors how many dollars in profits each dollar of capital employed generates.
ROCE is a long-term profitability ratio because it shows how effectively assets are performing while taking into consideration long-term financing. This is why ROCE is a more useful ratio than return on equity to evaluate the longevity of a company.
This ratio is based on two important calculations: operating profit and capital employed. Net operating profit is often called EBIT or earnings before interest and taxes. EBIT is often reported on the income statement because it shows the company profits generated from operations. EBIT can be calculated by adding interest and taxes back into net income if need be.
Capital employed is a fairly convoluted term because it can be used to refer to many different financial ratios. Most often capital employed refers to the total assets of a company less all current liabilities. This could also be looked at as stockholders' equity less long-term liabilities. Both equal the same figure.
Formula
Return on capital employed formula is calculated by dividing net operating profit or EBIT by the employed capital.
If employed capital is not given in a problem or in the financial statement notes, you can calculate it by subtracting current liabilities from total assets. In this case the ROCE formula would look like this:
Analysis
The return on capital employed ratio shows how much profit each dollar of employed capital generates. Obviously, a higher ratio would be more favorable because it means that more dollars of profits are generated by each dollar of capital employed. For instance, a return of 20% indicates that for every dollar invested in capital employed, the company made 20 cents of profits.
Investors are interested in the ratio to see how efficiently a company uses its capital employed as well as its long-term financing strategies. Companies' returns should always be high than the rate at which they are borrowing to fund the assets. If companies borrow at 10 percent and can only achieve a return of 5 percent, they are losing money.
Just like the return on assets ratio, a company's amount of assets can either hinder or help them achieve a high return. In other words, a company that has a small dollar amount of assets but a large amount of profits will have a higher return than a company with twice as many assets and the same profits.
Example
Scott's Auto Body Shop customizes cars for celebrities and movie sets. During the year, Scott had a net operating profit of $100,000. Scott reported $100,000 of total assets and $25,000 of current liabilities on his balance sheet for the year.
Accordingly, Scott's return on capital employed would be calculated like this:
As you can see, Scott has a return of 1.33 (133%). In other words, every dollar invested in employed capital, Scott earns $1.33. Scott's return might be so high because he maintains low assets level.
Companies with large cash reserves usually skew this ratio because cash is included in the employed capital computation even though it isn't technically employed yet.
Source - http://www.myaccountingcourse.com/financial-ratios/return-on-capital-employed
Strategies to improve profitability ratios
● Adjust prices if competition allows this
● Seek better deals for purchasing stock and supplies
● Reduce wastage and losses of stock
● Concentrate on stock with higher turnover rates
● Monitor and control expenses, avoid unnecessary expenses, be selective as indiscriminate cost cutting can affect sales
● Increasing the volume of sales and levels of output can compensate for low or falling profit ratios.
Introduction to ratio analysis
Profitability ratios
Task 1: KJG Ltd has two production divisions, A and B which operate as investment centres. A report for July has been prepared for the two divisions, extracts are shown below:
Calculate the return on capital employed for divisions A and B
Task 2: LWL Ltd has two production divisions, Y and X which operate as investment centres. A report for April has been prepared for the two divisions, extracts are shown below:
Calculate the return on capital employed for divisions Y and X
Liquidity Ratios
There are two main ratios that can be used to measure the liquidity of a business:
1. The current ratio
The current ratio is a liquidity and efficiency ratio that measures a firm's ability to pay off its short-term liabilities with its current assets. The current ratio is an important measure of liquidity because short-term liabilities are due within the next year. This means that a company has a limited amount of time in order to raise the funds to pay for these liabilities. Current assets like cash, cash equivalents, and marketable securities can easily be converted into cash in the short term. This means that companies with larger amounts of current assets will more easily be able to pay off current liabilities when they become due without having to sell off long-term, revenue generating assets.
Formula
The current ratio is calculated by dividing current assets by current liabilities. This ratio is stated in numeric format rather than in decimal format. Here is the calculation:
Analysis
The current ratio helps investors and creditors understand the liquidity of a company and how easily that company will be able to pay off its current liabilities. This ratio expresses a firm's current debt in terms of current assets. So a current ratio of 4 would mean that the company has 4 times more current assets than current liabilities.
A higher current ratio is always more favourable than a lower current ratio because it shows the company can more easily make current debt payments.
If a company has to sell of fixed assets to pay for its current liabilities, this usually means the company isn't making enough from operations to support activities. In other words, the company is losing money. Sometimes this is the result of poor collections of accounts receivable.
The current ratio also sheds light on the overall debt burden of the company. If a company is weighted down with a current debt, its cash flow will suffer.
Example
Charlie's Skate Shop sells ice-skating equipment to local hockey teams. Charlie is applying for loans to help fund his dream of building an indoor skate rink. Charlie's bank asks for his balance sheet so they can analysis his current debt levels. According to Charlie's balance sheet he reported $100,000 of current liabilities and only $25,000 of current assets. Charlie's current ratio would be calculated like this:
As you can see, Charlie only has enough current assets to pay off 25 percent of his current liabilities. This shows that Charlie is highly leveraged and highly risky. Banks would prefer a current ratio of 2, so that all the current liabilities would be covered by the current assets twofold. Since Charlie's ratio is so low, it is unlikely that he will get approved for his loan.
Source - http://www.myaccountingcourse.com/financial-ratios/current-ratio
2: Acid-test ratio/Quick ratio
The quick ratio or acid test ratio is a liquidity ratio that measures the ability of a company to pay its current liabilities when they come due with only quick assets. Quick assets are current assets that can be converted to cash within 90 days or in the short-term. Cash, cash equivalents, short-term investments or marketable securities, and current accounts receivable are considered quick assets.
The quick ratio is often called the acid test ratio in reference to the historical use of acid to test metals for gold by the early miners. If the metal passed the acid test, it was pure gold. If metal failed the acid test by corroding from the acid, it was a base metal and of no value.
The acid test of finance shows how well a company can quickly convert its assets into cash in order to pay off its current liabilities. It also shows the level of quick assets to current liabilities.
Formula
The quick ratio is calculated by adding cash, cash equivalents, short-term investments, and current receivables together then dividing them by current liabilities.
Sometimes company financial statements don't give a breakdown of quick assets on the balance sheet. In this case, you can still calculate the quick ratio even if some of the quick asset totals are unknown. Simply subtract inventory and any current prepaid assets from the current asset total for the numerator. Here is an example.
Analysis
The acid test ratio measures the liquidity of a company by showing its ability to pay off its current liabilities with quick assets. If a firm has enough quick assets to cover its total current liabilities, the firm will be able to pay off its obligations without having to sell off any long-term or capital assets. Since most businesses use their long-term assets to generate revenues, selling off these capital assets will not only hurt the company it will also show investors that current operations aren't making enough profits to pay off current liabilities.
Higher quick ratios are more favourable for companies because it shows there are more quick assets than current liabilities. A company with a quick ratio of 1 indicates that quick assets equal current assets. This also shows that the company could pay off its current liabilities without selling any long-term assets. An acid ratio of 2 shows that the company has twice as many quick assets than current liabilities.
Obviously, as the ratio increases so does the liquidity of the company. More assets will be easily converted into cash if need be. This is a good sign for investors, but an even better sign to creditors because creditors want to know they will be paid back on time.
Example
Let's assume Carole's Clothing Store is applying for a loan to remodel the storefront. The bank asks Carole for a detailed balance sheet, so it can compute the quick ratio. Carole's balance sheet included the following accounts:
- Inventory: $5,000
- Prepaid taxes: $500
- Total Current Assets: $21,500
- Current Liabilities: $15,000
The bank can compute her quick ratio like this:
Source - http://www.myaccountingcourse.com/financial-ratios/quick-ratio
Strategies to Improve Liquidity
● Reduce current liabilities such as overdrafts by added equity inputs such as retained profits.
● Sell non-essential non-current assets to have funds to reduce current liabilities.
● Used leasing and factoring agreements
● In an emergency renegotiate credit and overdraft arrangements
● Monitor and manage current assets and liabilities to a greater extent.
Liquidity Ratios
Task 3: The following data relates to Similarities Ltd, a manufacturing company, at 31 July 2013
Trade Creditors $60000
Closing Stock $40000
Debtors $90000
Plant and machinery (NBV) $185000
Land at cost $105000
Buildings (NBV) $110000
Share Capital $250000
Long-term loan (secured) $200000
Cash and bank balance $50000
Calculate the current and acid test ratios at 31 July 2013
Task 4: The following amounts relate to Taylor Ltd at the end of its accounting year dated 31 December 2013.
(a) Prepare a balance sheet at 31 December 2013 based on the above information. You should calculate the amount of the two above missing figures
Use the following template
(b) Compute the following ratios based on the balance sheet.
1. Current ratio
2. Acid-test ratio
Comment whether they appear to be satisfactory/unsatisfactory
Limitations of ratio analysis
There are many different groups of people (or stakeholders) who are interested in the accounts of a company, including:
1. The management and the employees – to see if pay rises are likely, or to ensure that their jobs are secure.
2. Creditors – to ensure that the business has the necessary money to repay them.
3. Potential lenders – to see if the business is solvent and profitable enough to repay any loans.
4. The community – to ensure that jobs and services for the local community are assured.
Using financial ratios can assist these people in identifying the financial strengths and weaknesses of a company, as well as indicating to the company itself those areas that need corrective action. However, ratio analysis does not provide a complete and exhaustive analysis of a company. There are several other factors that the stakeholders and the company will need to take into account, in order to get the ‘full picture’ of its financial position:
- The state of the economy (i.e. if the economy is in a recession, then the ratios are more likely to be unsatisfactory than if the economy is experiencing a ‘boom’).
- The performance of competitors (i.e. it may be the case that the industry is in decline, in which case all the rival businesses are likely to be experiencing deteriorating ratios).
- Comparison year on year. The ratios for the business from the current year must be compared to the ratios from previous years, in order to see any marked improvement or deterioration in the financial performance.
- External factors. The financial ratios do not take into consideration any effects on the local community (job losses) or the environment (pollution). Therefore, in order to measure the performance of a business, factors other than mere financial ratios need to be considered.
Task 5: You are considering the purchase of a small business, JK, and have managed to obtain a copy of its financial statements for the last complete accounting year to 30 September 2013. These appear as follows:
Income Statement for the year to 30 September 2013
Statement of Financial Position as at 30 September 2013
Calculate the following ratios from the financial statements presented above
a. Net Profit margin
b. Return on capital employed
c. Current ratio
d. Quick (acid test) ratio
Task 6: GUS is a toy manufacturing company. It manufactures Polly Playtime, the latest doll craze amongst young girls. The company is now at full production of the doll. The final accounts for 2013 have just been published and are as follows. 2012’s accounts are also known for comparison purposes.
Income statement year ended 31 December
Statement of Financial Position as at 31 December
(a) By studying the above accounts and using ratio analysis, identify the main problems facing GUS.
(b) Provide possible solutions to the problems identified in (a)
Files to download
3.5. Profit & Liquidity Ratio Analysis .docxImproving profits .pdfRatio analysis question .docx