Profitability ratios

Gross profit margin (GPM)

• Shows the gross profit as a percentage of sales revenue.
• Indicates the profitability of the business' core business activities.

Possible strategies to improve the GPM:

• Change the price
• Reduce the price by establishing economies of scale
• Reduce the price by finding cheaper suppliers
• Lower the cost of goods sold
• Reduce direct labour cost
• Adopt more aggressive promotional strategies

Net profit margin (NPM)

• Shows the net profit as a percentage of sales revenue.
• Shows how well managers can control overheads-expenses.

Possible strategies to improve the NPM:

• Increase sales revenue
• Lower the cost of goods sold
• Reduce operating expenses

Liquidity ratios

• Measure a firm's ability to pay off its short-term debt obligations.
• Liquidity is a measure of how quickly an asset can be converted to cash.

Current ratio

• Shows a firm's ability to pay off its short-term debts using its current assets.
• Since there is a short time to raise the needed funds, cash and more liquid assets are used to pay off the debts (liabilities).

Possible strategies to improve the current ratio:

• Reduce current liabilities, e.g. reduce bank overdrafts and seek long-term loans instead
• Improve the business' credit control system
• Sale of unused long-term fixed assets for cash
• Negotiate longer payment terms with suppliers
• Decrease overheads
• Monitor owner's draw: cash drain

Acid test (quick) ratio

• A more immediate and severe indicator of a firm's ability to pay off its short-term debt.
• Excludes the stock figure from the current assets because stocks are not as liquid and depend on the state of the market, promotion and many other factors.

Possible strategies to improve the acid test ratio:

• Increase sales
• Reduce current liabilities
• Reduce drawings
• Sale of unused assets
• Sell off stock at a discount for cash
• Increase credit period for debtors to purchase more stock on credit