1. IB Business Management
Unit 3/Section 3.5
Profitability and liquidity ratio analysis

2. 3.5 PROFITABILITY ND LIQUIDITY RATIO ANALYSIS On completing this chapter you should be able to
Calculate and interpret the profitability and efficiency ratios: gross profit margin (GPM), net profit margin(NPM) and return on capital employed (ROCE).
Examine possible strategies to improve the above profitability and efficiency ratios.
Calculate and interpret the liquidity ratios: current ratio and acid test ratio.
Discuss possible strategies to improve the above liquidity ratios.

3. RATIO ANALYSIS
Ratio analysis is a financial analysis tool used in the interpretation and assessment of a firm´s financial statements.
Types: Profitability ratios, efficiency ratios and liquidity ratios.
Objectives:
Standardize financial information for comparisons
Evaluate current operations
Compare performance with past performance
Compare performance against other firms or industry standards
Study the efficiency of operations
Study the risk of operations

4. Profitabilty ratios
These ratios assess the performance of a firm in terms of its profit generating ability.
1. Gross Profit Margin ( GPM) = (Gross profit / sales revenue) x 100
The higher the better.
Enables the firm to assess the impact of its sales and how much it cost to generate (produce) those sales.
Example: A business has sales revenue of US$100 million and gross profit of US$ 70 million. Calculate its GPM.
GPM= (70 million/ 100 million ) x 100 = 70 %
A gross profit margin of 70% means that for every $1 of sales, the firm makes 70 cents in gross profit.

5. Profitabilty ratios
2. Net Profit Margin (NPM) = (Net profit before interest and tax / sales revenue) x 100
The higher the better.
It is the measure of the profit that remains after deducting all costs from the sales revenue.
Example: A business has sales revenue of US$150 million and net profit before interest and tax of US$ 75 million. Calculate its NPM.
NPM= (75 million/ 150 million ) x 100 = 50 %
A net profit margin of 50% means that for every $1 of sales, the firm makes 50 cents in net profit.

6. efficiency ratios
These ratios assess how well a firm internally utilizes its assets and liabilities.
Return on capital employed (ROCE)= (net profit before interest and tax /capital employed) x 100
Capital employed=long-term liabilities + share capital + retained profit
The higher the better.
This ratio measures both the efficiency and profitability of a firm´s invested capital.
Example: A business has share capital of US$1 million, retained profit of US$0.5 million and loan capital of US$2 million. It generated a net profit before interest and tax of US$700,000. Calculate its ROCE..
Capital employed= 1 million million + 2 million = 3.5 million
ROCE= 0.7 million/ 3.5 million x100 = 20%
A ROCE of 20% means that for every $100 of capital invested, the firm generates $ 20 as its net profit before interest and tax.

7. liquidity ratios
These ratios measure the ability of a firm to pay off its short-term debt obligations.
Liquidity is a measure of how quickly an asset can be converted into cash.

8. liquidity ratios
1. Current ratio = Current assets / Current liabilities
Ideal level – 1.5 : 1
Too high – Might suggest that too much of its assets are tied up in unproductive activities – too much stock. Too low (below 1:1) - risk of not being able to pay your debts.
Example: A business has current assets totalling $ while its current liabilities amount to $ What is its current ratio?
Current ratio = / = 2, which can also be expressed as 2:1. This means that for every $1 of current liabilities the firm has $2 of current assets.
2. Acid test ( Quick ratio) = (Current assets – stock) / Current liabilities
Too low (below 1:1) - risk of not being able to pay your debts.
Example: Suppose in the previous example, the business has stock worth US$ What is the acid test ratio?
Acid test ratio= ( )/ = 1.4. This means for every $1of current liabilities the business has $1.4 of current assets less stock.

9. In-class exercise STUDENT WORKPOINT 3.14 OXFORD PG. 212
Referring to Tables and calculate and interpret:
a. Two profitability ratios
b. ROCE
c. Two liquidity ratios
Which of the ratios from a. to c. are in need of further improvements? Evaluate possible strategies to improve each of those ratios.