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    Chapter 18 Unit 3.5 - Profitability and liquidity ratio analysis “Many ofthe things you can count, don't count. Mar iny ofthe things you can't count, really count.” ~ Albert Einstein (1879 - 1955), Mathematics genius Contents 3.5 Profitability and liquidity ratio analysis, SL/HL content ‘The fellowing proftabllty ratios: Gross profit margin Profit margin Retutn on capital employed (ROCE) Depth of teaching 402, 404 Possible strategies to improve these ratios The following liquiltycatios: Current ratio Acid: test (quick ratio Possible strategies to improve these ratios © 180, 2022 ] Ratio analysis ls simplest sens, a ratio is one number expressed in ‘men and 30 women, the male to female ratio is 2:3, ie. for every two male workers, there are 3 female workers. Ratio analysis is a quantitative management tool that compares ditferent financial figures to examine and judge the financial performance ofa business. I requires the aplication of figures found inthe final accounts, namely the balance sheet and the profit and loss account (see Chapter 17). To assess whether financial performance has improved, ratios for the current period are compared with historical figures. In addition, the same ratios can be compared to those of rival businesses to judge whether the frm has improved against its competitors, Exam tip! Dont just simply learn the formulae for teratios without understanding what they actually mean. Instead, focus (on why or how the ratios could be used in the context of the given organization. You should address issues such How is the business performing (based on the given financial data)? How has the business performed over time (trends)? What else needs to be considered that Is not presented in the data? For example, think about business objectives and external constraints on the: ‘organization's performance. 273 Topic 3: ance and accounts. CORE The purpose of ratio analysis ‘+ Toexamine afirm’ financial postion, such asits profitability as well as short- and long-term liquidity position, + To assess a firm’ financial performance, such as it ability 10 control expenses + To compare actual figures with projected or budgeted figures (known as variance analysis) in order to improve financial management. 1+ Toad decision-making, sich as whether investors should risk their money by investing in the business Ratios are compared in two ways: + Historical comparisons involve comparing the same ratio {in two different time periods for the same business. Such ‘comparisons show trends, thereby helping managers and decision makers to assess the financial performance of the business over time. + Intersfirm comparisons involve comparing the same ratios of businesses in the same industry. For ‘example, two businesses might have the same amount of| profit although their sales revenue may be quite different. Ratio analysis can therefore show the relative financial performance of businesses competing inthe same market In reality, businesses use both historical and inter-firm comparisons when analysing their financial ratios, However, it is important to remember that ratio analysis is only’ of value if managers compare like with like, For example, McDonald's should only compare its financial ratios with rivals of similar size in the same industry. There is litle, if any, value in ‘MeDonale’s comparing its financial ratios against a sole trader ‘who runs a single fastfood restaurant or comparing its figures to manufacturers of furniture Figure 18.1 - Financial ratio analysis helps firms to determine theirreturnon investments aah Exam tip! When learning the different financial ratios in the syllabus, make sure that you understand the various units of measurement used. Some ratios are expressed as a number in terms of another (e-. 2:1), whilst others are shown as a percentage or even as'number of days! ‘The important thing is to understand the meaning of the ratio and to be able to write about the ratio in the ‘context of the organization, Profitability ratios ‘The fllowing profitability ratios () gress proft margin, (profit ‘margin andi) Return on capital employed ROCE).AO2. AOS Possible strategies to improve these ratios. AO3 21802022 figures, suchas the ratio of profit to sales revenue. These ratios tend tobe relevant to for-profit businesses (such as Jarge multinational conglomerates) rather than for non-profit ‘organizations (such as charities). Managers, employees and potential investors may be interested in profitability ratios as they show how well the firm has performed in finan p= ratios examine profit in relation to other For example, the two firms in Table 19.1 generate the same amount of absolute profit but Firm A is more profitable. This is because it generates $100m profit from using capital worth 200m (a return of 50%), whereas Firm B earns the same mount profit from using 250m worth of capital resources (a smaller return of 40%), Table 19.1 - Efficiency and the use of capital resources Profit 100m 100m Capital employed 200m ‘$250 Profiabily ratio 50% 40% Profit is a Key objective for most businesses and acts as a measure of a firms financial success, Profit is defined as the financial surplus earnings of an organization once all casts have been deducted from sales revenue. Profitability ratios measure profit in relation to other variables such as sales tarnover or capital employed. The main profitability ratios are the gross profit margin (GPM), profit margin and return on capital ‘employed (ROCE) “The absolute amount of profit, as declared in a profit and loss account (see Chapter 17), tells us little about the financial performance ofa business. For example, isa business financially successful i it earns $10 million profit? The answer might be ‘yee for a small partnership selling computer accessories, bist the answer would be a definite ‘no! for a muuch larger business such as Lenovo or IBM, We can draw this conclusion when comparing the ratio of profit to the huge sales turnover of or the amount invested by, Lenovo and IBM. Hence, to assess the profitability ofa business, it is necessary to compare and relate profit to other financial aspects of the business, A key limitation fof using profitability ratios is that they only apply to profi orientated businesses. Exam tip! When dealing with finance, its important to look at the bigger picture and to put the figures into context. For example, in February 2007, sportswear manufacturer Puma announced a 26% drop in profits to €38.2 million ($43m). Does this represent. poor performance? Not necessarily. This very limited information can, on its own, bbe misleading, In fact, Puma was undergoing expansion and was using its retained profits to finance its growth (hence the fal n its declared profits). Pumas sales had actually increased by more than 339%. Ten years later, Puma declared profit of €135.2 million. By the end of 2020, the company had profits of more than €262 million and total equity of $2 billion (i) Gross profit margin (GPM) ‘The gross profit margin shows the value of firm’ gross profit expressed as a percentage ofits sales revenue. The figures for ‘working out the GPM are found in the profit and loss account, ssing the formal Gross profit Sales revenue Gem = 100 “The GPM ratios expressed as a percentage figure. For example, ifa business has a gross profit of $120 million from sales of $200 ‘million, then the GPM is 60%. This means that for every $100 of sales revenue, $60 is gross profit (with costs of goods sold accounting fr the other $40). The higher the GPM, the better it is for abusiness as gross profit goes towards paying is expenses “The GPM ratio can be improved in two main ways Raising sales revenue Reding the selling price of products for which there are smany substitute products -This enables the fim to gun a competitive advantage by having lower prices for products that are price elastic (sce Chapter 28) Raising the selling price of products for which there are few if any substitutes -Ifcustomers are not very responsive to changes in price (due to strong brand loyalty ora lack ‘of close substitute products), then the business can gain Inigher sales revenue by charging a higher price for these price inelastic goods and services. Using improved marketing strategies to mise sales revenue - For example, special promotions (see Chapter 29) and product extension strategies (see Chapter 27) can help to increase sales Seeking alternative revenue streams (see Chapter 16) This can enable the business to improve its sales revenue, particularly when its affected by ductuations in seasonal ‘demand or intense rivalry in the market. Figure 182 - Beach holiday resorts are prone to seasonal fluctuations in demand Reducing direct costs + Cutting direct material costs - For example, businesses might choose to use cheaper suppliers and/or cheaper smaterials Some atlines have saved millions of dollars each ‘year by cutting back on the amount of chocolates or snacks that they offer on-board. Hovever, cost cutting can have a negative impact on the perceived quality of the good or 275 + Gutting direct Labour costs - Businesses might choose to reduce stating cost by redacing the mumber of staff Alesitime (se Chapter 10) or using non-financial incentives to get employees to do more work. In any case, labour productivity may increase, thereby reducing unit labour costs, However, this method can cause resentment and

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