CE – COLLEGE OF ENGINEERING

MASTER OF SCIENCE IN ELECTRICAL AND ELECTRONICS ENGINEERING

WITH MANAGEMENT

MANAGERIAL FINANCE

EEM733

INDIVIDUAL ASSIGNMENT

“Understanding Liquidity and Profitability Ratios in Financial Analysis”

PREPARED BY

MUHAMMAD HAFISZAN BIN MOHD AKHIR

2023761495
Introduction

In this reflection paper, I will discuss what I have learned about liquidity ratios and
profitability ratios. I will begin by defining each type of ratio and explaining how it is
calculated. I will then discuss the different types of liquidity ratios and profitability
ratios, and what they can tell us about a company's financial health. Finally, I will reflect
on what I have learned about these ratios and how I can use this knowledge to make
better investment decisions in the future.

Liquidity Ratios:

Liquidity ratios provide insights into a company's ability to meet its short-term financial
obligations. The two most commonly used liquidity ratios are the current ratio and the
quick ratio.

1. Current Ratio
The current ratio is a straightforward ratio that compares a company's current
assets to its current liabilities. It is calculated as:

A current ratio above 1 indicates that the company has enough current assets
to cover its current liabilities. This ratio gives an overall picture of a company's
liquidity. However, it is essential to consider industry standards and the
company's specific circumstances when interpreting the ratio.

For example, a current ratio of 2 might suggest strong liquidity, but if a

significant portion of current assets is tied up in slow-moving inventory, it may
not be as reliable as it seems.

Practical Application: The current ratio is vital for creditors when determining a
company's ability to repay its short-term loans.
 2. Quick Ratio (Acid-Test Ratio):
The quick ratio is a more stringent measure of liquidity as it excludes inventory
from current assets. It is calculated as:

This ratio is valuable in situations where inventory might not be easily

convertible to cash. It offers a more conservative assessment of a company's
ability to meet short-term obligations.

Practical Application: The quick ratio is crucial for businesses with significant
inventory and where quick liquidity is essential, such as retailers.

Profitability Ratios:

Profitability ratios gauge a company's overall financial performance and its ability to
generate profits. There are several key profitability ratios, including the gross profit
margin, net profit margin, return on assets (ROA), and return on equity (ROE).

1. Gross Profit Margin:

The gross profit margin measures the profitability of a company's core
operations. It is calculated as:

The gross profit margin reflects the efficiency of a company in producing goods
or services. A high gross profit margin indicates efficient cost management and
pricing strategy.

Practical Application: Investors often look at the gross profit margin to assess
a company's operational efficiency.
2. Net Profit Margin:
The net profit margin assesses a company's overall profitability after all
expenses, including operating, interest, and taxes. It is calculated as:

A high net profit margin signifies effective overall cost management and
profitability. It provides a clear picture of the company's ability to generate
profits for its shareholders.

Practical Application: Lenders and potential investors closely examine the net
profit margin to understand a company's bottom-line profitability.

3. Return on Assets (ROA):

Return on assets measures how efficiently a company generates profits from
its total assets. It is calculated as:

ROA indicates how well a company utilizes its assets to generate earnings. A
higher ROA suggests better asset utilization and overall efficiency.

Practical Application: ROA is valuable for investors looking to assess a

company's efficiency in utilizing its assets.

4. Return on Equity (ROE):

Return on equity evaluates a company's ability to generate profits for its
shareholders. It is calculated as:
 ROE measures the return earned by shareholders on their investment. A high
ROE is often associated with strong financial performance and efficient use of
equity.

Practical Application: ROE is essential for investors and management to gauge

a company's ability to create value for its shareholders.

Application in Real-World Decision Making

Investment Decisions
I've come to understand that liquidity and profitability ratios are essential for investors.
By analyzing these ratios, investors can make informed decisions about whether to
invest in a company. For instance, a company with a high current ratio and healthy net
profit margin may be an attractive investment opportunity.

Credit Decisions
Liquidity ratios are vital for creditors, as they determine a company's ability to repay
debts. A company with a low quick ratio may be seen as a riskier borrower, leading to
higher interest rates on loans. It's clear that these ratios can influence lending terms
and interest rates significantly.

Operational Decisions
Moreover, these ratios are invaluable for managers and executives in making
operational decisions. They provide insight into how efficiently a company is using its
assets and managing its costs. For example, a company with a low net profit margin
may need to identify cost-saving measures or strategies to boost revenue.

Conclusion

In conclusion, my journey of learning about liquidity and profitability ratios has been
illuminating. These financial metrics are not just numbers but tools that provide
invaluable insights into a company's financial health and performance. I've come to
understand the importance of considering context, industry norms, and the
interconnectedness of these ratios when conducting financial analysis.

These ratios are not only essential for investors and creditors but also for business
owners and managers. They guide strategic decision-making and help in assessing
the efficiency of resource utilization. Through practical application, I've seen how these
ratios can offer a clear picture of a company's financial well-being and its potential for
growth.

As I continue my exploration of finance and business, I am certain that the knowledge

and insights gained from understanding liquidity and profitability ratios will serve as a
solid foundation for making informed financial decisions and investments in the future.