Profitability and Liquidity Ratio Analysis

Key concepts:

Profitability: Profitability refers to the ability of a company to generate profit from

its operations. It measures the efficiency of the company in using its resources to
generate earnings. A profitable company earns more revenue than the costs it incurs
to produce goods or services. Profitability is typically assessed using metrics such as
net profit margin, return on investment (ROI), return on assets (ROA), and return on
equity (ROE).

Liquidity: Liquidity refers to the ability of a company to meet its short-term financial
obligations promptly and efficiently. It measures the company's ability to convert its
assets into cash quickly without significant loss in value. A liquid company has
sufficient cash or assets that can be readily converted into cash to cover its short-
term liabilities, such as bills, salaries, and loan repayments. Liquidity is commonly
evaluated using metrics such as the current ratio, quick ratio, and cash ratio.

Assets are resources owned or controlled by a company that provide future

economic benefits.

Liabilities are obligations or debts that a company owes to external parties, requiring
future transfer of economic resources.

Profitability Ratios
For any business entity, the ultimate goal is to make profits. No business runs on charity and
instead, it expects some returns against all the operations being performed in the business.
Return on Investment or Return on Capital Employed measures the Overall Profitability and
is used to analyze the capital efficiency of the firm.
Profitability ratios are financial metrics used to assess a company's ability to generate profits
relative to its revenue, assets, equity, or other financial metrics. They give investors and
analysts insights into how efficiently a company is using its resources to generate earnings.
Here are a few common profitability ratios and how they work:

1. Gross Profit Margin:

The term gross profit margin refers to a financial metric that analysts use to assess a
company's financial health. Gross profit margin is the profit after subtracting the cost of
goods sold (COGS). Put simply, a company's gross profit margin is the money it makes after
accounting for the cost of doing business. This metric is commonly expressed as a
percentage of sales and may also be known as the gross margin ratio.
It indicates how efficiently a company is producing its goods or services. The formula is:
Gross Profit Margin= (Gross Profit/sales) ×100 where:
 Gross Profit = Sales Revenue - Cost of Goods Sold (COGS)
 Sales = Total Revenue
Good to know:
Cost of Goods Sold (COGS): COGS is an important metric on financial statements as it is
subtracted from a company’s revenues to determine its gross profit. COGS = Opening
Inventory + Purchase or Production Costs – Closing Inventory
Gross Profit Ratio is used to ascertain the amount of profit available in hand to cover the
firm’s operating expenses. A higher gross profit ratio indicated an increase in the profit
margin. Gross profit ratio can be compared with the previous year’s ratio of the firm or with
similar firms to ascertain the growth. This ratio is also an important measure to know how
efficiently an establishment uses labour and supplies for manufacturing goods or offering
services to clients. In other words, it is an important determinant of the profitability and
financial performance of the business.
Illustration 1:

The gross profit margin for Year 1 and Year 2 are computed as follows:
Gross profit margin (Y1) = 265,000 / 936,000 = 28.3%
Gross profit margin (Y2) = 310,000 / 1,468,000 = 21.1%
Notice that in terms of dollar amount, gross profit is higher in Year 2. Nonetheless, the gross
profit margin deteriorated in Year 2. The cost of sales in Year 2 represents 78.9% of sales (1
minus gross profit margin, or 328/1,168); while in Year 1, cost of sales represents 71.7%.

2. Net Profit Margin:

Net Profit Ratio shows the relationship between the net profit and net revenue from
operations based on the all-inclusive concept of profit. It links operating revenue to net
profit after operational and non-operational costs and incomes.
Generally, a company with a high net profit ratio can successfully manage its costs and/or
offer products or services for a price that is much higher than its costs. Consequently, a high
ratio may be generated by:
  Optimal management
 Low prices (expenses)
 Effective pricing tactics
Whereas, a company that has a low net profit ratio either has an inefficient cost structure or
uses bad pricing tactics. Consequently, a low ratio may be formed by:
 Inadequate management
 High prices (expenses)
 Poor pricing tactics
Investors should utilise the profit margin ratio’s figures as a general measure of a company’s
profitability performance and, as necessary, initiate in-depth investigations of the factors
that contribute to an increase or decrease in profitability.
Net Profit Margin=(Net Profit/sales)×100 where
 Net Profit = Total Revenue - Total Expenses (including taxes and interest)
 Sales = Total Revenue
The net profit percentage is calculated by dividing after-tax profits by net sales. It displays
the residual profit after the recognition of income taxes and the deduction of all
manufacturing, administrative, and financing costs from sales.
 Net Profit: The money company makes after deducting all operational, interest, and
tax costs during a specific period is known as net profit. The bottom line of the
financial statement is reflected by the net profit in the balance sheet.
 Revenue from Operations: The income a company generates from its regular, core
business operations is known as revenue from operations, or operating revenue. It is
considered to have been running effectively if the entity can provide a consistent
stream of income from its operations.
 Illustration 1:
 Net profit margin (Y1) = 98 / 936 = 10.5%
Net profit margin (Y2) = 103 / 1,468 = 7.0%
The net profit margin declined in Year 2. Notice that in terms of dollar amount, net
income is higher in Year 2. Nonetheless, it represents only 7.0% of sales; while in Year 1,
it represents 10.5%. For every dollar of sales, the entity made $0.07 in Year 2 and $0.105
in Year 1. Hence in terms of managing costs and expenses, the company did better in
Year 1. A deeper analysis of the figures above would reveal that the company incurred
significantly high cost of sales and operating expenses in Year 2.
The higher the net profit margin (or return on sales), the better. A high percentage
means that the company did well in managing its expenses. It is also useful to compare it
to a benchmark, such as industry average or past performance, to determine the
company's standing.

3. Return on Capital Employed (ROCE):

This ratio measures the profitability of a company relative to the total capital employed in
the business. It shows how effectively the company is using its capital to generate profits.
The formula is:
Return on Capital Employed (ROCE)=( Net Profit/Capital Employed )×100
Where:
 Capital Employed = Total Assets - Current Liabilities (or, in some cases, it may be
calculated as Total Assets - Current Liabilities - Intangible Assets)

Like the previous ratios, multiplying the result by 100 gives you the percentage value. A
higher ROCE indicates that a company is generating more profit per unit of capital employed,
which is favorable for investors.

Strategies to Improve Profitability Ratios

Strategies to Improve Gross Profit Margin (GPM):
1. Increase Prices in Less Competitive Markets: By raising prices in markets where
competition is low or where customers are less sensitive to price changes, the
company can potentially increase its GPM. This works because customers may still
buy the product even with higher prices, leading to higher revenue without a
significant increase in costs.
Exemple: Imagine a luxury boutique selling high-end fashion accessories. By raising
prices in markets where exclusive clientele shop, such as upscale neighborhoods or
luxury resorts, the boutique can potentially increase its GPM. Wealthy customers may
 still purchase the products despite higher prices, leading to higher revenue without a
significant increase in costs.
2. Source Cheaper Suppliers: Finding suppliers that offer materials at lower costs can
directly reduce the cost of goods sold (COGS), thereby increasing the GPM. This
strategy focuses on optimizing the cost side of the profit equation.
Exemple: Suppose the boutique finds suppliers that offer premium materials at lower
costs. This can directly reduce the cost of goods sold (COGS), thereby increasing the
GPM. By negotiating better deals with suppliers or sourcing materials from more
cost-effective regions, the boutique can optimize the cost side of the profit equation.
3. Adopt Aggressive Promotional Strategies: Implementing effective promotional
strategies can drive more sales volume, which can spread fixed costs over a larger
revenue base, ultimately boosting GPM. This involves attracting more customers to
purchase the product through enticing promotions.
4. Increase Labor Productivity: Improving productivity among staff can lead to higher
output per unit of labor cost, effectively reducing the cost of production per unit and
increasing GPM. This might involve training employees, streamlining processes, or
reorganizing work schedules to enhance efficiency.
Strategies to Improve Net Profit Margin (NPM):
1. Reduce Indirect Costs: Identifying and eliminating unnecessary expenses, such as
extravagant holiday packages for senior managers, can directly improve NPM. This
involves scrutinizing all expenses to ensure they contribute directly to the company's
bottom line.
Example: Identifying and eliminating unnecessary expenses, such as lavish marketing
events or excessive administrative overhead, can directly improve NPM. By
scrutinizing all expenses and focusing on those that directly contribute to profitability,
the boutique can enhance its bottom line.
2. Negotiate Cost Reductions: Negotiating with key stakeholders, such as landlords or
suppliers, for lower costs can help reduce expenses and increase NPM. This might
involve renegotiating lease agreements for lower rent or securing discounts from
suppliers on raw materials.
Lease agreements: from leasing: Leasing is a financial arrangement where one party (the
lessor) owns an asset and allows another party (the lessee) to use the asset for a
specified period in exchange for periodic payments. Unlike purchasing, where ownership
of the asset transfers to the buyer, leasing allows the lessee to use the asset without
taking ownership.
3. Consider Long-term Implications: While cost-cutting measures like negotiating
cheaper rent may seem beneficial, it's important to consider the long-term impact on
the business. Moving to a cheaper location could affect customer perception and
potentially harm the company's image, impacting revenue and ultimately NPM.
 4. Balance Cost Reduction with Morale: When implementing cost-cutting measures, it's
crucial to consider their impact on employee morale and motivation. Demoralizing
staff, especially senior managers accustomed to certain perks, could lead to
decreased productivity and potentially offset any gains in NPM.
By implementing these strategies thoughtfully and strategically, a company can work
towards improving both its Gross Profit Margin and Net Profit Margin, ultimately enhancing
its overall profitability and financial health.

Liquidity Ratios
Liquidity ratios are the ones that determine the organisation’s ability to meet its short-term
obligations by defining a systematic relationship between the amount of current/liquid
assets and that of its current/short-term obligations.
Liquidity ratios assist analysts and investors in determining a company’s ability to meet its
immediate financial obligations. One of the most popular liquidity ratios is the current ratio,
which assesses a company’s capacity to settle its current debts with its current assets.
Liquidity ratios are an essential tool for businesses to assess their ability to meet their short-
term financial obligations. These ratios provide insight into the company’s liquidity position
and help investors and analysts determine its ability to pay off its debts and fund its day-to-
day operations. There are various types of liquidity ratios used in financial analysis, but the
two most commonly used ratios are the current ratio and liquid ratio.

1. Current Ratio:
The Current Ratio measures the company's ability to pay off its short-term liabilities (debts
due within one year) using its short-term assets (assets expected to be converted into cash
within one year). It's calculated by dividing current assets by current liabilities.
Current Ratio= Current Assets/Current Liabilities

 Current Assets typically include cash, cash equivalents, accounts receivable,

inventory, and other assets expected to be converted into cash within one year.
 Current Liabilities include short-term debts, accounts payable, and other obligations
due within one year.
A current ratio greater than 1 indicates that the company has more current assets than
current liabilities, suggesting it has enough short-term assets to cover its short-term debts.
However, a very high current ratio may indicate inefficiency in asset utilization, while a very
low ratio may indicate liquidity problems.
There can be three situations arising from the calculation:
- If Current Assets > Current Liabilities, then Current Ratio > 1: This implies that the
organisation would still have some assets left even after paying all the short-term debts
and is a desirable situation to be in.
- If Current Assets = Current Liabilities, then Current Ratio = 1: This means that the
current assets are just enough to cover the short-term obligations of the firm.
- If Current Assets < Current Liabilities, then Current Ratio < 1 This is not an ideal
situation to be in since it implies that the company does not have enough resources to
pay off short-term debts.
Illustration 1:
Calculate the current ratio from the following Balance Sheet for GFG Ltd. for the year
ending March 2022 and comment on the result
Illustration 2

Interpreting the Current Ratio

If the current ratio computation results in an amount greater than 1, it means that the
company has adequate current assets to settle its current liabilities. In the above example,
XYZ Company has current assets 2.32 times larger than current liabilities. In other words, for
every $1 of current liability, the company has $2.32 of current assets available to pay for it.
Solution:
Current Assets = Stock + Debtors + Bills Receivables + Marketable Securities+
Prepaid Expenses + Bank
= 2,00,000 + 80,000 + 60,000 + 50,000 + 10,000 + 20,000
= ₹4,20,000
Current Liabilities = Bank Overdraft + Sundry Creditors + Outstanding Expenses
+ Provision for Tax + Proposed Dividend
= 40,000 + 90,000 + 10,000 + 40,000 + 20,000
= ₹2,00,000
Therefore,
= 2.1 : 1
Comment: The current ratio of Geeks Ltd. is 2.1:1, which is slightly more than
the ideal ratio. It implies that the short-term financial position of the firm is sound
and it can meet its short-term liabilities well in time.

2. Acid Test Ratio:

The Acid Test Ratio (Quick Ratio):is a more stringent measure of liquidity compared to the
Current Ratio. It assesses the company's ability to pay off its short-term liabilities without
relying on the sale of inventory. It's calculated by subtracting inventory from current assets
and then dividing by current liabilities.
Acid Test Ratio= (Current Assets−Inventory)/Current Liabilities
 Since inventory is excluded from current assets, only the most liquid assets such as
cash, cash equivalents, and accounts receivable are considered.
 The Acid Test Ratio provides a clearer picture of a company's ability to meet its short-
term obligations quickly, without relying on inventory sales.
A higher Acid Test Ratio indicates a stronger liquidity position because it shows that the
company has enough liquid assets to cover its short-term liabilities even without relying on
selling inventory.
In summary, liquidity ratios like the Current Ratio and Acid Test Ratio help assess a
company's ability to meet its short-term financial obligations. They provide valuable insights
into the company's liquidity position and its ability to withstand financial challenges in the
short term.

Strategies to Improve Liquidity Ratios

Here are some strategies to improve profitability ratios by optimizing assets and liabilities:
 1. Sell Off Fixed Assets for Cash:
 Strategy: Identify underutilized or non-essential fixed assets, such as unused
machinery or excess real estate, and sell them to generate cash.
 Benefits: Selling off fixed assets can provide an immediate influx of cash, reduce
depreciation expenses, and streamline operations by focusing on core assets.
 Considerations: Ensure that the sale of fixed assets aligns with long-term business
goals and doesn't compromise essential operations or future growth opportunities.
2. Sell Off Inventories for Cash:
 Strategy: Review inventory levels and identify slow-moving or obsolete inventory
items. Sell these items at discounted prices or liquidate them to free up cash and
reduce carrying costs.
 Benefits: Selling excess inventory for cash can improve liquidity, reduce storage costs,
and prevent inventory obsolescence. It can also generate revenue to reinvest in more
profitable areas of the business.
 Considerations: Balance the need to liquidate inventory with maintaining adequate
stock levels to meet customer demand and avoid stockouts.
3. Increase Loans to Add Cash:
 Strategy: Evaluate borrowing options, such as bank loans or lines of credit, to increase
cash reserves. Use borrowed funds strategically to invest in revenue-generating
activities or fund expansion initiatives.
 Benefits: Increasing loans can provide immediate cash infusions to support business
operations, finance growth opportunities, or cover short-term expenses. It can also
leverage the business's existing assets to generate higher returns.
 Considerations: Assess the cost of borrowing, including interest rates, fees, and
repayment terms, to ensure that the benefits of increased cash flow outweigh the
costs of servicing the debt. Maintain a prudent level of debt to avoid overleveraging
and potential financial strain.
These strategies aim to optimize the balance between assets and liabilities to improve
profitability ratios. By unlocking cash from underutilized assets, optimizing inventory
management, and strategically leveraging borrowing, businesses can enhance liquidity,
reduce costs, and position themselves for sustainable profitability and growth.