Unit 3 – Finance and Accounts
3.5 – Profitability and Liquidity Ratio Analysis
Ratio analysis is a quantitative tool for analyzing a company’s financial position by examining relationships between items in its financial statements.
Profitability Ratios
Profitability ratios measure a business's ability to generate profit relative to revenue, assets, or capital employed.
Key Profitability Ratios:
- Gross Profit Margin (GPM): Indicates how efficiently a company produces and sells its goods.
\[ \text{Gross Profit Margin (\%)} = \frac{\text{Gross Profit}}{\text{Sales Revenue}} \times 100 \] - Net Profit Margin (NPM): Shows how much of sales revenue remains as net profit after all expenses.
\[ \text{Net Profit Margin (\%)} = \frac{\text{Net Profit}}{\text{Sales Revenue}} \times 100 \] - Return on Capital Employed (ROCE): Assesses how efficiently a business is using its capital to generate profits.
\[ \text{ROCE (\%)} = \frac{\text{Net Profit before Interest and Tax}}{\text{Capital Employed}} \times 100 \]
Liquidity Ratios
Liquidity ratios assess a firm's ability to meet its short-term debts and obligations using its most liquid assets.
Key Liquidity Ratios:
- Current Ratio: Measures short-term financial health.
\[ \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} \] A ratio around 2:1 is often considered healthy. - Acid-Test (Quick) Ratio: Excludes inventory from assets as it’s less easily converted to cash.
\[ \text{Acid\text{-}Test Ratio} = \frac{\text{Current Assets} - \text{Stock}}{\text{Current Liabilities}} \] A ratio ~1:1 shows solid liquidity without relying on selling inventory.
Summary Table: Main Ratios
| Ratio | Formula (MathJax) | What It Measures |
|---|---|---|
| Gross Profit Margin | \( \frac{Gross \ Profit}{Sales \ Revenue} \times 100 \) | Production & sales efficiency |
| Net Profit Margin | \( \frac{Net \ Profit}{Sales \ Revenue} \times 100 \) | Overall profitability |
| ROCE | \( \frac{Net \ Profit \ before \ I\&T}{Capital \ Employed} \times 100 \) | Return on invested capital |
| Current Ratio | \( \frac{Current \ Assets}{Current \ Liabilities} \) | Short-term liquidity |
| Acid-Test (Quick) Ratio | \( \frac{Current \ Assets - Stock}{Current \ Liabilities} \) | Liquidity without inventory |
Key Takeaways
- Profitability ratios judge how well a business converts revenue into profit (before/after expenses & using capital).
- Liquidity ratios assess if a business can pay short-term debts without financial distress.
- Both sets of ratios are essential for evaluating business health, securing loans, and strategic planning.