3.5 Profitability and liquidity ratio analysis

• Ratio analysis is a quantitative management tool for analysing and judging the financial performance of a business.
• Historical comparisons compare the same ratio in two time periods for the same firm.
• Inter-firm comparisons involve comparing the ratios of businesses in the same industry.
• Gross profit margin=gross profit/sales revenue x 100
• Profit margin = profit before interest and tax / sales revenue x 100
• Return on capital employed = profit before interest and tax / capital employed x 100
• Capital employed = non-current liabilities + equity
• The three profitability ratios are gross profit margin, profit margin, return on capital employed.
• The two liquidity ratios are current ratio and acid test (quick) ratio.
• Current ratio = current assets / current liabilities
• Liquid assets are cash or assets that can be turned into cash quickly.
• The ideal benchmark for the current ratio is 1.5 to 2 : 1.
• Quick (acid test) ratio = current assets - stock / current liabilities
• The ideal benchmark for the quick ratio is 1:1.