profitability ratios

• Profitability ratios

  Examine the firm's profit-making ability
• Profitability ratios

  • Gross profit margin
  • Profit margin
  • Return on capital employed (ROCE)
• Gross profit margin (GPM)

  Gross profit divided by Revenue times 100
• Profit margin

  Profit before interest and tax divided by Revenue times 100
• Return on capital employed (ROCE)

  Profit before interest and tax divided by Capital employed times 100
• Capital employed

  Non-current liabilities and Equity
• Comparing gross profit margin to profit margin can help evaluate how well a business is controlling its expenses
• Liquidity ratios

  Measure a firm's ability to meet its short-term obligations
• Liquidity ratios

  • Current ratio
  • Acid test ratio
• Strategies to improve gross profit margin

  1. Increase revenue

  2. Decrease costs
• Strategies to increase revenue

  • Increase prices
  • Decrease prices
• Increasing prices

  • Can negatively impact brand image if customers think the firm is taking advantage of them
• Decreasing prices

  • Can make customers think the product is of lower quality
• Strategies to decrease costs

  • Find cheaper suppliers
  • Decrease labour costs
• Cheaper suppliers

  • May be lower quality
• Decreasing labour costs

  • Can negatively impact employee motivation and output quality
• Strategies to improve profit margin

  1. Improve working capital

  2. Reduce expenses
• Strategies to improve working capital

  • Postpone payments to suppliers
  • Negotiate discounts with suppliers
• Postponing payments to suppliers

  • Can worsen relationships with suppliers and they may charge higher prices
• Negotiating discounts with suppliers

  • Requires having cash available to make early payments
• Strategies to reduce expenses

  • Delayer management
  • Cut overheads
• Delayering management

  • Can result in loss of control and chaos if not managed well
• Cutting overheads

  • Can negatively impact employee motivation
• IB terminology may differ from other sources, e.g. 'net profit' in IB may be called 'operating profit' elsewhere
• Gross profit margin

  Ratio that compares gross profit to sales revenue
• Profit margin

  Ratio that compares net profit to sales revenue
• Comparing gross profit margin and profit margin

  Can indicate if an organization's expenses are high
• Return on Capital Employed (ROCE)

  Ratio that measures the profitability of capital invested in a business
• Capital employed

  Non-current liabilities plus equity
• The higher the ROCE, the better the organization is at generating profits from capital employed
• Strategies to improve ROCE

  1. Minimize non-current liabilities

  2. Pay more dividends to reduce retained profits
• Liquidity

  The ease with which an asset can be converted into cash
• Current ratio

  Ratio that compares current assets to current liabilities
• Desirable current ratio

  • Between 1.5:1 and 2:1
  • Less than 1:1 indicates liquidity problems
  • More than 2:1 indicates too much cash, debtors or stock
• Acid test ratio (quick ratio)

  Ratio that compares current assets excluding stock to current liabilities
• Desirable acid test ratio

  • More than 1:1
  • More than 2:1 indicates too much cash or debtors
• Strategies to improve liquidity ratios

  1. Increase current assets by selling for cash

  2. Use more long-term financing instead of short-term

  3. Sell stock with a discount
• It's important to calculate and compare both profitability and liquidity ratios