3.5 Profitability and liquidity ratio analysis

Full video class on YouTube, summary and notes on Instagram, class extracts on TikTok, text below. Have fun!

The main point of this class is to learn how to calculate profitability and liquidity ratios.

Ratio analysis is a quantitative financial analysis tool for judging the financial performance of the business based on financial statements (balance sheet and profit & loss account). There are different types of ratios: profitability, liquidity and efficiency. The first two types of ratios are covered in this class, and efficiency ratios are covered in the next class for HL students only.

Profitability ratios examine organisation’s profit-making ability. The three types of profitability ratios are gross profit margin, profit margin and return on capital employed (ROCE).

Gross profit margin shows the percentage of gross profit in relation to revenue. You will need profit and loss account to obtain data for calculation of profit margin. The formula of gross profit margin is:

Gross profit margin = gross profit ÷ revenue ⨉ 100

The higher the gross profit margin is, the better. For example, gross profit of $150 from sales revenue of $250 is 60%. It means that for every $100 of sales, $60 is gross profit.

Before I tell you about the strategies to improve gross profit margin, I suggest you copy the table below and fill it in. This will help you to achieve the second class objective to discuss possible strategies to improve profitability ratios (AO3).

The first strategy to improve gross profit margin could be increasing revenue by reducing or increasing the prices. Reduction of prices may result in increased demand and thus higher revenue. Increasing the prices may result in higher revenues if the demand doesn’t fall (this usually works for products that do not have many alternatives). The downside of price increase/reduction is that it might impact brand image negatively as it can be perceived as inferior in case of price reduction or unethical in case of price increase.

The second strategy is increasing the revenue through increased promotion. This way, more potential customers will be likely to know about the product sold. However, being aware of the product does not necessarily result in purchasing the product. In addition, marketing costs might also increase with increased promotion.

Another strategy is reducing the cost of sales. As we learnt in the previous class, gross profit = revenue – cost of sales. So, one way to improve gross profit margin is to reduce cost of sales by using cheaper suppliers. On the one hand, cost of sales might decrease. But on the other hand, cheaper suppliers might be of inferior quality.

The last strategy to improve gross profit margin is to reduce the cost of sales by cutting labour costs. Similar to the previous strategy, costs will be lower, but the staff motivation might worsen and employees might have to be paid severance packages as a compensation for being laid off.

Reminder: “To fire someone” is dismissal. Dismissals occur when employees are performing their jobs badly. When employees are dismissed ("fired"), they do not get any compensation for it. “To lay someone off” is redundancy. Redundancies happen when employees do their job well but their service is no longer needed. When employees are made redundant ("laid off"), they are offered a severance package that usually amounts to 2-3 months pay. More about redundancies and dismissals in Unit 2.

Profit margin shows the percentage of net profit before interest and tax in relation to revenue. You will need profit and loss account to obtain data for calculation of profit margin. The formula of gross profit margin is:

Profit margin = profit before interest & tax ÷ revenue ⨉ 100

The higher the profit margin, the better the organisation controls its expenses. For example, profit margin of $100 from sales revenue of $250 is 40%. It means that for every $100 of sales, $40 is profit margin.

The first strategy to improve profit margin is to improve working capital by negotiating longer trade credit period. Working capital is money used in day-to-day trading operations (formula is total current assets – total current liabilities). If you negotiate longer trade credit period, it means that you postpone the payment for the supplies, which will apparently have a positive impact on working capital. Simply speaking, you’ll have more cash at hand. The downside is that your creditors (suppliers, who sell things to you and provide trade credit) might not appreciate that and relationship with them might worsen. Or they might simply increase the price in exchange for longer trade credit period.

The second strategy is to improve working capital by negotiating discounts with your creditors/suppliers. For example, if you promise to pay for supplies earlier than usual, you will get a certain discount for early payment. That is acceptable and it might free up some cash, but it might put too much pressure on the organisation to generate revenues asap, which might result in decreased quality of output or lower motivation of employees.

Another strategy is to reduce expenses. As you remember from the previous class, net profit = gross profit – expenses, so reduction of expenses will clearly result in increased net profit. This could be achieved by delayering. If an unnecessary level of management is delayered, then it will cut administrative/managerial costs, but it might result in loss of control over employees.

Lastly, profit margin can be improved by simply trying to reduce some other overheads: rent, internet fee, cost of stationary, etc. The advantage is clearly lower overheads but the disadvantage is staff dissatisfaction who might be used to certain things that they might have to give up because of management’s decision to cut some overheads. For example, if the office used to provide free coffee and then management decided to cut costs and remove free coffee from the office, some employees might be deeply discouraged, even though it might not seem like a big deal…

IB tip: In IB terminology there is only gross profit and net profit (before or after interest and tax). You might see other kinds of profits in some sources. Sometimes, net profit refers to net profit after interest and tax and operating profit refers to net profit before interest and tax. In IB, there is no such thing as operating profit. Only gross profit, net profit before interest and tax and net profit after interest and tax.

One more IB tip: Comparing gross profit margin with profit margin can help you assess organisation’s ability to control expenses. If the difference between the two ratios is too high, it means that expenses are very high and perhaps the organisation should do something about it.

Return on capital employed (ROCE) shows how well capital employed is used in making profit. You will need both profit and loss account and balance sheet to obtain data for calculating ROCE. The formula for ROCE is:

ROCE = profit before interest & tax ÷ capital employed ⨉ 100

Capital employed = non-current liabilities + equity

The higher the ROCE, the more profit organisation generates from invested capital. For example, 25% ROCE shows that for every $100 invested, $25 profit is generated. ROCE benchmarks are different in different industries but usually a benchmark of an acceptable ROCE is around 20%.

If you have a closer look at the formula of ROCE you will see that the main way to improve ROCE is to keep profits high and capital employed low. This can be achieved through two strategies.

Firstly, ROCE may be improved by minimising non-current liabilities by reducing long-term loans. The downside is that long-term loans are usually used to sustain business growth by purchasing non-current assets. So, not having enough funds for growth might diminish organisational growth in the long-term.

The second strategy to improve ROCE is to reduce retained profits by paying more dividends. This only works for limited liability organisations that have shareholders. As you remember from the previous class, equity of for-profit entities consists of retained profits and share capital. The more dividends are paid, the less profits are retained. This results in lower capital employed (see formula above) and thus results in improved ROCE. The problem with retaining insufficient profit is having to rely on loans in business growth, which brings us to the drawbacks of the previous strategy (see above).

Liquidity ratios examine organisation’s ability to pay for its current liabilities. Liquidity is defined as the state of being liquid. In the business world, water is cash, i.e. cash is the most liquid asset. So, liquidity refers to the availability of liquid assets to an organisation. In the balance sheet, liquid assets are in the current assets section and are usually cash, debtors and stock. The two types of liquidity ratios are current ratio and acid test (quick) ratio.

Current ratio compares organisation’s current assets to current liabilities. The formula of current ratio is:

Current ratio = current assets ÷ current liabilities

Desirable ratio depends on the industry, but it is usually between 1,5:1 to 2:1. If current ratio is lower than 1:1, it indicates that organisation is experiencing liquidity problems. If the ratio is more than 2:1, it means too much of one or some of the following:

• Cash. Cash is a depreciating asset. Its value decreases over time due to inflation, so it not a good idea to hold too much cash.
• Debtors. If an organisation holds too much of debtors, it means that it sells a lot of its product on credit, i.e. it means that debtors receive products, but pay for them later. It might result in bad debt — a situation when debts cannot be repaid. This should be avoided.
• Stock (unsold goods). This indicates that there is too much of unsold goods that take up storage place and do not generate any value. This situation is also undesirable.

So, overall, current ratio should be neither too low nor too high. It depends on the industry, but usually it should be in between 1,5:1 and 2:1.

How to understand 1,5:1 or 2:1? What does this “:” in the middle mean? For example, if current assets are $250,000 and current liabilities are $100,000, then current ratio is 2,5:1. It means that the organisation has $2,5 of current assets to pay for every $1 of current liabilities. That is why there is usually a colon (:) in between the numbers to indicate that this is a ratio of current assets to current liabilities.

The first strategy to improve current ratio is to increase current assets by selling non-current assets for cash, not on credit. On the one hand, it will increase cash and improve the ratio, but on the other cash, as I mentioned above, holding too much of cash is undesirable because it is a depreciating asset. It’s really important to be balanced here and to make sure there is just enough cash to sustain day-to-day operations: not too much and not too little, somewhere in between too much of depreciating asset and liquidity problem.

Another strategy to improve current ratio could be decreasing current liabilities by using long-term sources of finance instead of short-term. On the one hand, it improves the ratio and decreases the burden of frequent payments for short-term loans (current liabilities). But on the other hand, you might end up having liquidity problems if there is not enough cash to pay for short-term expenses, such as wages, electricity and other fees, and deliveries of supplies. So, again, balance is essential.

Acid test (quick) ratio compares organisation’s current assets less stock to current liabilities. The formula of acid test ratio is:

Acid test ratio = (current assets – stock) ÷ current liabilities

This ratio is very similar to current ratio, but it excludes stock from calculation, which makes this ratio more strict. It is more suitable for organisations, whose stock is not very liquid and yet is very high in value. For example, plane manufacturers like Airbus and Boeing might not use current ratio, because it would not be a good indicator of liquidity. Their stocks (planes) are really high in value and are slow to produce and sell, so it would make more sense to completely exclude stocks from the equation in order to assess the "real" liquidity of the organisation.

Similar to current ratio, desirable ratio depends on the industry, but should be higher than 1:1. If it’s lower than 1:1, it is an indicator of liquidity problems. Again, similar to current ratio, if acid test ratio is more than 2:1, it might mean too much of cash or debtors, which might result in too much of depreciating asset or bad debt accordingly.

The strategies to improve acid test ratio are the same as for current ratio, but in addition to them, the organisation might get rid of stocks quickly by selling them with a discount. On the one hand, it will improve liquidity because there will be more cash. But on the other hand, discount means lower revenue, which might have a negative effect on profitability.

IB tip: It never hurts to calculate both liquidity ratios for any organisation. Comparing them opens a new perspective in assessing liquidity and shows the relative importance of stocks in organisation’s liquidity.

Just a reminder about the table for evaluating the strategies to improve profitability and liquidity ratios. By now, you should be able to fill in the pros and cons of all strategies in the table below:

Make sure you can define all of these:

1. Ratio analysis
2. Profitability ratios
3. Gross profit margin
4. Profit margin
5. Return on capital employed (ROCE)
6. Liquidity ratios
7. Liquidity
8. Current ratio
9. Acid test (quick) ratio