3.

5 Profitability and liquidity ratio analysis

Ratio analysis is a quantitative management tool used for analyzing and judging the financial
performance of a business. This is done by calculating the financial ratios from a firm’s final
accounts. To assess whether financial performance has improved, current figures are compared
with historical figures. Alternatively, the same ratios can be compared with those of rivals to
judge whether the business has improved against its competitors.

On completion of this chapter, you should be able to:

Analyse and apply:

 Gross profit margin (GPM)

 Net profit margin (NPM)
 Return on capital employed (ROCE)
 Current ratio (CR)
 Acid test ratio (ATR)

Evaluate:

 Strategies to improve these ratios.

Calculate:

 Gross profit margin

 Net profit margin
 Return on capital employed.
 Current ratio
 Acid test ratio
 Microsoft Corporation (MSFT)

Income Statement Get Income Statement for:

View: Annual Data | Quarterly Data All numbers in thousands

Period Ending Jun 29, 2012 Jun 29, 2011 Jun 29, 2010

Total Revenue 73,723,000 69,943,000 62,484,000

Cost of Revenue 17,530,000 15,577,000 12,395,000

Gross Profit 56,193,000 54,366,000 50,089,000

Operating Expenses

Research Development 9,811,000 9,043,000 8,714,000

Selling General and Administrative 18,426,000 18,162,000 17,277,000

Non Recurring 6,193,000 - -

Others - - -

Total Operating Expenses - - -

Operating Income or Loss 21,763,000 27,161,000 24,098,000

Income from Continuing Operations

Total Other Income/Expenses Net 504,000 910,000 915,000

Earnings Before Interest & Taxes 22,267,000 28,071,000 25,013,000

Interest Expense - - -

Income Before Tax 22,267,000 28,071,000 25,013,000

 Income Tax Expense 5,289,000 4,921,000 6,253,000

Minority Interest - - -

Net Income From Continuing Ops 16,978,000 23,150,000 18,760,000

Non-recurring Events

Discontinued Operations - - -

Extraordinary Items - - -

Effect Of Accounting Changes - - -

Other Items - - -

Net Income 16,978,000 23,150,000 18,760,000

Preferred Stock And Other Adjustments - - -

Net Income Applicable To Common Shares 16,978,000 23,150,000 18,760,000

- Microsoft Corporation (MSFT)

Balance Sheet Get Balance Sheet for:

View: Annual Data | Quarterly Data All numbers in thousands

Period Ending Jun 29, 2012 Jun 29, 2011 Jun 29, 2010

Assets

Current Assets

Cash And Cash Equivalents 6,938,000 9,610,000 5,505,000

Short Term Investments 56,102,000 43,162,000 31,283,000

Net Receivables 17,815,000 17,454,000 15,198,000

Inventory 1,137,000 1,372,000 740,000

 Other Current Assets 3,092,000 3,320,000 2,950,000

Total Current Assets 85,084,000 74,918,000 55,676,000

Long Term Investments 9,776,000 10,865,000 7,754,000

Property Plant and Equipment 8,269,000 8,162,000 7,630,000

Goodwill 13,452,000 12,581,000 12,394,000

Intangible Assets 3,170,000 744,000 1,158,000

Accumulated Amortization - - -

Other Assets 1,520,000 1,434,000 1,501,000

Deferred Long Term Asset Charges - - -

Total Assets 121,271,000 108,704,000 86,113,000

Liabilities

Current Liabilities

Accounts Payable 9,653,000 9,560,000 8,564,000

Short/Current Long Term Debt 1,231,000 - 1,000,000

Other Current Liabilities 21,804,000 19,214,000 16,583,000

Total Current Liabilities 32,688,000 28,774,000 26,147,000

Long Term Debt 10,713,000 11,921,000 4,939,000

Other Liabilities 8,208,000 8,072,000 7,445,000

Deferred Long Term Liability Charges 3,299,000 2,854,000 1,407,000

Minority Interest - - -

Negative Goodwill - - -

Total Liabilities 54,908,000 51,621,000 39,938,000

Stockholders' Equity
Misc Stocks Options Warrants - - -

Redeemable Preferred Stock - - -

Preferred Stock - - -

Common Stock 65,797,000 63,415,000 62,856,000

Retained Earnings 566,000 (6,332,000) (16,681,000)

Treasury Stock - - -

Capital Surplus - - -

Other Stockholder Equity - - -

Total Stockholder Equity 66,363,000 57,083,000 46,175,000

Net Tangible Assets 49,741,000 43,758,000 32,623,000

Explain the purpose of ratio analysis and the two ways that ratios can be compared.
 3.5.1 Profitability ratios [ a measure of performance]
What do profitability ratios measure?

Types of profitability ratios

3.5.1a Gross profit margin (GPM)

3.5.1b Net profit margin (NPM)

3.5.1c Return on capital employed (ROCE)

3.5.1a Gross profit margin (GPM)

Gross Profit Margin shows the gross profit made on sales. A GPM of 70% for example, means
that for every sale of $100, $70 is gross profit and $30 is the costs of production.

The higher the figure the figure the better it is for a business as gross profit goes towards paying
for its expense. However, this figure does not take into account overheads or tax so is not a
reliable indication of the success or profitability of the business.

Explain how GPM can be improved.

Any strategy suggested must be relevant to the business and must recognize the external
environment in which the business operates.

3.5.1 b Net profit margin (NPM)

NPM shows the percentage of sales that is turned into profit. A NPM of 55% means that for
every $100 of sales, $55 is net profit. NPM is calculated as:

Net Profit Margin therefore, helps to measure how well the business controls its overheads.
The lower the overheads, the smaller is the difference between the gross and net profit
margins.

NPM is considered to be a more accurate measure of the success or profitability of the

business. As with gross profit margin, the general rule is, the higher the NPM, the better.
However, it is common for high volume products such as sweets and fast food, to have a
relatively low profit margin. The high sales volume compensates for this. Conversely, for low
volume products such as ships and vintage wines, the profit margin tends to be relatively high
to compensate for the lower units of sales.

Evaluate the strategies for improving profit margins [see example on page 280]

Any strategy suggested must be relevant to the business and must recognize the external
environment in which the business operates.

Do 3.5.1 and 3.5.3

3.5.2 Efficiency ratios

The only efficiency ratio for both SL and HL students to learn is ROCE.

3.5.1c Return on Capital employed (ROCE)

Return on capital employed (ROCE) measures the profit of the business as a percentage of the
total amount of money used to generate it. ROCE is an efficiency ratio that assesses how well a
firm’s financial resources are being used.
Generally, ROCE will run between 5% and 25% although it may be higher for higher risk
accounts.

A ROCE of 25% means that every $100 invested in the business earns $25 in returns.

Do Activity 3.5.1 and Karachi Paper Products Ltd.

Evaluate the strategies that can be used to increase the ROCE

Any strategy suggested must be relevant to the business and must recognize the external
environment in which the business operates.

Using Microsoft’s financial statement above and the formulae provided, calculate following
profitability and efficiency ratios for 2005 and 2006:

Ratio 2010 2011 2012

GPM
NPM
ROCE

Analyse Microsoft’s performance over the three years. Hint: what changed? How? Why? How
profitable was Microsoft?

How to analyse profitability ratios

 Is the business making a profit?

 How efficient is the business at turning revenues into profit?

 Is it enough to finance reinvestment?

  Is it growing?

 Is it sustainable (high quality)?

 How does it compare with the rest of the industry?

http://www.tutor2u.net/business/reference/profitability-ratios-revision-presentation

3.5.3 The liquidity ratios

Liquidity ratios look at the firm’s ability to pay its short-term liabilities (current
liabilities).

Liquidity is the ease at which assets can be changed into cash (e.g. premises would not
be very liquid while stock is quite liquid). Certain assets can quickly be turned into cash
without losing value. These are known as liquid assets. Examples of liquid assets are
current assets.

Stakeholders and their interests in the liquidity of a business

Creditors and financial lenders are interested in the liquidity ratios to help them assess
the likelihood of getting back the money they are owed.

Shareholders and potential investors may also be interested as these ratios can reveal a
firm’s ability to repay its debts.

The two main liquidity ratios are: current ratio and acid test ratio.

3.5.3a Current ratio (CR)

The current ratio deals with a firm’s liquid assets and short-term liabilities, i.e. working capital.
It reveals whether a firm is able to use its liquid assets to pay for its current liabilities (short-
term debts).
The current assets ratio uses the same information as working capital as it is considering the
relationship between current assets and current liabilities. Businesses should aim for a current
assets ratio between 1.5:1 and 2:1 (or between 150% and 200%). If the current asset ratio is
below 1.5 the business may have difficulty paying debts and could run into trouble should
creditors demand payment. If current ratio is above 2.0 it may indicate that too much money is
tied up unproductively. However, supermarkets hold a huge amount of stock so may have
current ratio of over 2:1 but this is acceptable as their stocks are highly liquid.

CR can be improved by raising the value of current assets and reducing current liabilities. For
example, overdrafts can be reduced by opting for medium term loans.

3.5.2b Acid test ratio (quick ratio)

The acid test (or quick) ratio is a more severe test of liquidity as it does not consider stock to be
a liquid asset as there is no guarantee that stock (inventory) will be sold (e.g. The product might
be apples which may rot or the product may become obsolete such as a video recorder).

An acid test ratio of 1:1 is desired as current liabilities can be paid with the existing current
assets even when stock is not considered. As with CR, too high acid test ratio can suggest that a
firm is holding on to too much cash rather than using it more effectively.

Mathematically, acid test ratio can be improved by either raising the value of current assets
(cash or debtors) or lowering the amount of current liabilities. It is dangerous to increase
debtors since this increases the likelihood of bad debt occurring. There is also an opportunity
cost of holding on too much cash. Hence, it’s better for a business to reduce the amount of
current liabilities.

Using Microsoft’s financial statements, calculate its liquidity and comment on them.

Ratio 2010 2011 2012

Current
Acid test

What strategies can be used to improve liquidity ratios?

Any strategy suggested must be relevant to the business and must recognize the external
environment in which the business operates.

What to look for when analyzing liquidity ratios:

 Is the business able to meet its short-term debts as they fall due?

 Is the business generating enough cash?

 Does the business need to raise further finance?

 How risky is the finance structure of the business?

Explain the uses and limitations of ratio analysis.

Do Activity 3.5.1, 3.5.2, 3.5.3

Worked example of Ratio Analysis
HW
Next topic 3.7: Cashflow