Profitability and liquidity ratios, and users of accounts

Last time

Before we start: last time, in Profit, the statement of profit or loss and the statement of financial position, you learned these points. Here they are again on one card. Keep them in mind, because today builds on them.

Comparing performance

A profit of 1 million dollars sounds good. But is it, for a business with 100 million dollars of sales? Ratios compare figures, so performance can be judged fairly. This lesson covers profitability and liquidity ratios, and who uses the accounts.

Gross profit margin

Gross profit margin is gross profit divided by revenue, times 100. With gross profit of 200 thousand and revenue of 400 thousand, the gross profit margin is 50 per cent. A higher margin means more of each dollar of sales is left after the cost of the goods.

Profit margin

Profit margin is profit divided by revenue, times 100. With profit of 140 thousand and revenue of 400 thousand, the profit margin is 35 per cent. If gross profit margin holds but profit margin falls, expenses are rising.

Return on capital employed

ROCE is profit divided by capital employed, times 100. Capital employed is the long-term money invested in the business. Profit of 150,000 dollars on capital employed of 750,000 gives a ROCE of 20 per cent. Compare it with the interest a bank pays: if ROCE is higher, the investment is worthwhile.

Liquidity

Liquidity is the ability of a business to pay its short-term debts when they are due. A business can be profitable but illiquid, and creditors could force it to close. Liquidity matters to suppliers and banks deciding whether to give credit.

The current ratio

The current ratio is current assets divided by current liabilities. With current assets of 660 and current liabilities of 600, the ratio is 1.1. A result between 1.5 and 2 is often seen as healthy. Below 1, the business may not be able to pay its debts.

The acid test ratio

The acid test ratio is current assets minus inventory, divided by current liabilities. Inventory is left out because it may be hard to sell quickly. If inventory is 300, the acid test is 660 minus 300, which is 360, divided by 600: 0.6. A result of about 1 is healthy. 0.6 suggests the business relies on selling its stock to pay its debts.

The five ratios

Here are all five formulas on one table. Learn them exactly.

Users of accounts

Owners and shareholders: to see profit and whether to invest more. Managers: to plan and control. Banks and lenders: to judge whether loans can be repaid. Suppliers: whether to give credit. Employees: job security and pay. Government: tax. Competitors: to compare performance.

Limits of ratios

Ratios are based on past figures, which may not show what will happen next. They should be compared with past years or competitors, or they mean little. And they ignore things that are not in the accounts, such as staff morale or a new competitor.

Mistakes that lose marks

Mistake one: forgetting to multiply by 100, or writing a percentage for the current ratio. Mistake two: calculating a ratio but not saying what it means for the business. Mistake three: using profit for liquidity. Liquidity is about current assets and liabilities. The fix: formula, working, units, and what it means.

The full-marks tip

The full-marks tip: show the formula, the working, and the answer with its unit: per cent for margins, a plain number for the current ratio. Then compare it with another year or a competitor, and say what it means.

On one card

So, on one card: ratios and users of accounts. Keep it for revision.