Liquidity Ratios
Formula for Current Ratio
Current Assets/ Current Liabilities
Formula for NPM and GPM
1. Net Profit
______________ x 100
Sales REvenue
2. Gross Profit
___________ x 100
Sales Revenue
Liquidity ratios are primarily used to assess this aspect of a business.
Short-term ability to pay expenses.
Shareholders use profitability ratios to assess this aspect of their investment.
Return on their investment.
Gross profit margin includes operating expenses and taxes in its calculation. What is False?
Gross profit margin only includes revenue and cost of sales in its calculation, excluding operating expenses and taxes.
Formula for Acid-Test Ratio
Current Assets - Inventories
__________________________
Current Liabilities
Formula for ROCE and its significance
Net Profit
___________ x 100
Capital employed
How much return is being made on the capital invested in the business.
A potential investor uses liquidity ratios to
A potential investor uses liquidity ratios to determine whether the company can make dividend payments.
A manager would analyze profitability ratios to make decisions about these two areas of costs.
Reducing costs, increasing efficiency.
Return on capital employed (ROCE) measures how effectively a business generates revenue from its assets.
What is False?
ROCE measures profit relative to capital employed, not revenue.
Cash 50
Inventories 50
Accounts Payable 50
Accounts Receivable 100
Overdraft 50
Calculate Current Ratio
2:1
Calculate the GPM and NPM:
Sales Revenue $100
Cost of Sales $40
Expenses $20
GPM: 60 %
NPM: 40%
What is creditworthiness?
Banks and lenders use liquidity ratios to evaluate this before granting a loan., ability to return loan, in its instalments and the interest payments.
Profitability ratios are of no use until they are:
Compared with previous years, and competitors/ industry averages.
A high net profit margin always indicates a company is efficient in controlling its operating costs.
False: A high net profit margin may be influenced by factors like high revenue or low taxes, not just efficient cost control.
Cash 50
Inventories 50
Accounts Payable 50
Accounts Receivable 100
Overdraft 50
Calculate Acid-Test Ratio
1.5:1
Calculate ROCE:
Profit 100
Non-Current Liabilities 100
Shareholders funds 100
Overdraft 20
Assets 100
50%
Prove that: Banks use liquidity ratios more than other stakeholders.
Banks use liquidity ratios more than other stakeholders because they focus on a company’s ability to meet short-term obligations and reduce the risk of loan defaults. Other stakeholders, like investors, are more concerned with long-term profitability and overall business performance.
Prove: Profitability ratios are a better indicator of a company's success than liquidity ratios.
Profitability ratios provide a clearer picture of long-term business success and efficiency, while liquidity ratios only focus on short-term financial health.
ROCE is a measure of a company's ability to generate returns for its shareholders based on equity.
False: ROCE considers both equity and long-term debt as part of capital employed, not just equity.
1. Sell non-current assets.
2. Sell inventories for cash
How is it possible for a business to have improved its NPM but not its GPM?
NPM can improve with improved expenses compared to its sales, GPM cannot improve/ worsen if its cost of sales are more than its increase in sales.
Prove that: Liquidity Ratios are More Useful for Internal Management than External Stakeholders
Liquidity ratios are more useful for internal management as they help with cash flow and short-term financial decisions. However, external stakeholders, like investors, focus more on long-term profitability and growth potential.
Investors prioritize profitability ratios to evaluate potential returns on their investment and assess company performance. While managers also use them, they focus more on improving operational efficiency and profitability rather than investment decisions.
if a business sells its inventory for cash, its current ratio will remain the same. If a business sells its non-current assets for cash, its current ratio will remain the same. What is true and what is false?
First is true. Second is false.