<3.5 PROFITABILITY & LIQUIDITY RATIO ANALYSIS>

--PROFITABILITY RATIOS--

--INTRODUCTION--

From the last unit we know the term profit well, especially from its inclusion in the PROFIT & LOSS account.
Obviously profit is a great indicator that that the product is selling for a price greater than costs, and we can work out PROFITABILITY RATIOS that can allow us the compare how well companies are at generating both gross and net profit as well as how well it is using its funds to generate profit

--GROSS PROFIT MARGIN--

The GROSS PROFIT MARGIN (GPM) shows THE % OF SALES REVENUE THAT IS TURNED INTO GROSS PROFIT.
It shows the amount of profit that remains after the COGS (DIRECT COSTS ONLY) have been accounted for.
GPM = GROSS PROFIT / SALES REVENUE * 100
Using the data from our P&L account: 39.87% = $1220m / $3060m * 100
In other words for ever dollar of revenue it was able to generate 39.87% of Gross Profit.

HOW TO IMPROVE?
- - 1) REDUCTION in COGS (RAW MATERIALS/LABOUR COSTS), without LOWERING SELLING PRICE?
  - 2) INCREASE in SALES REVENUE, through RAISING PRICE and KEEPING COGS the SAME.
  - 3) LOWER COGS, by IMPROVING its PRODUCTIVITY/EFFICIENCY.

--QUICK TASK--

Quickly research the gross profit margins of Apple, Google, Microsoft and Tesla. Do you think these are useful for an investor?

--PROFIT MARGIN--

The PROFIT MARGIN (PM) shows THE % OF SALES REVENUE THAT IS TURNED INTO NET PROFIT BEFORE TAX AND INTEREST.
It shows the amount of profit that remains after ALL COSTS, both DIRECT and INDIRECT COSTS have been accounted for.
PM = NET PROFIT BEFORE TAX & INTEREST / SALES REVENUE * 100
Using the data from our P&L account: 20.92% = $640m / $3060m * 100
In other words for ever dollar of revenue it was able to generate 20.92% of net Profit.

HOW TO IMPROVE?
- - 1) REDUCTION in COGS (MATERIAL/LABOUR COSTS)
  - 2) REDUCTION in EXPENSES (RENT, CREDITOR DISCOUNTS)
  - 3) INCREASE in SALES REVENUE.

--QUICK TASK--

Do the same for net profit margins of Apple, Google, Microsoft and Tesla. Do you think these are useful for an investor?

--RETURN ON CAPITAL EMPLOYED (ROCE)--

Firms attempt to turn their SOURCES OF FINANCE (also known as 'funds' or 'CAPITAL EMPLOYED') into PROFIT.
The sources of significant finance consists of SHAREHOLDER FUNDS, RETAINED EARNINGS and NON-CURRENT LIABILITIES such as long-term LOANS.

CAPITAL EMPLOYED =

SHAREHOLDER EQUITY + NON-CURRENT LIABILITIES

The RETURN ON CAPITAL EMPLOYED (ROCE) therefore shows how much profit before tax & interest is being generated ('RETURNED') as a % of the capital used and is therefore calculated as follows:
ROCE = PROFIT BEFORE TAX & INTEREST / CAPITAL EMPLOYED * 100
Using the data from the BALANCE SHEET & P/L ACCOUNT below we get at ROCE of 29.63% = $640m / $2160m * 100
In other words for ever dollar of capital employed it was able to generate 29.63% of Net Profit before tax and interest.

HOW TO IMPROVE?
- - 1) REDUCTION in COGS (MATERIAL/LABOUR COSTS)
  - 2) REDUCTION in EXPENSES (RENT, CREDITOR DISCOUNTS)
  - 3) INCREASE in SALES REVENUE.
  - 4) REDUCE the amount of CAPITAL EMPLOYED

--QUICK TASK--

Do the same for ROCE of Apple, Google, Microsoft and Tesla. Do you think these are useful for an investor?

--LIQUIDITY RATIOS--

--WHAT IS THE IMPORTANCE OF LIQUIDITY?--

'CURRENT LIABILITIES' refers to debts that need to be repaid within 12 months such as BANK OVERDRAFTS, PAYMENTS TO CREDITORS, and SHORT TERM DEBT REPAYMENTS etc... and to pay for these the firm must have access to enough cash which is dependent on the amount of 'CURRENT ASSETS' that the firm holds, which includes CASH, as well as PENDING PAYMENTS FROM DEBTORS and STOCKS. The speed at which an asset can be turned into cash is called its level of 'LIQUIDITY'.
Clearly if a firm is unable to pay for its liabilities then there is a greater chances that they will go bankrupt and be 'LIQUIDATED'.
The two main liquidity ratios are the current ratio and the acid test ratio.

--CURRENT RATIO--

The CURRENT RATIO measures the ratio of CURRENT ASSETS to CURRENT LIABILITIES and shows HOW ABLE A FIRM IS AT GETTING ACCESS TO CASH ( VIA ITS CURRENT ASSETS) TO COVER ITS SHORT-TERM DEBTS (ITS CURRENT LIABILITIES) (within the next twelve months of the balance sheet date). The current ratio is calculated by using the formula:
CURRENT RATIO = CURRENT ASSETS / CURRENT LIABILITIES
What is the ideal ratio?
- - - - LESS THAN ONE TIMES? , If its current assets are lower than its current liabilities (negative working capital), then the business may have problems paying back trade creditors and suppliers. In the worst-case scenario, negative working capital can lead a firm to go bankrupt. Therefore, a current ratio of LESS THAN ONE means the short-term debts of the business are greater than its liquid assets, which could jeopardise its survival if creditors demand payment.
      - GREATER THAN TWO TIMES? Equally though, a firm can have TOO HIGH of a current ratio. This suggests that any combination of three outcomes:
        i) There is too much cash in the business, which could be better spent to generate more trade.
        ii) There are too many debtors, which increases the likelihood of bad debts or customers defaulting on the money they owe.
        iii) There is too much stock, which increases storage and insurance costs.
      - BETWEEN 1.5 TO 2.0 TIMES? as this gives the firm a safety net as in reality it might not be possible to sell current assets quickly without losing some value. It also means that there is likely to be sufficient working capital (the numerical difference between current assets and current liabilities). If a business has substantial positive working capital, then it has the potential to invest and grow.

HOW CAN IT BE IMPROVED? The current ratio can be improved by a combination of raising the value of current assets and reducing the value of current liabilities.
For example, overdrafts (CURRENT LIABILITY) can be reduced by opting for long term loans (NON-CURRENT LIABILITY) that offer more attractive rates of interest. This will also free up working capital in the short term. However, this option may, of course, affect the long term liquidity of the firm.

--QUICK TASK--

Do the same for THE CURRENT RATIO of Apple, Google, Microsoft and Tesla. Do you think these are useful for an investor?

--ACID TEST (QUICK) RATIO--

The ACID TEST RATIO (aka the QUICK RATIO) is almost the same as the current ratio except it IGNORES THE VALUE OF STOCK when calculating current assets and only counts CASH and DEBTORS as LIQUID ASSETS. Thus the formula for the ACID TEST RATIO is:

ACID TEST = CURRENT ASSETS - STOCK / CURRENT LIABILITIES

WHY IGNORE THE VALUE OF STOCK? of the three types of current assets; STOCK is often the most difficult to convert to cash, for example it is hard to turn a Boeing aircraft into cash, therefore to give potential investors a more realistic idea about the firm's ability to cover short-term debts the acid test is applied.
Ideally the quick ratio should be at least ONE TO ONE otherwise the firm might experience working capital difficulties or even a liquidity crisis (a situation where a firm is unable to pay its short-term debts).

--QUICK TASK--

Do the same for THE ACID TEST RATIO of Apple, Google, Microsoft and Tesla. Do you think these are useful for an investor?

--HOW TO IMPROVE THESE RATIOS?--

Both these ratios can be improved by either raising the level of current assets or lowering the amount of current liabilities.
- - RAISE CURRENT ASSETS?
    - - i) INCREASE DEBTORS? Can be risky for a firm to increase debtors since this increases the likelihood of bad debts occurring.
      - ii) INCREASE CASH? There is potentially a large opportunity cost in holding too much cash.
      - iii) INCREASE STOCK? IMPORTANT NOTE: This would improve the current ratio but would worsen the acid test, and increasing the value of the least liquid current asset is potentially dangerous.
- REDUCE SHORT-TERM LIABILITIES? It is more practical for a business to concentrate on reducing its short-term liabilities, such as overdrafts and trade creditors. For example, it might be possible to negotiate delayed payments to trade creditors.

--FINAL TASK--

Tabulate your findings on the four firms you have gathered data on and comment on the results [You may use ChatGPT to help you on this]

appFY24_Q1_Consolidated_Financial_Statements.pdf

427857-1-_7_Nike-2024-Combo_Form-10-K_WR (1).pdf

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