3.5 Profitability and liquidity ratio analysis

Profitability ratios show how much revenue becomes profit or how effectively invested capital generates profit. Gross profit margin = gross profit ÷ sales revenue × 100; profit margin uses profit before interest and tax; RoCE = profit before interest and tax ÷ capital employed × 100.

Gross margin focuses on cost of sales, profit margin includes operating costs, and RoCE links profit to long-term finance. Compare a ratio with the same business over time or with similar firms, not with an unrelated sector’s normal structure.

If gross profit is £105,731 on revenue of £124,653, gross margin is about 84.82%. A RoCE calculation also needs capital employed; keep units consistent and show what the percentage means for the business decision.

A high ratio is not automatically healthy: price, quality, risk, leverage and one-off events can change it. Ratios support judgement; they do not replace the accounts or context.

Profitability improves when more of each sales pound becomes profit or when the same capital produces more operating return. Actions should be linked to the ratio that is weak rather than chosen from a generic list.

Gross margin can rise through higher prices, a better product mix or lower direct costs; profit margin also depends on overheads. RoCE can improve by increasing operating profit without new capital or by releasing capital that earns too little.

Bulk buying may reduce unit cost but can increase storage and stock risk; cutting staff may reduce overhead but harm service and productivity. A branch with the lowest RoCE may be a closure candidate, but demand, strategic role and restructuring cost still matter.

Cost cutting is not automatically improvement, and a benchmark such as 20% is not a universal rule. Explain the mechanism, likely side effects and time horizon before recommending an action.

The current ratio = current assets ÷ current liabilities. The acid-test ratio = (current assets − inventory) ÷ current liabilities. The second is stricter because inventory may take time to sell or may realise less than its book value.

A current ratio of 3.07:1 means £3.07 of current assets per £1 of short-term liabilities; if inventory is £8,250 in the same example, the acid test is 1.44:1. Whether that is safe depends on credit terms, stock speed and industry norms.

A stock-heavy retailer can look liquid on the current ratio while struggling to turn stock into cash. Compare both ratios with cash-flow forecasts and the timing of payables rather than treating one threshold as a guarantee.

Liquidity is not profitability and a high ratio can signal idle stock or receivables. Check the quality and timing of current assets, not just the quotient.

Liquidity improves when cash or near-cash assets arrive sooner, short-term obligations are delayed or unnecessary stock is converted into cash. The action must be judged against cost, supplier relationships and future demand.

Collect receivables faster, negotiate longer supplier terms, sell excess stock or add capital can increase available cash. An overdraft or short loan may bridge a temporary gap, but it raises obligations and can be withdrawn.

A retailer may reduce its customer credit period and clear slow stock before a seasonal bill falls due. The improvement is real only if customers do not leave, stock is not sold at a damaging loss and the next cash forecast remains viable.

Selling assets or leasing them can improve immediate cash while creating future payments; raising new capital can dilute control. State the cash-flow timing, trade-off and evidence before calling a measure ‘improvement’.