How do you evaluate profitability and liquidity?
Ratio analysis is a quantitative method of gaining insight into a company's liquidity, operational efficiency, and profitability by studying its financial statements such as the balance sheet and income statement. Ratio analysis is a cornerstone of fundamental equity analysis.
Fundamentally, all liquidity ratios measure a firm's ability to cover short-term obligations by dividing current assets by current liabilities (CL).
The best way to analyze a company's profitability is with as much financial data as possible. You want access to all the company's financial statements, including their balance sheet, income sheet, and statement of cash flows. You'll use this information to holistically analyze the company.
The gross profit margin and net profit margin ratios are two commonly used measurements of business profitability. Net profit margin reflects the amount of profit a business gets from its total revenue after all expenses are accounted for. Gross profit margin indicates profit that exceeds the cost of goods sold.
Net income before taxes is the norm when it comes to measuring a company's profitability. Average net earnings keep increasing. This is often because companies adopt cost-saving strategies and new technology. As a rule of thumb, a good operating profitability ratio is anything greater than 1.5 percent.
In short, a “good” liquidity ratio is anything higher than 1. Having said that, a liquidity ratio of 1 is unlikely to prove that your business is worthy of investment. Generally speaking, creditors and investors will look for an accounting liquidity ratio of around 2 or 3.
These financial metrics gauge the company's ability to generate revenue relative to costs, assets, and equity over time. The most well-known profitability ratios are gross/net profit margin, operating profit margin, and return on assets/equity.
- #1 Gross Profit Margin. Gross profit margin – compares gross profit to sales revenue. ...
- #2 EBITDA Margin. ...
- #3 Operating Profit Margin. ...
- #4 Net Profit Margin. ...
- #6 Return on Assets. ...
- #7 Return on Equity. ...
- #8 Return on Invested Capital.
Among the tools to which you will be introduced are profitability ratios, break-even analysis, return on assets and return on investment. Some of these concepts, and some of the vocabulary we will use to describe them, may be new to you. But we've tried to explain the terminology and concepts as they are introduced.
Current, quick, and cash ratios are most commonly used to measure liquidity.
Which item is used to evaluate liquidity?
The Current Ratio is one of the most commonly used Liquidity Ratios and measures the company's ability to meet its short-term debt obligations. It is calculated by dividing total current assets by total current liabilities.
Liquidity and profitability ratios provide insight into different aspects of a company's financial health. While liquidity ratios focus on a company's ability to meet its short-term obligations, profitability ratios evaluate a company's ability to generate returns over the long run.
Investors should also compare these three metrics—gross profit, operating profit, and net profit—to those of a company's competitors. Many investors look at earnings per share figures, which are based on net profit, when deciding which stocks offer the best value.
- Gross Profit Ratio.
- Operating Ratio.
- Operating Profit Ratio.
- Net Profit Ratio.
- Return on Investment (ROI)
- Return on Net Worth.
- Earnings per share.
- Book Value per share.
Return on Assets (ROA): Return on assets expresses a company's profitability compared to its total assets. Put simply, it indicates how well a company can generate a profit relative to its asset base. To calculate ROA, divide the company's net income by its total assets.
Example of Performing Profitability Analytics in a Business
The business earns $10,000 in net income for the year. This means that for every dollar of assets the business has, it is earning 10 cents in net income. This means that for every dollar of equity the business has, it is earning 20 cents in net income.
Formulaically, the structure of a profitability ratio consists of a profit metric divided by revenue. The resulting figure must then be multiplied by 100 to convert the ratio into percentage form.
In terms of profitability, gross profit margin calculates how much a producer spends to produce a sold product. The ratio includes gross profit and net sales. Gross profit is divided by net sales and is then multiplied by 100. For example, AIBC makes $2 million in gross profit from net sales of $11 million.
Low current ratio: A ratio lower than 1.0 can result in a business having trouble paying short-term obligations. As such, it may make the business look like a bigger risk for lenders and investors.
But it's also important to remember that if your liquidity ratio is too high, it may indicate that you're keeping too much cash on hand and aren't allocating your capital effectively. Instead, you could use that cash to fund growth initiatives or investments, which will be more profitable in the long run.
What are the 3 basic liquidity ratios?
What are three types of liquidity ratios? The three types of liquidity ratios are the current ratio, quick ratio and cash ratio. These are useful in determining the liquidity of a company.
- Net Sales (or Revenue) – Cost of Sales (or Cost of Goods Sold) = Gross Profit (or Gross Margin)
- Gross Profit – Operating Expenses = Net Operating Profit.
- Net Operating Profit + Other Income – Other Expenses = Net Profit Before Taxes.
Typically considered the most important of the financial statements, an income statement shows how much money a company made and spent over a specific period of time.
A ratio of less than 1 (e.g., 0.75) would imply that a company is not able to satisfy its current liabilities. A ratio greater than 1 (e.g., 2.0) would imply that a company is able to satisfy its current bills. In fact, a ratio of 2.0 means that a company can cover its current liabilities two times over.
A good metric for evaluating profitability is net margin, the ratio of net profits to total revenues. 3 It is crucial to consider the net margin ratio because a simple dollar figure of profit is inadequate to assess the company's financial health.
