Importance and limitation of profitability ratios

Overview:

Profitability ratios are a group of quantitative values that measure a company’s profitability against its revenue, cost of sales, equity, and balance sheet assets. It is a metric that measures a company’s ability to generate income from its operations over a specific period of time.

Profitability ratio is a category falling under financial ratios that are used by investors, bankers, financial institution, creditors and other stakeholders for evaluation of financial performance of the company in regards of annual profitability.

These ratios help them to assess how profitable an entity currently earns from using or managing the existing resources to generate profits and add value to its shareholders or owners.

For example, the gross profit margin is the ratio used to assess how efficiently the company manages its costs compared to its competitors or industry averages.

If the margin is high competitors’, it means that the company could generate high profit from 1 USD that it spends compare to competitors or industry averages.

Even though these ratios are importance for most of key stakeholders, that ratios themselves also have the limitation.

In this article, we will discuss the key importance and limitation of profitability ratio that might help analyst or users for their interpretation and usages.

But, before heading to the key importance and limitation, let see the list and formula of ratios first.

List and Formula:

The following is the list of a few ratios that are included in the category of profitability ratios:

Gross profit margin ratio = (Gross Profit / Revenue) * 100

Net profit margin ratio = (Net Profit / Revenue) * 100

Return on equity = (Profit after tax / Shareholder’s equity) * 100

Return on capital employed = Profit before interest and tax / (Total assets – current liabilities)

Return on assets = Profit before interest and tax / Total net assets

A high profitability ratio as compared to the previous year’s performance or the industry in general is an indication of improvement in the profits earned by the company.

On the contrary, though, a low profitability ratio as compared to the previous year’s or the industry in general is an indication of a reduction in profits earned in the current year.

Importance of profitability ratios:

Here, we will discuss the significance of profitability ratio in terms of each ratio mentioned above.

  • Gross profit margin is a measure of the profit earned on sales. It denotes the profit part of the total revenue earned after deducting the costs of goods sold. It is significantly important since the gross profit is what covers the admin and office costs and the dividends to be distributed to the shareholders. The higher the gross profit the more profitable the company is and is a good catch to invest in. As mention above, it is also used to assess the efficiency of cost management. If the calculation shows that the ratio is now, then the key areas to look or improve are purchasing as well as productions in terms of economy and effectiveness.
  • The net profit margin is the final ratio that demonstrates the overall performance of a company. We could say that it is the most important ratio for the management since any disturbances in other ratios indirectly hit the net profit margin as well. For example, a low quick ratio may be because of low sales which would obviously lower the net profit margin as well. This ratio is important since it could help the company or investors to see where it could go wrong in the company’s current operating expenses. Maybe the interest expenses are too high due to the financing strategy that weighs more to loan rather than equity.
  • Where the net profit margin is an important metric for the company itself, returns on equity are one of the most important ratios for the investors. It is a percentage of the earnings the shareholders get in return for the money invested in the company. The higher the ROE means the higher the dividends the shareholders will receive and hence, more investors are attracted.
  • Returns on capital employed (ROCE) measures how efficiently the company uses its assets. It helps the management minimize inefficiencies by evaluating the ROCE ratio. The higher the ROCE as compared to other industries, the higher the efficiency in the production process of the company.
  • Return on assets (ROA) is a measure of every dollar of income earned on every dollar of the asset owned by the company. It is similar to the ROCE and helps the management in managing the utilization of assets.

Limitations of profitability ratios:

  • The profitability ratios like, the net profit margin is not an “evergreen” ratio that can be used to compare profitability amongst various industries. For example, a tech-savvy company has a higher net profit margin compared to a bakery.
  • The value of investment and profit can easily be manipulated to increase or decrease the profitability ratios as per their needs which can be misleading for the investors and stakeholders.
  • The ratios are dependent on several calculations made behind each value reported on the financial statements. A material error or fraud in a line item will result in a miscalculated ratio which would be hazardous for investors and companies in the future.
  • Ratios may also be high or good due to the chance factor and hence, shouldn’t be followed religiously. The context behind ratios must always be checked to confirm with the analysis.

Importance and limitations of quick ratio

Overview:

The quick ratio is a financial ratio used to measure the short-term liquidity of a company where liquidity is defined as the ability of a firm to convert its most liquid assets into cash so that it could settle its current liabilities.

The quick ratio, also known as acid test ratio, measures how quickly a company can pay off its short-term debts and obligations through its near-cash (current) assets.

It is calculated by dividing current assets excluding stock-in-hand by current liabilities as shown below:

Here is the formula:

Quick ratio = (Cash& cash equivalent + Marketable security + Accounts receivable) / Current Liabilities

OR

Quick ratio = (Current assets – Inventory – Prepaid expenses) / Current liabilities

An acid test ratio is a more aggressive method of measuring liquidity as compared to the standard current ratio. The difference between both is inventory and prepaid expenses which may take some time to turn into cash and may also have a reduction in value.

For example, to convert inventories into cash, the company need to cash those inventories to customers. Not all of the sales are through cash in most of the business. The majority of them are sales on credit and the company does need more time to collect the payment.

The current ratio includes all the current assets that can be converted to cash within a year whereas quick ratio includes current assets that can be converted to cash in 90 days only i.e. 3 months.

An optimal quick ratio is considered as 1:1 i.e. current liabilities = current assets. The ratio calculates every dollar of current assets available to pay off a dollar of current liability.

For example, if a current ratio of a company is 2:1, it means that it has $2 available to pay off every $1 liability. Similarly, a ratio of less than 1:1 signifies that the company doesn’t have enough liquid assets to pay off its short-term obligations.

In this article, we will discuss the key importance and limitation of quick ratio when it comes to the assessment of the liquidity of the entity:

Importance of quick ratio:

  • The quick ratio is one of the fastest and easiest ways of measuring a company’s liquidity. It is majorly used by creditors and lenders to evaluate an entity’s creditworthiness and timely payments before approving their application for the loan. Financial information to be used for calculation is easily obtained from financial statements.
  • The quick ratio is an inflexible method of demonstrating the liquidity of a company. It excludes assets like inventory and prepaid expenses that take more than a year to turn into cash and may lose value as well during the time period. For example, a company that has inventory piled up due to low sales may have a high current ratio which would portray it as a liquid company even if it is running low on cash due to lower sales. Quick ratio ensures no such misleading information is portrayed regarding the liquidity of an entity.
  • A quick ratio around the ideal value of 1:1 also signifies that the company is able to pay dividends on time which is considered a major pro since everyone wants money on time. Potential investors consider the quick ratio to make decisions about investing in the entity or not.
  • A high quick ratio also implies that businesses are well prepared to adapt to any changes in business environments that attract investors as well.
  • Measuring inventory involves judgment of management making it susceptible to human error. Quick ratio excludes inventory and hence, is a more precise unit of measure as compared to the current ratio.

Limitations of the quick ratio:

  • One of the major cons of the quick ratio is that it can’t be used to compare various industries and can only be a metric of comparison for similar companies. A quick ratio is a mathematical value that provides no context of the assets and liabilities calculated.
  • It doesn’t take into consideration the time frame of payments. For example, some of the accounts receivables included in current assets may become bad debts that will never be recovered in the future or may include receivable recovered after more than a year which actually has a negative impact on the liquidity of the company whereas the quick ratio portrays otherwise. Even the ratio is more than one but there is a high proportion of inventories compare to current assets that use for calculating the ratio then the decision that made based on this ratio is highly likely to be wrong.
  • Where excluding inventory may be a pro it can also be a con for industries that have higher inventories. For example, a supermarket purchases millions of dollars of inventory by credit or by using cash and cash equivalents. In this case, the current liability balance would increase due to inventory purchased on credit and cash balance would be low which would cause a reduction in current assets resulting in an extremely low quick ratio. In such a case, justification should be made whether the inventories should be included or not.

How to Improve Assets Turnover Ratio?

Asset Turnover ratio is one of the important financial ratios that depicts how the company has been utilizing its asset to generate turnover or sales.

Asset Turnover ratio compares the net sales of the company with the total assets. It measures per rupee investment in assets used to generate amount of sales.

There are different versions of the ratio which depends on what type of asset is to be considered.  

The formula to calculate this ratio is

Asset Turnover Ratio = Net Sales/ Average Total Assets

Here, Net sales is after sales return as well as sales discount. Average total assets is calculated after dividing the opening and closing balance of the assets by 2.

Various popular variations of this ratio include Fixed Asset Turnover Ratio, Current Assets Turnover Ratio among others.

A higher ratio indicates that assets are being utilized efficiently while the lower ratio reflects ineffective management of the assets.

Let’s discuss how the assets turnover ratio can be improved:

  • Improve Debtors Collection: The slow pace of collection of accounts receivables increases the chance of lowering the sales. This reduces asset turnover ratio. By preparing and strictly adhering to a debtor’s policy, the company can actually improve the assets turnover ratio. This can be done by outsourcing the collection task to collection agency, hiring an employee overseeing accounts receivable or reducing the debtors credit period to at least industry norms.
  • Improve Revenue: Improving revenue is easiest way to a healthy asset turnover ratio. The company needs to move its stock effectively and engage in promotional activities through advertisements. The company can also the examine the warehouse to ascertain whether there are slow moving stocks held in the warehouse. The company should find a way to move those slow-moving goods quickly.
  • Liquidate Assets and Improve Efficiency: The company needs to have proper asset plan which deals with purchase and sale of assets strategically. Obsolete assets should be sold quickly as they are of no use to the contribution to sales and only makes the balance sheet look poor to the stakeholders. Assets frequently used should be regularly maintained in a scheduled manner while on the other hand, assets that are not frequently used, the company should arrive at strategic decision-making process whether to discard, replace or repair the assets. Bottleneck activities should be removed on the spot. If the company has delivery vehicles, the management should have a plan in place making sure that these vehicles leave the warehouse at full capacity delivery all the goods traveling the least. The management should also make effort to find various other ways to increase the efficiency of the asset.
  • Take Assets on Lease: Well, this is not a fool proof way to improve assets turnover ration but on technical grounds, this can be used. If the company takes the assets on lease, the value of assets is not on balance sheet and is shown in Profit and Loss Account. The denominator i.e. of Average Assets in calculation of Assets Turnover Ratio is technically lower, thus, resulting in higher assets turnover ratio.
  • Formulate Robust Inventory Management: The company should analyze how its stock move from company to its customer and know whether there are slow moving or fast-moving products of the company. The company can have slow or ineffective delivery system that can result in delay of service which in result will delay in collection period of accounts receivable. Hence, the company should computerize the process of order taking, inventory management and billing in order to improve and effectively manage cash flows of the company. This will eventually show up in sales numbers and improve the asset turnover ratio.

Advantages and Limitation of Current Ratio

When you wish to evaluate the performance of a company the best method to use is the ratio analysis. The ratio analysis uses the financial statements such as the income statement and the statement of financial position.

One of the critical components of the financial ratio is the current ratio that measures the relationship between the current assets and current liability (Cate, 2008).

Current ratio can also be referred to us the working capital ratio. If a company wish to know its liquidity the proper ratio to use is the current ratio.

The primary purpose of the current ratio is to measure the short-term financial position of the company.

The formula for calculating the current ratio is; the current assets divided with the Current Liabilities (Cate, 2008). In this article, we are going to discuss the advantages and limitation of using the current ratio.

It is worth to note that the current ratio is the component of current assets and the current liability.

The current assets are composed of the company assets that easily convertible into cash. The majority of the current assets are used in the normal operation of the company (Cate, 2008).

Examples of the current assets; inventory, the cash, and cash equivalent, account receivable. Likewise, the current liability is composed of the liability which will be due in less than one fiscal year.

Example of the current liability includes; account payable, the current portion of long-term liability, Bank overdraft due in one year and deferred revenue.

In most cases, the current ratio is confused with the acid ration since they are calculated using the same formula and also indicate the liquidity of the company.

The main difference between the current ratio and acid ratio is the inclusion of the inventory in the current assets when calculating the current ratio.

Advantages of the Current Ratio

The current ratio has numerous advantages that make it superior compared to other liquidity ratios, the primary advantage of the current ratio is that the ratio helps the measure the financial health of a company.

If a company record a current ratio of more than one, it indicates that the company is in good health in term of liquidity (“Financial Statement Analysis,” 2012).

If the management realizes they have less than 1 of the current ratios, they must make a swift decision to salvage the situation.

The current ratio has numerous advantages that make it superior compared to other liquidity ratios, the primary advantage of the current ratio is that the ratio helps the measure the financial health of a company.

If a company record a current ratio of more than one, it indicates that the company is in good health in term of liquidity (“Financial Statement Analysis,” 2012).

If the management realizes they have less than 1 of the current ratios, they must make a swift decision to salvage the situation.

Similarly, the current ratio gives the efficiency of the firms operating cycle. The current ratio indicates the efficacy of the management to manage the operating assets.

If the ratio id adverse or below one the company will be able to come up with the strategy to optimize the overhead in the company.

The last advantage of the current ratio is that the ratio indicates the ability of the management to honor the creditor’s obligations. The ratio acts as the litmus paper on how well the administration can manage the working capital (“Financial Statement Analysis,” 2012).

Limitation of the Current Ratio

Although the current ratio has numerous pros, it also has several limitations. The primary disadvantage of the current ratio is that the ratio is not a sufficient indicator of the liquidity of the company.

The company cannot solely rely on the current ratio since it gives little information about the company working capital.

The other limitation of the current ratio is the inclusion of the inventory in the calculation of the current assets. The inventory sometimes may take more than one to be converted into cash or revenue to the firm.

If the company has a high level of stock, it will indicate that the company in an excellent liquidity position but in a real sense, the company is in severe financial health (“Financial Statement Analysis,” 2012).

Lastly, the company may have inconsistent current ratio if the sales are seasonal. If the sales are low, the company will record the lowest current ration but when the sales increase the current ratio will be high.

The fluctuation  of the current ratio will lead to a misconception of the company liquidity

Limitation and Advantages of Fixed Asset Turnover Ratio

Fixed Asset Turnover Ratio is an efficiency ratio which depicts how well business has utilized fixed assets in order to generate sales.

It measures business returns on investment in plants, properties, equipment and other fixed assets by comparison of net sales with fixed assets.

Here is the formula to calculate ratio,

Fixed Assets Turnover Ratio = Net Sales / Average Fixed Assets

Here, Sales is taken annually while average fixed assets is calculated by dividing the opening balance of fixed assets at the beginning of year and closing balance of fixed assets at the end of thee year by 2.

Fixed Assets Balance are net of accumulated depreciation at the end of period.

and,

The reason for taking average fixed assets is that businesses often purchase or sells the fixed assets during the year and also due to fact that this ratio is mainly used in the analysis by manufacturing concerns.

Now, let us look at the advantages and limitations of calculation of fixed assets turnover ratio:

ADVANTAGES:

  • Fit for Manufacturing Industry: Bulk of investments are made in manufacturing industry. Manufacturing concerns buy a lot of plants, equipment and other fixed assets. Fixed Assets Turnover ratio gives a good edge to manufacturing concerns, a different view in analyzing the return on assets with respect to top line growth. The high turnover ratio indicates that fixed assets are working efficiently and effectively in generating good number of sales.
  • Makes Comparison easy for investors: Investors analyze this ratio year over year reflecting the efficiency increment or decrement of fixed assets. It also helps them to know when the reinvestments should be made on fixed assets so as to keep in line with growth guidelines.
  • Helps in planning for Asset Sale and Investment: If fixed assets turnover ratio has suddenly dropped, it means that fixed assets to the operations has become obsolete and it needs to be sold. The comparison with other companies in the same domain also states that when new plants, machineries and equipment should be bought.

LIMITATIONS:

  • Industry Limitations: It is useful mainly in comparing companies across manufacturing concerns. For asset light industries like those based heavily on technologies, fixed assets turnover ratio cannot be put to play.
  • Does not take Profit into account: The fixed assets turnover ratio only measures correlation between fixed assets and net sales and not the cause of what impacted the figures. A drop in asset turnover ratio can lead management on useless manhunt chasing for obsolete assets, while in reality, revenue has dropped for independent reason. Due to such drawback, fixed assets turnover ratio should be analyzed over a variety of profit and revenue ratios.
  • Difference in Accounting Policies: Two companies in the same industry or over separate industry can have different accounting policy with regards to depreciation methods. This skews the results of comparison of fixed assets turnover ratio over the industry. There can be cases where two companies having similar asset model and sales can show different fixed assets turnover ratio due to differences in accounting policies of depreciation. Hence, this ratio suffers from management discretion over employment of accounting policies with respect to sales and fixed assets.
  • Performance Subject to Manipulation: The Fixed Assets turnover ratio is helpful in performing entities having high value investments in assets where board of directors want to assess the efficiency of these fixed assets in relation to turnover of the company. However, the major limitation, the fixed asset turnover ratio suffers is in its use as performance measuring yardstock as it encourages the manager to keep using the old asset without providing for the replacement costs of new one.
  • To take full advantage of fixed assets turnover ratio, one should also correlate profit ratios with this ratio in order to get larger picture.

Average total assets

Definition:

Averages total assets is the average book value of the entity’s assets over the different reporting date. Normally, the value of assets at the reporting date is shown in the balance sheet of the entity. These assets including book current and fixed assets.

Averages total assets is normally uses to assess the return on averages assets which is assessing the efficiency of using assets for the two or more consecutive time. For example, the entity might want to assess the return on averages assets for the last three years.

To assess this, the entity needs to measure the amount of net income for those three years and then calculate the averages of total assets. These averages of total assets are the value of assets that use by the entity to support the sales and operation of the entity.

Average total assets formula:

Averages total assets = Accumulation of total assets at X period / X period

Total assets at X period is the book value of assets at the reporting period that the entity wants to assess. For example, the book value of assets at the end of 31 December 2015, 31 December 2016, and 31 December 2017

X period is the number of periods that the book value of assets is used for calculation. For example, X period of 31 December 2015, 31 December 2016, and December 2017 is 1 + 1 + 1 = 3

The entity could also use the fair value of assets for calculation.

Example:

The entity wants to assess the return average asset over the last three years 2015, 2016, and 2017. Based on financial statements, the value of assets over that last three year is 6,000K, 7000k, and 8,000K. CFO wants his accountant to calculate the average total assets for him.

Calculate the average total assets:

Based on the formula above, we can calculate the average total assets follow:

Average total assets = (6,000 + 7,000 + 8,000) / 3 = 7,000K

Based on the above calculation we can get average total assets equal to 7,000K. This figure could be used for calculating return on averages assets for the entity.