Profitability Ratios

Revision notes on profitability ratios for A2 Business Studies.

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  • Created by: Emma Rudd
  • Created on: 25-03-08 16:29
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Lindsay Emma Rudd BMA
Profitability Ratios
These ratios compare the profit earned by a business with other key variables such as the level of sales
achieved or the capital available to the managers of the business.
Gross Profit Margin
This ratio compares the gross profit achieved by a business with its sales turnover. Gross profit is earned
before direct costs such as administration expenses are deducted. The ratio calculates the percentage of
the selling price of a product that constitutes gross profit. The answer is expressed as a percentage.
Gross Profit Margin = Gross profit X 100
Turnover
Using this Ratio
The figure for gross profit margins varies depending upon the type of industry. Firms that turn over
their stock rapidly and then can trade with relatively few assets may operate with low gross profit
margins. Greengrocers and bakers fall into this category. Firms with slower turnover of stock and
requiring substantial fixed assets may have a high figure. For example house builders.
The sales mix can have a major influence on this ratio.
The ratio can be improved by increasing prices although this may result in lower turnover.
Alternatively reducing direct costs (raw material costs and wages, for example) will also improve the
figure.
Net Profit Margin
This ratio calculates a percentage of a products selling price that is net profit ir after costs have been
deducted. Because this ratio includes all of a business's operating expenses, it may be regarded as a
better indication of performance than gross profit margin. Once again the answer to this ration is written as
a percentage.
Net Profit Margin = Net Profit X 100
Turnover
Using this Ratio
Results of this ratio can vary according to the type of business, though a higher net profit margin is
preferable.
A comparison of gross and net profit margins can be informative. A business enjoying a stable
gross profit margin and a declining net profit margin may be failing to control indirect costs
effectively. This may be due to the purchase of new premises for example.
Improvements in the net profit margin may be achieved through higher selling prices or tighter
control of costs, particularly indirect costs.
Return on Capital Employed
This is a vital ratio comparing the operating profit earned with the amount of capital employed by the
business. The result of this ratio, which is expressed as a percentage, allows an assessment to be made
of the overall financial performance of the business. A fundamental comparison can be made between the
rate of interest and the ROCE generated by a business.
Return on Capital Employed = Operating Profit X 100
Capital Employed
Using this Ratio
A typical ROCE may be expected to be in the range of 20 ­ 30 per cent. It is particularly important
to compare the results from calculating this ratio with the business's ROCE in previous years and
also those achieved by competitors.
A business may improve its ROCE by increasing its operating profit without raising further capital or
by reducing the amount of capital employed, perhaps by repaying come long term debt.
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Comments

davidsalter

This is a one page summary on what each of the profitability ratios are and what they mean to a business.

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