Business Studies: Profitability Ratios

• These measures indicate how well a business is performing in terms of its ability to generate profit
• The ratios relate profits to sales and assets
• There are three commonly used ratios:
• Return on Capital Employed (ROCE)
• Profit Margin and
• Profit Markup

Return on Capital Employed

• Is normally expressed as a percentage
• The formula for finding Return on Capital Employed is:
• \dfrac{\mathrm{Net \quad Profit}}{\mathrm{Capital \quad Employed}}\quad\mathrm{x} \quad 100
• Capital Employed can be obtained using the formula
• \mathrm{Working \quad Capital(Current \quad Assets-Current \quad Liabilities)+Fixed \quad Assets}
• Alternatively Capital employed can be given using the formula:
• \mathrm{Equity (Capital+Retained \quad Earnings)+ Long Term Liabilities}
• All these figures can be obtained from the Balance Sheet and Income statement
• For example a business made a profit of $5 000, it has Fixed Assets of $30 000, Current Assets of 15 000 and Current Liabilities of $5 000
• The Capital Employed would be:
• \mathrm{30 000+15 000-5 000 = 40 000}
• The return on capital employed would be:
• \mathrm{\dfrac{5000}{40000}\quad x\quad 100}
• 12.5%
• The higher the return on capital employed the better for example if the business had ROCE of 10% the previous year then we say ROCE has improved by 2.5%
• ROCE is a measure of operational efficiency i.e. how well is the business turning invested assets into profit

Margin

• Margin is the difference between the selling price (sales) and cost price (cost of sales)
• There are two margin ratios i.e. Gross Profit Margin and Net Profit Margin
• The formula for Gross Profit Margin is:
• \mathrm{\dfrac{Gross\quad Profit}{Sales\quad Revenue}\quad x\quad 100}
• It can also be expressed as a fraction in its lowest terms
• \mathrm{\dfrac{Gross\quad Profit}{Sales\quad Revenue}}
• Net Profit Margin is given using the formula:
• \mathrm{\dfrac{Net\quad Profit}{Sales\quad Revenue}\quad x\quad 100}
• It can also be expressed as a fraction in it’s lowest terms
• \mathrm{\dfrac{Net\quad Profit}{Sales\quad Revenue}}
• The ratio shows the percentage of sales that goes towards profit
• The higher the percentage the better
• If the gross profit margin is falling over time it might mean the costs are increasing but the business is not passing them to customers
• It might also mean the business is has reduced it’s selling price
• Here is an example:
• Chinembiri Ltd had the following results after trading for a year:
• Sales $ 30 000, Cost of Sales $24 000, Operating Expenses $ 3 000
• Gross Profit Margin would be:
• \mathrm{\dfrac{6000}{30000}\quad x\quad 100}
• 20%
• Remember to calculate gross profit first which is found by Sales-Cost of Sales
• Alternatively this can be expressed as:\mathrm{\dfrac{1}{5}}
• The Net Profit Margin would be:
• \mathrm{\dfrac{3000}{30000}\quad x\quad 100}
• 10%
• Alternatively this can be expressed as:\mathrm{\dfrac{1}{10}}
• Remember Net Profit can be calculated using the formula: Gross Profit – Operating Expenses

Markup

• This is the amount of profit added to the cost price to arrive at the selling price
• The ratio is obtained by dividing profit by cost of sales
• \mathrm{\dfrac{Gross\quad Profit}{Sales\quad Revenue}}
• It can also be expressed as a fraction
• In example above the Gross Profit mark up is:
• \mathrm{\dfrac{6000}{24000}\quad x\quad 100}
• 25%
• Or:\mathrm{\dfrac{1}{4}}
• The higher the mark up the better

Relationship between mark up and margin

• When you have the markup you can calculate the margin
• This can be done using the formula
• \dfrac{x}{y+x}
• For example if the mark up as above is:\mathrm{\dfrac{1}{4}}
• Then the margin would be calculated as follows:
• \dfrac{1}{4+1}
• \mathrm{\dfrac{1}{4}}
• Conversely if we have the margin we can calculate the markup
• This can be done using the formula
• \dfrac{x}{y-x}
• For example if the margin is: \mathrm{\dfrac{1}{5}}
• Then the markup is:
• \dfrac{1}{5-1}
• \mathrm{\dfrac{1}{4}}
• If you are given one of this as a percentage and are tasked with finding the other
• You need to first convert the given percentage into a fraction and then use the formula above
• For example given that the markup is 20% find the margin
• The margin can be calculated as follows:
• \mathrm{\dfrac{20}{100}}
• Now add the numerator to the denominator
• \mathrm{\dfrac{20}{100+20}}
• The result is:
• \mathrm{\dfrac{20}{120}}
• Reduce the fraction to it’s lowest terms and you get:
• \mathrm{\dfrac{1}{6}}
• Or as a percentage:
• \mathrm{16\dfrac{2}{3}\%}

To access more topics go to the O Level Business Notes