ZIMSEC O Level Business Studies Notes: Business Finance and Accounting: Ratio Analysis: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}\%}

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