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}\%}

To access more topics go to the O Level Business Notes

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