ZIMSEC O Level Principles of Accounts Notes: Profitability Ratios
- So we have already introduced you to accounting ratios
- These ratios include a group of ratios that are known as profitability ratios
- Such ratios measure how well a business performed in profit terms in a given period
- At this level you are required to know how to calculate three profitability ratios:
- Markup
- Margin
- Net Profit (percentage)
- As shown by the Income Statement (and Trading and Profit and Loss Accounts) there are two major types of profit:
- Gross Profit i.e. Sales (Net Turnover) – Cost of Sales and
- Net Profit i.e. Gross Profit – Operating Costs
- Traditionally markup and margin are calculated using Gross Profit
- For this reason they are often called gross profit margin and gross profit markup
Markup
- Is the amount added to the cost of an item to obtain its selling price
- Markup= Selling Price-Cost of Sales
- As you can tell markup is usually similar to Gross Profit
- Markup as a ratio is calculated using the formula:\mathrm{\frac{Profit}{Cost \quad of \quad Sales}}
- For example a business has:
- Sales of 10 000
- Cost of Sales 8 000
- In a given period
- Calculate the markup:
- Gross Profit = $10 000- $8 000
- $2 000
- Markup= \frac{2 000}{8 000}
- \frac{1}{4}
- Typically markup is expressed as a fraction in its lowest terms or as a percentage
- In the above example the markup will be:
- 25%
- Bear in mind that markup can be calculated either for entire sales or for each unit
Margin
- This is when profit is expressed in terms of the selling price
- It is calculated using the formula:
- \mathrm{\frac{Profit}{Sales}} alternatively this can be expressed as
- \mathrm{\frac{Profit Per Unit}{Selling Price}}
- In the above example the margin would thus be:
- \frac{2000}{10000}
- \frac{1}{5}
- In percentage terms this would be:
- 20%
Relationship between Markup and Margin
- Because they are essentially derived from the same forumulae and items
- There is a relationship between markup and margin
- When given the margin \frac{1}{x} markup can be calculated using the formula:
- \frac{1}{x-1}
- For example if the margin is \frac{1}{5}
- The markup would be:
- \frac{1}{5-1} i.e.
- \frac{1}{4}
- Conversely given the markup \frac{1}{y} the margin can be calculated as a formula:
- \frac{1}{y+1}
- For example if the margin is \frac{1}{4}
- Then the markup would be:
- \frac{1}{4+1} i.e.
- \frac{1}{5}
- You should be mindful of this relationship when it is needed e.g. during accounting using incomplete records
Net Profit Percentage
- This is when the net profit is expressed in terms of Sales
- It is sometimes known as Net Profit Margin for obvious reasons
- The ratio is expressed and presented in percentage terms
- The formula is: \mathrm{\frac{Net Profit}{Sales} x \frac{100}{1}}
- For example a Business had Sales of $25 000 and a net profit of $5 000 calculate the Net Profit Percentage
- \mathrm{\frac{5000}{25000} x \frac{100}{1}}
- 20%
Where to get the figures/amounts
- Profitability ratios as already pointed out involve the analysis of profit figures
- Figures/Amounts used in the calculation of these ratios can be obtained from Income Statement/Trading and Profit and Loss Accounts
To access more topics go to the Principles of Accounting Notes.
