IBBusinessDPBusiness ManagementHLRevision Notes3. Finance & Accounts3.5 Profitability & Liquidity Ratio AnalysisProfitability Ratios

Profitability Ratios (DP IB Business Management)

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Lisa Eades

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DP Business Management: HLDP Business Management: SL

An Introduction to Ratio Analysis

  • Ratio analysis involves extracting information from financial accounts to assess business performance and answer key questions including 

    • Why is one business more profitable than another in the same industry?

    • Is a business growing?

    • How effectively is a business using assets and capital invested?

    • What returns on investment are expected?

    • How risky is the financial structure of the business?

 Information Extracted from the Profit & Loss Account and Balance Sheet for Ratio Analysis

Statement of Profit or Loss

Statement of Financial Position

  • Revenue

  • Cost of Sales

  • Gross Profit

  • Operating Profit

  • Profit for the Year (Net profit)

  • Current Assets

  • Current Liabilities

  • Inventory (stock)

  • Trade Receivables

  • Trade Payables

  • Long-term liabilities

  • Capital & Reserves

  • Ratio analysis supports evidence-based decision making, as it provides measurable data that can be used to support judgements and compare performance against objectives

Diagram: the ratio analysis process

The Ratio Analysis Process 
The Ratio Analysis Process

  • The three main profitability ratios are

    • The Gross Profit Margin

    • The Profit Margin

    • Return on Capital Employed (RoCE)

  • The two main liquidity ratios are

    • The Current Ratio

    • The Acid Test Ratio

Profit Margins

  • A profit margin measures the proportion of revenue that is converted into profit

  • Profit margins can be compared to previous years to better understand business performance

    • Higher and increasing profit margins are preferable, as it means that more revenue is being converted to profit

Gross profit margin 

  • This shows the proportion of revenue that is turned into gross profit and is expressed as a percentage

    • It is calculated using the formula below 

 fraction numerator Gross space Profit over denominator Sales space Revenue end fraction cross times space 100 space space space space space space

Worked Example

Head to Toe Wellbeing’s revenue in 2022 was £124,653. Its gross profit was £105,731.

Calculate Head to Toe Wellbeing Ltd’s Gross Profit Margin in 2022. [2]

Answer:
Step 1: Substitute the values into the formula

      fraction numerator Gross space Profit space over denominator Sales space Revenue end fraction space cross times space 100 space space space equals space fraction numerator £ 105 comma 731 over denominator space £ 124 comma 653 space end fraction equals space space 0.8482 space space            [1 mark]

Step 2: Multiply the outcome by 100 to find the percentage

   0.8482 x 100

    = 84.82%                   [1 mark]

84.82% of Head to Toe Wellbeing’s revenue was converted into gross profit during 2022

 
Profit margin

  • The Profit Margin shows the proportion of revenue that is turned into profit before interest and tax

  • It is calculated using the formula below and is expressed as a percentage
     

fraction numerator Profit space before space Interest space & space Tax over denominator Sales space Revenue end fraction cross times 100

Worked Example

Head to Toe Wellbeing’s revenue in 2022 was £124,653. Its profit before interest and tax was £65,864.

Calculate Head to Toe Wellbeing Ltd’s Profit Margin in 2022. [2]

Answer:

Step 1: Substitute the values into the formula


 fraction numerator Profit space before space Interest space & space Tax over denominator Revenue end fraction cross times 100 space equals fraction numerator £ space 65 comma 864 over denominator £ space 124 comma 653 end fraction equals 0.5284 [1 mark]

Step 2: Multiply the outcome by 100 to find the percentage

 
0.5284 x 100

=  52.84%                [1 mark]

In 2022 52.84% of Head to Toe Wellbeing’s revenue was converted into profit before interest and tax.

Return on Capital Employed

  • The Return on Capital Employed is also known as the Primary Ratio

  • It compares the profit made by a business to the amount of capital invested in the business

  • It is a measure how effectively a business uses the capital invested in the business to generate profit

  • Return on Capital Employed is a key performance indicator that can be compared over time and also with competitors and other potential capital investments

  • Return on Capital Employed is expressed as a percentage and can be calculated using the formula
     

Return space on space Capital space Employed space equals space fraction numerator Profit space before space interest space & space tax over denominator Capital space Employed end fraction space space cross times space 100

  • Capital employed is usually provided for you

  • If required, it is calculated using the formula

    Capital space Employed space equals space Non minus current space Liabilities space plus space Equity

Worked Example

The table shows an extract from the company accounts of Keals Cosmetics.

Non-current Liabilities

£1.5 million

Revenue

£7 million

Equity

£15.4 million

Profit before Interest & Tax

£2.2 million

Calculate Keals Cosmetics' Return on Capital Employed.         [3 marks]

Answer:
Step 1: Calculate the capital employed

Capital space employed space equals space N o n minus c u r r e n t space L i a b i l i t i e s space plus space E q u i t y space Capital space employed space equals space £ 1.5 straight m space plus space £ 15.4 straight m space Capital space employed space equals space £ 16.9 straight m      [1 mark]

Step 2: Divide Operating Profit by Capital Employed

Return space on space Capital space Employed space equals space fraction numerator Profit space before space interest space & space tax over denominator Capital space Employed end fraction space space cross times space 100 Return space on space Capital space Employed space equals space fraction numerator £ 2.2 straight m over denominator £ 16.9 straight m end fraction Return space on space Capital space Employed space equals space 0.13    [1 mark]

Step 3: Multiply the result by 100 and express the outcome as a percentage

0.13 x   100       = 13%            [1 mark]

The capital employed in Keals Cosmetics has generated a return of 13%  

Improving Profitability Ratios

  • Businesses aim to improve their profit margins over time

  • Whilst profit margins may fall as a result of external factors (for example, the cost of raw materials may rise as a result of poor weather damaging raw materials) there are a number of internal steps a business can take to improve its profit margins

Improving the gross profit margin

  • The gross profit margin can be improved in two ways

    • They can increase their sales revenue

    • They can reduce their direct costs

How to Increase the Gross Profit Margin

Increase Sales Revenue

Increase the value of sales

1. Raise prices

  • If costs remain the same this will improve profitability as the difference between the selling price and costs is now greater

2. Sell premium products

  • If customers are willing to spend money on these goods the business could earn more profit per item sold

     

Increase the volume of sales

1. Price tactics 

  • Use price tactics to encourage higher quantity or more frequent purchases

    • E.g. 'buy one get one half price' doubles the number of items a customer purchases, increasing revenue

2. Increase marketing activities

  • Engage in more marketing activities to increase sales volume

Reduce Direct Costs

Reduce variable costs 

  1. This may involve purchasing cheaper/alternative resources, negotiating with suppliers or purchasing in bulk

  2. Businesses must ensure that reducing variable costs will not have an adverse effect on the quality or desirability of products

  3. Buying stock in greater quantities may require investment in increased storage space which will reduce the impact of the cost savings made
     

  • Businesses may also be able to reduce wastage of raw materials and components 

Improving the profit margin

  • The profit margin can be improved in two ways

    • Increasing the gross profit margin (see above)

    • Reducing overhead costs

Reduce Overhead Costs

  • Reducing staffing levels, relocating to cheaper premises or changing utility companies can reduce expenses

    • Reducing staffing levels may affect staff morale and negatively affect productivity

    • Relocation costs can outweigh some benefits of moving to a cheaper location

    • Replacing inefficient or outdated equipment may require staff training
       

Understanding return on capital employed (RoCE)

  • RoCE differs between industries so comparison across sectors is not recommended

    • However, RoCE can be compared with other forms of return such as interest rates on savings in a bank account, and with other businesses within the same industry

  • RoCE can be used to support strategic decisions (e.g. investment or divestment decisions) to determine the most profitable option given the level of capital employed

  • With RoCE the higher the rate the better as it indicates that the business is profitable and using its capital efficiently

    • Investors prefer businesses with stable and rising levels of RoCE as this indicates low-risk growth is being achieved

    • A ROCE of at least 20 per cent is usually a good sign that the company is in a good financial position

  • To increase the RoCE level a business can

    • Increase the level of profit generated without introducing new capital into the business

    • Maintain the level of profit generated whilst reducing the amount of capital in the business

Worked Example

Faced with increasing costs Kent & Medway Properties Ltd is looking to close one of its three high street estate agency branches.

The table below shows some key data for each of the branches.

Branch

Capital Employed 

Profit Before Interest & Tax

Sevenoaks

£2.4m

£0.37m

Whitstable

£3.1m

£0.57m

Rochester

£2.9m

£0.51m

Calculate the Return on Capital Employed (RoCE) for each branch and recommend which branch, on profitability terms, should close.  [5 marks]

Answer: 

Step 1: Apply the formula to calculate the RoCE for each branch

      

Step 2: Identify the least profitable branch for closure

Sevenoaks is the least profitable branch with a RoCE of 15.42% and should be the branch selected for closure.  (2 marks)

Exam Tip

When calculating financial ratios, check that you are using the correct units.

In some cases, financial data is presented as raw figures (e.g. £14,520) but in most cases, you will be working in thousands (£000) or millions (£m).

  • Ensure that you convert correctly, e.g. £0.39m is equal to £390,000 and £34.9 (000) is equal to £34,900

  • Make sure the decimal place is in the correct place

  • Calculate to two decimal places unless stated otherwise

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    Lisa Eades

    Author: Lisa Eades

    Lisa has taught A Level, GCSE, BTEC and IBDP Business for over 20 years and is a senior Examiner for Edexcel. Lisa has been a successful Head of Department in Kent and has offered private Business tuition to students across the UK. Lisa loves to create imaginative and accessible resources which engage learners and build their passion for the subject.