Profitability Ratios (DP IB Business Management)
Revision Note
Written by: Lisa Eades
Reviewed by: Steve Vorster
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 |
---|---|
|
|
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 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
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
[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
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
[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
Capital employed is usually provided for you
If required, it is calculated using the formula
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
[1 mark]
Step 2: Divide Operating Profit by Capital Employed
[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
Method | Explanation |
---|---|
Increase Sales Revenue | Increase the value of sales 1. Raise prices
2. Sell premium products
Increase the volume of sales 1. Price tactics
2. Increase marketing activities
|
Reduce Direct Costs | Reduce variable costs
|
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)
Examiner 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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