Profitability Ratios (DP IB Business Management)

Revision Note

Written by: Lisa Eades

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 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

$\frac{Gross Profit}{Sales Revenue} \times 100$

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

$\frac{Gross Profit}{Sales Revenue} \times 100 = \frac{£ 105, 731}{£ 124, 653} = 0.8482$ [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

$\frac{Profit before Interest & Tax}{Sales Revenue} \times 100$

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

$\frac{Profit before Interest & Tax}{Revenue} \times 100 = \frac{£ 65, 864}{£ 124, 653} = 0.5284$ [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

$Return on Capital Employed = \frac{Profit before interest & tax}{Capital Employed} \times 100$

Capital employed is usually provided for you
If required, it is calculated using the formula
$Capital Employed = Non - current Liabilities + Equity$

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

$Capital employed = N o n - c u r r e n t L i a b i l i t i e s + E q u i t y Capital employed = £ 1.5 m + £ 15.4 m Capital employed = £ 16.9 m$ [1 mark]

Step 2: Divide Operating Profit by Capital Employed

$Return on Capital Employed = \frac{Profit before interest & tax}{Capital Employed} \times 100 Return on Capital Employed = \frac{£ 2.2 m}{£ 16.9 m} Return on Capital Employed = 0.13$ [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

Method	Explanation
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 This may involve purchasing cheaper/alternative resources, negotiating with suppliers or purchasing in bulk Businesses must ensure that reducing variable costs will not have an adverse effect on the quality or desirability of products 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

Method

Explanation

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

This may involve purchasing cheaper/alternative resources, negotiating with suppliers or purchasing in bulk
Businesses must ensure that reducing variable costs will not have an adverse effect on the quality or desirability of products
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

$Return on Capital Employed = \frac{Profit before Interest & tax}{Capital Employed} \times 100 Return on Capital Employed Sevenoaks = \frac{£ 0.37 m}{£ 2.4 m} \times 100 = 15.42 % (1 mark) Return on Capital Employed Whitstable = \frac{£ 0.57 m}{£ 3.1 m} \times 100 = 18.39 % (1 mark) Return on Capital Employed Rochester = \frac{£ 0.51 m}{£ 2.9 m} \times 100 = 17.59 % (1 mark)$

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 Tips and Tricks

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

Last updated: 29 October 2024

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Profitability Ratios (DP IB Business Management)

Revision Note

An Introduction to Ratio Analysis

Diagram: the ratio analysis process

Profit Margins

Gross profit margin

Worked Example

Profit margin

Worked Example

Return on Capital Employed

Worked Example

Improving Profitability Ratios

Improving the gross profit margin

Improving the profit margin

Understanding return on capital employed (RoCE)

Worked Example

Examiner Tips and Tricks

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Author: Lisa Eades

Author: Steve Vorster