Profitability Ratios (Edexcel IGCSE Accounting)

Profitability

What is profitability?

• Profitability is a measure of the ability of a business to generate profits from its activities

  • This measures the ability to succeed in the future

What are the profitability ratios?

• Profitability ratios assess a company's ability to earn profits from sales, operations or assets

  • They compare profits to other values such as revenue, costs and capital employed

• The main profitability ratios are:

  • Gross profit percentage

  • Mark-up

  • Profit for the year as a percentage of revenue

  • Return on capital employed

Gross Profit Percentage

What is the gross profit percentage?

• If the gross profit percentage decreases then this suggests that:

  • The goods are being sold at a cheaper price than in previous years

    • Allowing more trade discounts has the same effect

  • The costs of goods have increased but their selling price has remained the same

Mark-up

What is the mark-up?

• The mark-up is normally a fixed percentage applied to the cost of the goods

  • The percentage can be raised to increase profits

Profit for the Year as a Percentage of Revenue

What is the profit for the year as a percentage of revenue?

• A decreasing profit for the year as a percentage of revenue suggests that:

  • Gross profit has decreased from previous years

  • The business is paying more for expenses

  • The business is not earning as much other income as in previous years

Return on Capital Employed (ROCE)

What is the return on capital employed (ROCE)?

• A business aims to increase the return on capital employed

  • The business should consider whether it can use more short-term sources of finance rather than long-term loans

Evaluating Profitability

How do I evaluate the profitability of a business?

• It is best to look at multiple profitability ratios together to get a better understanding

  • The gross profit percentage might be high but the profit for the year as a percentage of revenue might be low

    • This suggests that gross profit is not an issue

    • The business needs to look at other income and expenses

  • The difference between the gross profit percentage and profit for the year as a percentage of revenue is the proportion of revenue that is spent on expenses after deducting other income

    • A smaller difference indicates that a business has better control of expenses

• Consider actions which have a positive and negative effect

  • For example, if a business finds a cheaper supplier:

    • The gross profit percentage might increase as a result of lower cost of sales

    • However, the quality of the goods might not be as good, which could cause customers to shop elsewhere, reducing sales revenue

How do I compare the profitability of a business between years?

• Compare the ratios to the same ratios from previous years

• For each ratio

  • Make a general comment

    • State whether it has improved or gotten worse

  • Give possible reasons for the change

• Calculate the difference between the gross profit percentage and the profit for the year as a percentage of revenue to see if the business has gotten better at controlling expenses

• Give an overall comment or conclusion about the profitability