Profitability Ratios (Cambridge (CIE) O Level Accounting)

Revision Note

Written by: Dan Finlay

What are 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 margin
- Mark-up
- Profit margin
- Return on capital employed

Gross Margin

What is the gross margin?

What is the formula?	$\frac{Gross profit}{Revenue} \times 100$
How should the value be written?	Write as a percentage (X%)
How should the value be rounded?	Round to two decimal places
What does the value mean?	The value represents the proportion of the revenue that is turned into gross profit
How can the ratio be improved?	Increase the selling price of the goods Buy the goods from a cheaper supplier

If the gross margin 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

Examiner Tips and Tricks

The gross margin must be less than 100%. If you get an answer bigger than 100% then check your working.

Worked Example

Kaley is a sole trader. She provides the following information for the year ended 31 December 2023.

	$
Revenue	128 000
Purchases	52 000
Inventory at 1 January 2023	8 000
Inventory at 31 December 2023	6 000

Calculate Kaley's gross margin. Your answer should be correct to two decimal places.

Answer

Calculate the cost of sales
- Opening inventory + Purchases - Closing inventory
- $8 000 + $52 000 - $6 000 = $54 000
Calculate the gross profit
- Revenue - Cost of sales
- $128 000 - $54 000 = $74 000
Calculate the gross margin
- $\frac{Gross profit}{Revenue} \times 100$
- $\frac{74 000}{128 000} \times 100 = 57.8125$
Round to two decimal places
- Gross margin = 57.81%

Mark-up

What is the mark-up?

What is the formula?	$\frac{Gross Profit}{Cost of sales} \times 100$
How should the value be written?	Write as a percentage (X%) This can be bigger than 100%
How should the value be rounded?	Round to two decimal places
What does the value mean?	The value represents the percentage of the cost of sales that is added to the costs to form the selling price
How can the ratio be improved?	Increase the selling price of the goods Buy the goods from a cheaper supplier

The mark-up is normally a fixed percentage applied to the cost of the goods
- The percentage can be raised to increase profits

Examiner Tips and Tricks

The mark-up can be bigger than 100% so do not worry if your answer is bigger than 100%.

Profit Margin

What is the profit margin?

What is the formula?	$\frac{Profit for the year}{Revenue} \times 100$
How should the value be written?	Write as a percentage (X%)
How should the value be rounded?	Round to two decimal places
What does the value mean?	The value represents the proportion of the revenue that is turned into profit for the year
How can the ratio be improved?	Increase the gross profit Increase selling prices Buy goods from cheaper suppliers Increase income from other sources Reduce expenses such as staff salaries, marketing or administrative costs

A decreasing profit margin 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

Worked Example

Kaley is a sole trader. She provides the following information for the year ended 31 December 2023.

	$
Revenue	128 000
Gross profit for the year	74 000
Other income	9 000
Expenses	46 000

Calculate Kaley's profit margin. Your answer should be correct to two decimal places.

Answer

Calculate the profit for the year
- Gross profit + Other income - Expenses
- $74 000 + $9 000 - $46 000 = $37 000
Calculate the profit margin
- $\frac{Profit for the year}{Revenue} \times 100$
- $\frac{37 000}{128 000} \times 100 = 28.90625$
Round to two decimal places
- Profit margin = 28.91%

Return on Capital Employed (ROCE)

What is the return on capital employed (ROCE)?

What is the formula?	$\frac{Operating profit for the year}{Capital employed} \times 100$ Capital employed = Equity (or capital) + Non-current liabilities
How should the value be written?	Write as a percentage (X%)
How should the value be rounded?	Round to two decimal places
What does the value mean?	The value represents the proportion of the capital employed that is turned into profits
How can the ratio be improved?	Increase the profit for the year Increase income Decrease expenses Reduce non-current liabilities such as bank loans

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

Examiner Tips and Tricks

Notice that this profitability ratio uses the operating profit rather than the profit for the year. This means you need to use the profit before finance costs (loan interest or debenture interest).

Worked Example

The equity and liabilities of Khazam Ltd at 31 December 2023 are listed below.

	$
Ordinary share capital	140 000
General reserve	40 000
Retained earnings	50 000
5% Debentures	30 000
Trade payables	25 000

The profit for the year ended 31 December 2023 was $35 000 after charging debenture interest.

Calculate the return on capital employed for the year ended 31 December 2023. The calculation should be correct to two decimal places.

Answer

Calculate the debenture interest for the year
- 5% × $30 000 = $1 500
Calculate the operating profit for the year
- Add the debenture interest back onto the profit for the year
- $1 500 + $35 000 = $36 500
Calculate the capital employed
- Equity (Share capital + Reserves + Retained earnings) + Non-current liabilities
- $140 000 + $40 000 + $50 000 + $30 000 = $260 000
Calculate the return on capital employed
- $\frac{Operating profit for the year}{Capital employed} \times 100$
- $\frac{36 500}{260 000} \times 100 = 14.0384 . . .$
Round to two decimal places
- ROCE = 14.04%

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 margin might be high but the profit margin 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 margin and profit margin 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 margin 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
  - State the percentages
- Give possible reasons for the change
Calculate the difference between the gross margin and the profit margin to see if the business has gotten better at controlling expenses

Worked Example

Sana and Taz are business partners. They provide information for the financial years ending 31 December 2022 and 31 December 2023.

	Year ended
	31 December 2022	31 December 2023
Gross margin	32.25%	43.75%
Profit margin	9.43%	10.31%
Return on capital employed	21.08%	10.45%

Comment on the performance of the business over the two years.

Answer

Comment on the gross margin

The gross margin has improved from 32.25% to 43.75%. This could be because Sana and Taz increased the selling prices of their goods. They could have decreased the cost of sales by changing to a cheaper supplier.

Comment on the profit margin

The profit margin has improved from 9.43% to 10.31%. This could be due to a higher gross profit, but it could also be due to an increase in other income.

Comment on the differences between the gross and profit margins

In 2022, the difference between the gross and profit margins was 22.82%. In 2023, this difference was 33.44%. The difference worsened, which could be because Sara and Taz had worse control over their expenses.

Comment on the return on capital employed

The return on capital employed worsened from 21.08% to 10.45%. This could be due to an increase in the capital employed. This may have involved more capital being introduced by the partners or a long-term loan.

Last updated: 20 May 2024

You've read 0 of your 5 free revision notes this week

Sign up now. It’s free!

Join the 100,000+ Students that ❤️ Save My Exams

the (exam) results speak for themselves:

Did this page help you?

Previous:Calculating Values using Accounting RatiosNext:Liquidity Ratios

Profitability Ratios (Cambridge (CIE) O Level Accounting)

Revision Note

What are profitability ratios?

Gross Margin

What is the gross margin?

Examiner Tips and Tricks

Worked Example

Mark-up

What is the mark-up?

Examiner Tips and Tricks

Profit Margin

What is the profit margin?

Worked Example

Return on Capital Employed (ROCE)

What is the return on capital employed (ROCE)?

Examiner Tips and Tricks

Worked Example

Evaluating Profitability

How do I evaluate the profitability of a business?

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

Worked Example

You've read 0 of your 5 free revision notes this week

Sign up now. It’s free!

Join the 100,000+ Students that ❤️ Save My Exams

Author: Dan Finlay

Author: Lucy Kirkham