Using Profitability Ratios to Analyse Performance (Cambridge (CIE) O Level Business Studies)

Revision Note

Written by: Lisa Eades

Reviewed by: Steve Vorster

The Gross Profit Margin

This calculation shows the proportion of revenue that is turned into gross profit
- It is calculated using the following formula and is expressed as a percentage

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

Improving the gross profit margin

The gross profit margin can be improved in two ways
- The business can increase its sales revenue
- The business can reduce its direct costs

How to Increase the Gross Profit Margin

Method	Explanation
Increase the sales revenue	1. Increase the value of sales Raise prices If costs remain the same, this will improve profitability as the difference between the selling price and costs is now greater Sell premium products If customers are willing to spend money on these goods, the business could earn more profit per item sold 2. Increase the volume of sales 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 Increase marketing activities Engage in more marketing activities to increase sales volume
Reduce the 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 the sales revenue

1. Increase the value of sales

Raise prices
- If costs remain the same, this will improve profitability as the difference between the selling price and costs is now greater
Sell premium products
- If customers are willing to spend money on these goods, the business could earn more profit per item sold

2. Increase the volume of sales

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
Increase marketing activities
- Engage in more marketing activities to increase sales volume

Reduce the 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

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 marks]

Step 1: Substitute the values into the formula

$Gross profit = \frac{Gross profit}{Sales revenue} \times 100 = \frac{$ 105, 731}{$ 124, 653} = 0.8482$ [1 mark]

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

$= 0.8482 \times 100 = 84.82 %$ [1 mark]

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

The Net Profit Margin

The Net Profit Margin shows the proportion of revenue that is turned into profit before interest and tax
- It is calculated using the formula below and the outcome is expressed as a percentage

$Net Profit Margin = \frac{Profit Before Interest and Tax}{Sales Revenue} \times 100$

Improving the net profit margin

The profit margin can be improved in two ways
- Increasing the gross profit margin (see above)
- Reducing overhead costs by reducing staffing levels, relocating to cheaper premises or changing utility companies
  - Reducing staffing levels may affect staff morale and negatively affect productivity
  - Relocation costs can outweigh some of the benefits of moving to a cheaper location
  - Replacing inefficient or outdated equipment may require staff training

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 marks]

Step 1: Substitute the values into the formula

$Net Profit Margin = \frac{Profit Before Interest and Tax}{Sales Revenue} \times 100 = \frac{$ 65, 864}{$ 124, 653} = 0.5284$ [1 mark]

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

$= 0.5284 \times 100 = 52.84 %$ [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 (RoCE) measures how how effectively a business uses the capital invested in the business to generate profit
- It is calculated using the formula below and is expressed as a percentage

$Return on Capital Employed = \frac{Profit Before Interest and Tax}{Capital Employed} \times 100$

RoCE be compared over time and with competitors
- It can also be compared with other potential capital investments, such as savings rates
The Capital Employed figure is usually provided for you
- If required, it is calculated using the formula

$Capital Employed = Non - current Liabilities + Equity$

Improving RoCE

When analysing the 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, 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

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]

Step 1: Calculate the capital employed

$Capital employed = Non - current liabilities + Equity Capital employed = € 1.5 m + € 15.4 m Capital employed = € 16.9 m$ [1 mark]

Step 2: Divide Operating Profit by Capital Employed

$RoCE = \frac{Profit Before Interest and Tax}{Capital Employed} \times 100 = \frac{€ 2.2 m}{€ 16.9 m} \times 100 = 0.13$ [1 mark]

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

$= 0.13 \times 100 = 13 %$ [1 mark]

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

Using RoCE to make decisions

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

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]

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

$RoCE = \frac{Profit Before Interest and Tax}{Capital Employed} \times 100 RoCE Sevenoaks = \frac{£ 0.37 m}{£ 2.4 m} \times 100 = 15.42 %$ (1 mark)

$RoCE Whitstable = \frac{£ 0.57 m}{£ 3.1 m} \times 100 = 18.39 %$ (1 mark)

$RoCE Rochester = \frac{£ 0.51 m}{£ 2.9 m} \times 100 = 17.59 %$ (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. £0.39 million 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: 23 October 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:Profitability & LiquidityNext:Using Liquidity Ratios to Analyse Performance

Using Profitability Ratios to Analyse Performance (Cambridge (CIE) O Level Business Studies)

Revision Note

The Gross Profit Margin

Improving the gross profit margin

Worked Example

The Net Profit Margin

Improving the net profit margin

Worked Example

Return on Capital Employed

Improving RoCE

Worked Example

Using RoCE to make decisions

Worked Example

Examiner Tips and Tricks

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: Lisa Eades

Author: Steve Vorster