34.2 Profitability ratios

Profitability

The ability of a company to generate earnings relative to revenue, operating costs, balance sheet assets or shareholder's equity over time. It assesses company performance by comparing profit levels with sales or capital invested.
- Gross profit margin ratio
- Operating profit margin ratio
- Return on capital employed ratio

Gross profit margin ration

A profitability ratio that aims to measure the ability of management to convert revenue into gross profit. It is a good indicator of how well the management team has added value to the cost of sales. A low gross profit margin ratio might suggest that a low-pricing strategy is employed or that there is higher cost of sales per unit.

Formula: (gross profit / revenue) x 100

Operating profit margin ratio

A profitability ratio that aims to measure how successful a business is in converting sales into profit from operations. A high operating profit margin ratio indicates efficient expense management, in order to maximize profitability. Previous figures should also be considered to gain a clearer picture of company performance.

Formula: (operating profit (profit from operation) / revenue) x 100

Return on capital employed/Primary efficiency ratio

A profitability ratio that aims to measure how successful a business is, in using capital to generate profits.
The higher the value of this ratio, the greater the return on the capital invested in the business.
The RoCE of a business can be raised by increasing the profitable, efficient use of the assets owned by the business, which were purchased by the capital employed.

Formula: (operating profit (profit from operation) / capital employed) x 100

Capital employed

The total amount of capital a business uses to operate and generate profits. It aims to provide a picture of how the company invests its money.
Formula: non-current liabilities + shareholders' equity (where shareholders' equity = issued shares + reserves)

Method to improve profitability

1. Reduce direct costs:
- Lower-cost materials: quality may be damaged and as a result the product reputation as well
- Cut labor costs (offshoring production): quality and communication issues (distance & different quality control)
- Cut labor costs by increasing productivity through automation: overhead costs for buying equipment, training employees and short-term profits might be cut
- Cut wage costs by reducing pay: motivation levels may fall


2. Increase prices:
- Increase profit on each item sold: customers may switch to competitors who are offering lower prices. Link between price elasticity of demand


3. Increase profit margin by reducing overheads/interests costs
- Reduce promotion costs: can lead to lower sales by more than fixed costs
- Delayer organization: taking out management might negatively affect the efficiency of operations
- Reduce long-term borrowing by raising finance through issue of shares: success heavily depends on investors confidence
- Relocate to low-cost site: low rental might mean less attractive area

Methods to increase return on capital employed

1. Increase operating profit without increasing capital employed:
- raise prices: demand could be price elastic
- reduce direct costs per unit: cheaper materials might cause quality issues
- reduce overheads (delayering, reduce promotion costs): might have drawbacks such as fall in sales)

2. Reduce capital employed:
- sell assets that don't contribute to the business and use finance to reduce debt: the asset might be needed in the future