F3 - Measuring profitability

What does ratio analysis allow for?

Allows for a more meaningful analysis of published accounts.

• Shows relationship between figures

• Used for comparisons over time

Inter and intra business comparisons

• Intra means between businesses e.g. to compare performance to competitors or to benchmark.

• Inter means within a business e.g. over time within one organisation or between branches.

What is Gross profit margin?

• Gross profit margin (GPM) is a measure of a firm’s profitability by looking at the relationship between gross profit and revenue.

If GPM is low or failing this may indicate that a firm

• Is not managing its costs of sales effectively e.g. are the cost of raw materials increasing?

• Sales are in decline

How is Gross profit margin calculated?

• Gross profit / revenue X 100

• GP / R X 100

What is Operating profit margin?

• Profit margin (or operating profit margin) is a measure of a firm’s profitability by looking at the relationship between operating profit and revenue.

If OPM is low or failing this may indicate that a firm

• Is not managing its expenses effectively e.g. wages are increasing or overheads are going up.

• Sales are in decline

How is Operating profit margin calculated?

• Profit / revenue X 100

• P / R X 100

What is Mark up?

• Mark-up is a measure of a firm’s profitability by looking at the relationship between gross profit and cost of sales.

If mark-up is low this may indicate that a firm

• Is not managing its cost of sales effectively e.g. raw material costs are too high.

• Is in a highly competitive market where firms compete on price.

How is mark-up calculated?

• Gross profit / cost of sales X 100

• GP / COS X 100

What is Return on Capital Employed (ROCE)

• A measure on how efficiently a business is using capital employed to generate profits.

What is Capital employed?

• All the money invested in the business from, share capital, reserves, long term loans.

How is Capital employed calculated?

• Total equity + non-current liabilities

• TE + NCL

How is Return on Capital Employed calculated?

• Operating profit / capital employed X 100

• OP / CE X 100

What is capital employed?

• Refers to the total amount of capital that a business uses to generate profits

What is share capital?

• The amount of money a company raises by issuing shares to its shareholders.

What are reserves?

• Funds set aside from profits for specific purposes or as a safety buffer.

What are retained earnings?

• The portion of net profit that is not distributed as dividends but kept in the business.