Unit 3.5 Ratio Analysis - Profitability Ratios

Ratio Analysis

A method of interpreting and assessing the financial performance of a business

Gross Profit Margin (GPM)

Gross Profit Margin (%) = Gross Profit / Sales Revenue x 100

How successful a company is in turning sales revenue into profit

• Example:
  GPM = 2500 / 4000 = 0.625 = 62.5%

• Represents:

  • For every dollar of revenue, how much gross profit it makes

  • The % profit made on just the production and sale of the product

  • Here, 62.5% of the revenue is kept as profit (before expenses)

• Can be used to assess

  • Whether pricing or production costs are sustainable

Increasing Gross Profit Margin (GPM)

• Increase quantity sold might not improve GPM because of the proportional increase in cost of sales (2nd box on the right)

• To increase GPM, (3rd box on the right)

  • Increase the difference between price and direct cost

    • Cheaper materials (eg. change supplier)

    • Cheaper labour (eg. outsourcing)

    • Increase productivity (eg. automation)

    • Raise the price if inelastic (e.g. few substitutes)

    • Reduce the price if elastic (e.g. lots of substitutes)

  • Alternative revenue streams

Profit Margin (PM)

Profit Margin (%) = Profit before interest and tax / Sales Revenue x 100

Measures overall profitability - after all costs have been removed

• Example:
  1400 / 4000 = 0.35 = 35%

• What contribute to low Profit Margin

  • High overhead (in-direct) costs

  • High R&D costs

  • High cost of sales (direct)

  • Low revenue 

• Pro: examining only the operating efficiency
  Limitation: not taking borrowing costs into consideration

Increasing Profit Margin

• Raising Revenue 

  • As per GPM

• Cutting Cost of Sales

  • As per GPM

• Cutting Expenses

  • Reduce utilities (e.g. electricity)

  • Reduce Managers salaries

• What about increasing marketing budget

  • Increase Sales

  • Increase Cost of Sales

  • Increase Expenses (Marketing)

  • Overall effect is hard to say

Return On Capital Employed (ROCE)

Profit before interest and tax / Capital Employed x 100

where, Capital Employed = Total Equity + Non-Current Liabilities

Capital Employed

• long-term source of finance for the company

• Total equity, i.e. share capital + Non-Current Liabilities, i.e. long-term debt capital

• Measures how much profit the business makes per $100 of long-term source of finance

• Improving ROCE

  • Increase Profit by 

    • raising revenues or 

    • decreasing COS or 

    • decreasing expenses

  • Increase operational efficiency, eg.

    • Selling old assets

    • Improving stock control

    • Increase economy of scales

    • Improve quality control