Chapter 18 ; The interpretation of profitability ratios

Profitability

The ability of a business to earn a profit basin on the use of resources

What are comparisons usually made between

Previous accounting periods

Indurstry averages

Budgets and expectations

Government statistics

Other ratios

Gross profit margin calculation

(gross profits / sales revenue) x 100

What does gross profit represent

The difference between sales revenue and cost of sales. It works out the proportion of sales revenue that becomes gross profit

Profit margin

refers to sales minus the cost of goods sold

Mark up

refers to the amount by which the cost of a good is increased in order to get the final selling price

How to calculate the gross profit margin

Sales revenue is 100%

Cost of goods sold is 100% minus margin

Gross profit is the margin %

How to calculate the gross profit mark up

Sales revenue is 100% plus the mark up

Cost of goods sold it 100%

Gross profit is the margin

Net profit margin calculation

(profit for the year/ sales revenue) x 100

Net profit margin

represents the difference between sales revenue and all costs i.e the overall profit made for the year . It is an expansion of the gross profit margin and includes all of the expense and other items that come after gross profit

return on capital employed calculation

(profit for the year/capital employed) x 100 where capital employed = capital + non-current liabilities

Return on capital employed

Measures how much net profit is generated for every £1 capital invested in the business

Expense over revenue percentage calculation

(expense/sales revenue) x 100

Expense over revenue percentage

To show the relationship between an individual expense or a group of expense and sales revenue

Relationship between the SPL and the SFP

The net profit figure in the statement of profit or loss is added to the capital section in the statement of financial position, to alter the overall total. In the case of the net loss figure this would be deducted for the capital section on the statement of financial position to alter the overall total

Planning

The detail formulation of activities to achieve defined objectives, planning tales into consideration where a business is, where it wants to be and therefore how it will get there

Decision making

The process of deciding upon a solution based upon a number of alternatives

Control

Monitoring the performance of a business in comparison to its objectives, in order to know if the objectives are being met and if not what corrective action should be taken

Factors that cause changes in a businesses ratios and differences between businesses ratios

Changes in this ration may be attributable to changes in

-Selling prices

-Product mix

-Purchase costs

-Production costs for a manufacturing business

-Inventory valuations

Comparing gross profit margin over time

IF gross profit has not increased in line with sales revenue it may be due to

-Increased purchase costs

-Inventory write offs

-Other costs allocated to cost of sales

Comparing net profit margin over time

If the gross profit margin is measure of how profitably a business can produce and sell its products and services the net profit margin also measures how effectively the business manages and administers that process