Profitability ratio

Profitability ratio

• Ratio analysis involves extracting information from financial accounts to assess business performance and answer key questions including 

  • Why is one business more profitable than another in the same industry?

  • Is a business growing?

  • How effectively is a business using assets and capital invested?

  • What returns on investment are expected?

  • How risky is the financial structure of the business?

ratio analysis process

three main profitability ratios are

• The Gross Profit Margin

• The Profit Margin

• Return on Capital Employed (RoCE)

Profit Margins

• A profit margin measures the proportion of revenue that is converted into profit

• Profit margins can be compared to previous years to better understand business performance

  • Higher and increasing profit margins are preferable, as it means that more revenue is being converted to profit

Gross profit margin 

• This shows the proportion of revenue that is turned into gross profit and is expressed as a percentage

  • (Gross profit / sales revenue) x 100

Return on Capital Employed

• It compares the profit made by a business to the amount of capital invested in the business

• It is a measure how effectively a business uses the capital invested in the business to generate profit

• Return on Capital Employed is a key performance indicator that can be compared over time and also with competitors and other potential capital investments

• Return on Capital Employed is expressed as a percentage and can be calculated using the formula (profit before interest and tax) / capital employed x 100

capital employed

non-current liabilities + equity

Improving Profitability Ratios

• Businesses aim to improve their profit margins over time

• Whilst profit margins may fall as a result of external factors (for example, the cost of raw materials may rise as a result of poor weather damaging raw materials) there are a number of internal steps a business can take to improve its profit margins

Improving the gross profit margin

• They can increase their sales revenue

• They can reduce their direct costs