Profitability ratios

Profitability Ratios are used to measure things in proportion to a benchmark of some kind.  Below are some of the most common showing the formula, what they mean and (in theory at least) how they can be improved.

Gross Profit Margin

Gross Profit x 100 = x%

Sales

•          Explain: This means that for every £1 of sales a firm makes x pence in direct profit– i.e. a higher profit for each item which has been sold

•          Comparison - a  higher figure is usually better so compare with similar business, last year’s figures or industry averages

•          How can we improve it?   

–        Increase the selling price without affecting cost of sales (purchase price).  This might reduce the sales quantity and thus the overall gross profit though.

–        Reduce the cost of sales whilst maintaining the selling price (this might affect quality which could put customers off)

Profit in relation to turnover ratio

Profit for the year (Net Profit)   x 100 = x%

Sales Revenue (Turnover)

•          Explanation: This means that every £1 of sales a firm makes x pence in total profit.

•          Comparison:  a higher figure is usually better so compare with similar business, last year’s figures or industrial averages

•          How can we improve it?  –

–        increase the Gross profit margin (see above) whilst maintaining the expenses figure

–        reduce expenses (such as wages, utility bills) without affecting the sales revenue (this could compromise staffing or H&S which could affect sales revenue.  It is not always that easy to do this though!

Gross Profit Mark up

Gross Profit x 100 = x%

Cost of Sales

•           Explanation -  This means that for every £1 of purchase cost a firm adds on x pence
•      Comparison:  a higher figure is usually better so compare with similar business, last year’s figures       or  industrial averages 
•          How can we improve it?  
•         Increase the selling price without affecting cost of sales (this might reduce the sales quantity and thus the overall gross profit)
• Reduce the cost of sales (purchase price)  whilst maintaining the selling price (this might affect quality which could put customers off)

Expenses in relation to turnover

Expenses              x 100 = x%

                (Sales) Revenue

•  Explanation: This means that for every £1 of sales a firm has x pence in expenses 
•  Comparison:  a lower figure is usually better so compare with similar business, last year’s figures or  industrial averages

• How can we improve it  – 
• increase the Gross profit margin (see above) whilst maintaining the expenses figure
• reduce expenses (such as wages, utility bills) without affecting the sales revenue (this could compromise staffing or H&S which could affect sales revenue.  It is not always that easy to do this though!

Return on Capital Employed

Profit from Operations x 100

Opening Capital

NB if no Operating profit available then use Net Profit

• Explanation: ROCE shows how quickly a firm recoups your investment.  A 50% figure means you get your opening capital back in 2 years
•  Comparison:  A higher figure means the company is returning the owners investment at a faster rate.  You need to compare with similar business, last year’s figures or industrial averages
•  How can we improve it? –
• increase the Operating profit (see other profitability ratios) in proportion to capital.

• Assessment: Figures for this may be high in new markets.  However as firms grow this is hard to maintain.  Companies with a high ROCE percentage may find copycat companies enter the market aiming to steal customers and market share.