This document discusses various profitability ratios that can help measure and assess a business's performance. It defines profit, gross profit margin, operating profit margin, and net profit margin. Gross profit margin measures profit as a percentage of revenue. Operating profit margin measures operating profit as a percentage of sales. Net profit margin indicates how effectively a business turns sales into profit. Return on capital employed (ROCE) measures operating profit as a percentage of capital invested in the business. Ratio analysis allows comparison of ratios over time and between competitors to evaluate relative performance.

1. Profitability
Ratios

2. What is profit?
Profit is the
reward or return for
taking risks & making
investments

3. Two ways of measuring profit
• Profit in absolute terms
– The £ value of profits earned
– E.g. £50,000 profit made in the year
• Profit in relative terms
– The profit earned as a proportion of sales
achieved or investment made
– E.g. £50,000 profit from £500,000 of sales is a
profit margin of 10%
– E.g. £50,000 profit from an investment of £1
million = a 5% return on investment

4. Remember the profit formula
PROFIT =
TOTAL SALES
less
TOTAL COSTS

5. Profit can be broken down into…

6. What is ratio analysis?
Analysing relationships
Analysing relationships
between financial data
between financial data
to assess the
to assess the
performance of a
performance of a
business
business

7. Profitability ratios can help answer
questions like…

8. Main profitability ratios

9. Gross Profit
Margin

10. The gross profit margin
£'000 2010 2011 2012
Revenue 250 325 400
Cost of Sales 150 186 225
Gross Profit 100 139 175
Gross margin 40.0% 42.8% 43.8%
Gross profit = revenue Gross margin (%) = gross
less cost of sales profit / revenue

11. Gross profit margin - formula
Gross profit
Margin (%) = x 100
Sales Revenue
Example
Example
Gross profit = £200,000
Gross profit = £200,000
Revenue = £800,000
Revenue = £800,000
ROCE = £200,000/ £800,000 = 25%
ROCE = £200,000/ £800,000 = 25%

12. Operating Profit
Margin

13. What is operating profit?
Operating profit Example £’000
is what is left Sales 150
after all the Wages (50)
costs of a Energy costs (25)
business have Marketing (15)
been taken Other overheads (30)
from its sales OPERATING PROFIT 30
revenue Operating profit margin 20%

14. Operating profit margin - formula
Operating Operating profit
profit = X 100
margin Sales (or revenues)
Note: operating profit margin is
expressed as a percentage

15. What does Net Profit Margin tell us?
• How effectively a business turns its
sales into profit
• How efficiently a business is run
• Whether a business is able to “add
value” during the production process
(a high margin business must be
doing something right!)

16. The Importance of Comparison (1)
The net profit margin of a business should be
compared with other competitors in the same
market, and over time
Company A Company B Company C
Example
£’000 £’000 £’000
Sales 150 250 500
Net profit 50 25 125
Net margin 20% 10% 25%

17. The Importance of Comparison (2)
Company A Company B Company C
Example
£’000 £’000 £’000
Sales 150 250 500
Net profit 50 25 125
Net margin 20% 10% 25%
Company A makes a higher Company C makes the
net profit than Company B highest net margin of these
even though its sales are three & also the highest
lower – because it has a sales. So it makes the
higher net profit margin largest net profit too

18. Return on Capital
Employed (ROCE)

19. Return on Capital Employed
Operating profit
ROCE (%) = x 100
Capital employed
Example
Example
Operating profit = £280,000
Operating profit = £280,000
Capital employed = £1,400,000
Capital employed = £1,400,000
ROCE = £280,000 / £1,400,000 = 20%
ROCE = £280,000 / £1,400,000 = 20%

20. Evaluating ROCE
Higher % is better
Higher % is better
ROCE Watch for trend over time
Watch for trend over time
% Watch out for low quality
Watch out for low quality
profit which boosts ROCE
profit which boosts ROCE
Leased equipment will not be
Leased equipment will not be
included in capital employed
included in capital employed

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