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# Interpreting Accounts: Profitability Ratios

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### Interpreting Accounts: Profitability Ratios

1. 1. Profitability Ratios
2. 2. What is profit? Profit is the reward or return fortaking risks & making investments
3. 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. 4. Remember the profit formula PROFIT = TOTAL SALES less TOTAL COSTS
5. 5. Profit can be broken down into…
6. 6. What is ratio analysis?Analysing relationshipsAnalysing relationshipsbetween financial databetween financial data to assess the to assess the performance of a performance of a business business
7. 7. Profitability ratios can help answer questions like…
8. 8. Main profitability ratios
9. 9. Gross Profit Margin
10. 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. 11. Gross profit margin - formula Gross profitMargin (%) = 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. 12. Operating Profit Margin
13. 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. 14. Operating profit margin - formulaOperating Operating profit profit = X 100 margin Sales (or revenues) Note: operating profit margin is expressed as a percentage
15. 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. 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. 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. 18. Return on CapitalEmployed (ROCE)
19. 19. Return on Capital Employed Operating profitROCE (%) = x 100 Capital employedExampleExample 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. 20. Evaluating ROCE Higher % is better Higher % is betterROCE 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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