Profitability Ratios (Cambridge International A-Level Business)

The meaning and importance of profitability

• Profitability is a measure of how effectively a business converts revenue into profit or how well capital invested in a business is used to generate profit

• Profitability can be compared to previous years to better understand business performance

• Higher and increasing profit margins are preferable

  • More revenue is being converted to profit
  • Capital invested is being used more effectively to generate profit

Why is profitability important?

1. Profitability shows business success

• It indicates whether a business is generating more income than it spends, which is a key measure of financial health

1. Profits provide internal finance

• Retained profit can be reinvested in the business, reducing the need for external borrowing

1. Profitability attracts investors and lenders

• A profitable business is more likely to secure funding, as it shows the business can generate returns and repay debts

Return on capital employed

• The return on capital employed compares the profit made by a business to the amount of capital invested in the business

  • It is a measure how 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

$\mathrm{Return} \mathrm{on} \mathrm{capital} \mathrm{employed}=\frac{\mathrm{Profit} \mathrm{from} \mathrm{operations}}{\mathrm{Capital} \mathrm{employed}}\times100$

• Capital employed is calculated using the formula

$\mathrm{Capital} \mathrm{employed}=\mathrm{Issued} \mathrm{shares}+\mathrm{Reserves}+\mathrm{Non}-\mathrm{current} \mathrm{liabilities}$

Worked Example Faced with increasing costs, Kent & Medway Properties Ltd* *is looking to close one of its three high-street estate agency branches.

The table below shows some key data for each of the branches.

Branch	Capital Employed	Operating Profit
Sevenoaks	£2.4m	£0.37m
Whitstable	£3.1m	£0.57m
Rochester	£2.9m	£0.51m

Calculate the return on capital employed (RoCE) for each branch and recommend which branch, on profitability terms, should close.

(5)

Step 1: Apply the formula to calculate the RoCE for each branch

$\text{Return} \text{on} \text{capital} \text{employed} = \frac{Profit \text{from} operations}{Capital employed} \times 100

\text{Sevenoaks} = \frac{\pounds 0.37 \mathrm{m} }{\pounds 2.4 \mathrm{m} } \times 100 = 15.42 %

\text{Whitstable} = \frac{\pounds 0.57 \mathrm{m} }{\pounds 3.1 \mathrm{m} } \times 100 = 18.39 %

\text{Rochester} = \frac{\pounds 0.51 \mathrm{m} }{\pounds 2.9 \mathrm{m} } \times 100 = 17.59 % $ (3)

Step 2: Identify the least profitable branch for closure

• Sevenoaks is the least profitable branch (1) with a RoCE of 15.42% (1) and should be the branch selected for closure

Interpreting ROCE

• The ROCE rate differs between industries, so comparison across different sectors is not recommended

  • It can be compared with other forms of return, such as:

    • interest rates on savings and
    • with other businesses within the same industry

• The higher the ROCE rate, the better, as it indicates that the business is profitable and using its capital efficiently

  • Investors prefer businesses with stable and rising levels of ROCE, as this indicates low-risk growth is being achieved
  • A ROCE of at least 20 per cent is usually a good sign that the company is in a good financial position

Gross profit margin

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

  • A higher and increasing gross profit margins is preferable, as it means more revenue is being converted to gross profit

Using the gross profit margin

• Pricing and product mix

  • A high gross margin gives scope to discount or bundle products
  • A low gross profit margin signals the need for higher prices or cheaper materials and components

• Supplier negotiations

  • A falling gross profit margin can be a trigger for discussing better raw material prices with suppliers or switching to alternative suppliers

• Changes in the gross profit margin indicate how well managers are keeping direct costs low or encouraging sales

  • A rising gross profit margin indicates increasing levels of sales revenue and/or falling cost of sales
  • A falling gross profit margin indicates lower sales revenue and/or a rising cost of sales

Calculating the gross profit margin

• Gross profit margin is expressed as a percentage and calculated using the formula

$\mathrm{Gross} \mathrm{profit} \mathrm{margin}=\frac{\mathrm{Gross} \mathrm{profit}}{\mathrm{Sales} \mathrm{revenue}}\times100$

Worked Example An e-scooter manufacturer sells its products to retailers for €180 per unit. Variable costs are €72 per scooter, with monthly fixed costs being €82,000. The manufacturer sells 2,200 scooters a month

The business pays €240 interest on a mortgage each month. It pays corporation tax of €372,000

Calculate the business's gross profit margin for the year

(3)

Step 1: Calculate the gross profit per unit

$= \text{€} 180 - \text{€} 72

= \text{€} 108$ (1)

Step 2: Calculate the gross profit per month

$= \text{€} 108 \times 2 , 200 \text{scooters} > > = \text{€} 237 , 600$

Step 3: Calculate the gross profit per year

$= \text{€} 237 , 600 \times 12

= \text{€} 2 , 851 , 200$ (1)

Step 4: Calculate the revenue per month and then per year

$= \text{€} 180 \times 2 , 200

= \text{€} 396 , 000

= \text{€} 396 , 000 \times 12

= \text{€} 4 , 752 , 000$

Step 5: Calculate the gross profit margin

$= \frac{\text{€} 2 , 851 , 200}{\text{€} 4 , 752 , 000} \times 100

= 60 %$ (1)

Profit margin

• The profit margin shows the proportion of revenue that is turned into profit from operations

• Changes in the profit margin indicate how well managers are keeping indirect costs low or encouraging sales

  • A rising profit margin indicates increasing levels of sales revenue and/or falling indirect costs
  • A falling profit margin indicates lower sales revenue and/or rising indirect costs

Using the profit margin

• Cost structure reviews

  • A falling profit margin highlights rising overheads (e.g. logistics, energy or wages) and may require managers to take steps to improve efficiency

• Expansion or cutbacks

  • Steady profit margins support store openings or marketing campaigns, while falling margins may delay these plans

Calculating the profit margin

• It is expressed as a percentage and calculated using the formula:

$\mathrm{Profit} \mathrm{margin}=\frac{\mathrm{Profit} \mathrm{from} \mathrm{operations}}{\mathrm{Sales} \mathrm{revenue}}\times100$

Worked Example An e-scooter manufacturer sells its products to retailers for €180 per unit. Variable costs are €72 per scooter, with monthly fixed costs being €82,000. The manufacturer sells 2,200 scooters a month

The business pays €240 interest on a mortgage each month. It pays corporation tax of €372,000

Calculate the business's profit margin for the year

[3]

Step 1: Calculate the total variable costs for the year

$= ( \text{€} 72 \times \pounds 2 , 200 ) \times 12

= \text{€} 1 , 900 , 800$ (1)

Step 2: Calculate the total fixed costs for the year

$= \text{€} 82 , 000 \times 12

= \text{€} 984 , 000$

Step 3: Calculate the total costs for the year

$= \text{€} 1 , 900 , 800 + \text{€} 984 , 000

= \text{€} 2 , 884 , 800$ (1)

Step 4: Calculate the profit for the year

$= \text{€} 4 , 752 , 000 - \text{€} 2 , 884 , 800

= \text{€} 1 , 867 , 200 $

Step 5: Calculate the profit margin

$= \frac{\text{€} 1 , 867 , 200}{\text{€} 4 , 752 , 000} \times 100

= 39.29 %$ (1)

Methods of improving profitability

Ways to increase ROCE

• Make more profit without spending more money

  • If a business earns more money (profit) but doesn't take on extra loans or investment, it will get more return from the same amount of capital
  • Example: A shop sells more products without having to buy new equipment

• Use less capital to make the same profit

  • If a business keeps profit the same but uses less money overall (e.g. sells off unused equipment or pays off debt), it will be more efficient with what it has
  • Example: A company stops renting a second office and saves money, but still keeps sales and profit steady

Ways to improve the gross profit margin

• The gross profit margin can be improved in two ways

  • They can increase their sales revenue
  • They can reduce their direct costs

1. Increase sales revenue

• Increase the value of sales

  • Raise prices

    • If costs remain the same, raising prices will increase profitability
    • The gap between selling price and costs becomes larger, resulting in more profit per unit sold

  • Sell premium products

    • Offering higher-end or luxury products can increase the profit earned per item
    • If customers are willing to spend more, the business benefits from higher revenue per sale

• Increase the volume of sales

  • Price tactics

    • Use promotional pricing strategies to encourage customers to buy more or buy more often
    • For example, a "buy one get one half price" offer may double the number of items purchased, increasing total revenue

  • Increase marketing activities

    • Run more promotional campaigns or advertising to raise awareness and drive sales volume
    • Greater exposure can lead to more customers and more frequent purchases

2. Reduce direct costs

• Reduce variable costs

  • Look for ways to cut the cost of raw materials or components

    • This might involve purchasing cheaper alternatives, negotiating better deals with suppliers, or buying in bulk
    • Care must be taken to ensure that reducing costs does not harm product quality or customer satisfaction
    • Bulk buying may also require more storage space, which could reduce the overall cost savings

  • Businesses can also reduce waste in the use of materials and components to further cut costs

Ways to improve the profit margin

• The profit margin can be improved in two ways

  • Increasing the gross profit margin (see above)
  • Reducing overhead costs

Reduce overhead costs

• Reducing staffing levels, relocating to cheaper premises or changing utility companies can reduce expenses

  • Reducing staffing levels may affect staff morale and negatively affect productivity
  • Relocation costs can outweigh some benefits of moving to a cheaper location
  • Replacing inefficient or outdated equipment may require staff training