Using Profitability Ratios To Analyse Performance (Cambridge International IGCSE Business)

The gross profit margin

Spec point — "• Gross profit margin • Profit margin • Return on Capital Employed • Current ratio • Acid test ratio"

The gross profit margin

• This calculation shows the proportion of revenue that is turned into gross profit

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

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

Improving the gross profit margin

• The gross profit margin can be improved in two ways

  • The business can increase its sales revenue
  • The business can reduce its direct costs

How to increase the gross profit margin

Worked Example Head to Toe Wellbeing’s revenue in 2022 was $124,653. Its gross profit was $105,731

Calculate Head to Toe Wellbeing Ltd’s Gross Profit Margin in 2022

(2)

Step 1: Substitute the values into the formula

$\text{Gross} \text{profit} = \frac{Gross \text{profit} }{Sales revenue} \times 100

= \frac{$ 105 , 731}{ $ 124 , 653 }

= 0.8482$ [1]

Step 2: Multiply the outcome by 100 to find the percentage

$= 0.8482 \times 100

= 84.82 %$ [1]

• 84.82% of Head to Toe Wellbeing’s revenue was converted into gross profit during 2022

The net profit margin

• The Net Profit Margin shows the proportion of revenue that is turned into profit before interest and tax

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

$\text{Net profit margin =}\frac{\mathrm{Profit} \mathrm{before} \mathrm{interest} \mathrm{and} \mathrm{tax}}{\mathrm{Sales} \mathrm{revenue}}\times100$

Improving the net profit margin

• The profit margin can be improved in two ways

  • Increasing the gross profit margin (see above)

  • Reducing overhead costs by reducing staffing levels, relocating to cheaper premises or changing utility companies

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    • Replacing inefficient or outdated equipment may require staff training

Worked Example Head to Toe Wellbeing’s revenue in 2022 was $124,653. Its profit before interest and tax was $65,864

Calculate Head to Toe Wellbeing Ltd’s Profit Margin in 2022

(2)

Step 1: Substitute the values into the formula

text Net profit margin = end text (Profit before interest and tax)/(Sales revenue) x 100 > > = ($ 65 , 864)/($ 124 , 653) > > = 0.5284 **[1]

Step 2: Multiply the outcome by 100 to find the percentage

$= 0.5284 \times 100

= 52.84 %$ [1]

• In 2022,** 52.84% of Head to Toe Wellbeing’s revenue was converted into profit before interest and tax

Return on capital employed

• The return on capital employed (RoCE) measures how how effectively a business uses the capital invested in the business to generate profit

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

$\mathrm{Return} \mathrm{on} \mathrm{capital} \mathrm{employed}=\frac{\mathrm{Profit} \mathrm{before} \mathrm{interest} \mathrm{and} \mathrm{tax}}{\mathrm{Capital} \mathrm{employed}}\times100$

• RoCE be compared over time and with competitors

  • It can also be compared with **other potential capital investments, **such as savings rates

• The** capital employed figure** is usually provided for you

  • If required, it is calculated using the formula

$\mathrm{Capital} \mathrm{employed}=\mathrm{Non}-\mathrm{current} \mathrm{liabilities}+\mathrm{Equity}$

Improving RoCE

• When analysing the RoCE, the higher the 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

• To increase the RoCE, a business can

  • Increase the level of profit generated without introducing new capital into the business
  • Maintain the level of profit generated whilst reducing the amount of capital in the business

Worked Example The table shows an extract from the company accounts of Keals Cosmetics.

Non-current Liabilities	€1.5 million
Revenue	€7 million
Equity	€15.4 million
Profit before Interest & Tax	€2.2 million

Calculate Keals Cosmetics' Return on Capital Employed.

(3)

Step 1: Calculate the capital employed

$Capital \text{employed} = Non - \text{current} \text{liabilities} + Equity > > Capital \text{employed} = \text{€} 1.5 \mathrm{m} + \text{€} 15.4 \mathrm{m} > > Capital \text{employed} = \text{€} 16.9 \mathrm{m}$ [1]

Step 2: Divide Operating Profit by Capital Employed

RoCE = ( Profit before interest and tax)/(Capital employed) x 100 > > = (\text{€} 2.2 m)/(\text{€} 16.9 m) x 100 > > = 0.13 > > [1]

Step 3: Multiply the result by 100 and express the outcome as a percentage

$= 0.13 \times 100 = 13 \%$****[1 mark]**

• Capital employed in Keals Cosmetics has generated a return of** 13%

Using RoCE to make decisions

• RoCE can be used to support strategic decisions (e.g. investment or divestment decisions) to determine the most profitable option given the level of capital employed

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	Profit before interest and tax
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

RoCE = (Profit before interest and tax)/(Capital employed) x 100 > > RoCE Sevenoaks = (\pounds 0.37 m)/(\pounds 2.4 m) x 100 = 15.42 %****[1]**

$> \text{RoCE} \text{Whitstable} = \frac{\pounds 0.57 \mathrm{m} }{\pounds 3.1 \mathrm{m} } \times 100 = 18.39 \%$** [1]

$\text{RoCE} \text{Rochester} = \frac{\pounds 0.51 \mathrm{m} }{\pounds 2.9 \mathrm{m} } \times 100 = 17.59 \%$****[1]**

Step 2: Identify the least profitable branch for closure

• Sevenoaks is the least profitable branch with a RoCE of 15.42% and should be the branch selected for closure** [2]

Exam Hint When calculating financial ratios check that you are using the correct units.

In some cases financial data is presented as raw figures (e.g. £14,520) but in most cases, you will be working in thousands (£000) or millions (£m).

• Ensure that you convert correctly, e.g. £0.39 million is equal to £390,000 and £34.9 (000) is equal to £34,900
• Make sure the decimal place is in the correct place
• Calculate to two decimal places unless stated otherwise