Profitability Ratios (Edexcel IGCSE Accounting)

Profitability

Spec point — IGCSE_ACCOUNTING:S4.171

What is profitability?

• Profitability is a measure of the ability of a business to generate profits from its activities

  • This measures the ability to succeed in the future

What are the profitability ratios?

• Profitability ratios assess a company's ability to earn profits from sales, operations or assets

  • They compare profits to other values such as revenue, costs and capital employed

• The main profitability ratios are:

  • Gross profit percentage
  • Mark-up
  • Profit for the year as a percentage of revenue
  • Return on capital employed

Gross Profit Percentage

Spec point — IGCSE_ACCOUNTING:S4.171

What is the gross profit percentage?

• If the gross profit percentage decreases then this suggests that:

  • The goods are being sold at a cheaper price than in previous years

    • Allowing more trade discounts has the same effect

  • The costs of goods have increased but their selling price has remained the same

Exam Hint The gross profit percentage must be less than 100%. If you get an answer bigger than 100% then check your working.

Worked Example Kaley is a sole trader. She provides the following information for the year ended 31 December 2023.

	$
Revenue	128 000
Purchases	52 000
Inventory at 1 January 2023	8 000
Inventory at 31 December 2023	6 000

Calculate Kaley's gross profit percentage. Your answer should be correct to two decimal places.

Answer

• Calculate the cost of sales

  • Opening inventory + Purchases - Closing inventory
  • $8 000 + $52 000 - $6 000 = $54 000

• Calculate the gross profit

  • Revenue - Cost of sales
  • $128 000 - $54 000 = $74 000

• Calculate the gross profit percentage

  • $\frac{\mathrm{Gross} \mathrm{profit}}{\mathrm{Revenue}}\times100$
  • $\frac{74000}{128000}\times100=57.8125$

• Round to two decimal places

  • Gross margin = 57.81%

Mark-up

What is the mark-up?

• The mark-up is normally a fixed percentage applied to the cost of the goods

  • The percentage can be raised to increase profits

Exam Hint The mark-up can be bigger than 100% so do not worry if your answer is bigger than 100%.

Profit for the Year as a Percentage of Revenue

Spec point — IGCSE_ACCOUNTING:S4.171

What is the profit for the year as a percentage of revenue?

• A decreasing profit for the year as a percentage of revenue suggests that:

  • Gross profit has decreased from previous years
  • The business is paying more for expenses
  • The business is not earning as much other income as in previous years

Worked Example Kaley is a sole trader. She provides the following information for the year ended 31 December 2023.

	$
Revenue	128 000
Gross profit for the year	74 000
Other income	9 000
Expenses	46 000

Calculate Kaley's profit for the year as a percentage of revenue. Your answer should be correct to two decimal places.

Answer

• Calculate the profit for the year

  • Gross profit + Other income - Expenses
  • $74 000 + $9 000 - $46 000 = $37 000

• Calculate the profit for the year as a percentage of revenue

  • $\frac{\mathrm{Profit} \mathrm{for} \mathrm{the} \mathrm{year}}{\mathrm{Revenue}}\times100$
  • $\frac{37000}{128000}\times100=28.90625$

• Round to two decimal places

  • Profit margin = 28.91%

Return on Capital Employed (ROCE)

Spec point — IGCSE_ACCOUNTING:S4.171

What is the return on capital employed (ROCE)?

• A business aims to increase the return on capital employed

  • The business should consider whether it can use more short-term sources of finance rather than long-term loans

Worked Example The equity and liabilities of Khazam at 31 December 2023 are listed below.

	$
Equity	160 000
Bank loan	100 000
Trade payables	25 000

The profit for the year ended 31 December 2023 was $36 500.

Calculate the return on capital employed for the year ended 31 December 2023. The calculation should be correct to two decimal places.

Answer

• Calculate the capital employed

  • Equity + Non-current liabilities
  • $160 000 + $100 000 = $260 000

• Calculate the return on capital employed

  • $\frac{\mathrm{Profit} \mathrm{for} \mathrm{the} \mathrm{year}}{\mathrm{Capital} \mathrm{employed}}\times100$
  • $\frac{36500}{260000}\times100=14.0384...$

• Round to two decimal places

  • ROCE = 14.04%

Evaluating Profitability

Spec point — IGCSE_ACCOUNTING:S4.171

How do I evaluate the profitability of a business?

• It is best to look at multiple profitability ratios together to get a better understanding

  • The gross profit percentage might be high but the profit for the year as a percentage of revenue might be low

    • This suggests that gross profit is not an issue
    • The business needs to look at other income and expenses

  • The difference between the gross profit percentage and profit for the year as a percentage of revenue is the proportion of revenue that is spent on expenses after deducting other income

    • A smaller difference indicates that a business has better control of expenses

• Consider actions which have a positive and negative effect

  • For example, if a business finds a cheaper supplier:

    • The gross profit percentage might increase as a result of lower cost of sales
    • However, the quality of the goods might not be as good, which could cause customers to shop elsewhere, reducing sales revenue

How do I compare the profitability of a business between years?

• Compare the ratios to the same ratios from previous years

• For each ratio

  • Make a general comment

    • State whether it has improved or gotten worse

  • Give possible reasons for the change

• Calculate the difference between the gross profit percentage and the profit for the year as a percentage of revenue to see if the business has gotten better at controlling expenses

• Give an overall comment or conclusion about the profitability

Worked Example Sana and Taz are business partners. They provide information for the financial years ending 31 December 2022 and 31 December 2023.

	Year ended
31 December 2022	31 December 2023
Gross margin	32.25%	43.75%
Profit margin	9.43%	10.31%
Return on capital employed	21.08%	10.45%

Comment on the performance of the business over the two years.

Answer

• Comment on the gross profit percentage

Final answer: The gross profit percentage has improved from 32.25% to 43.75%. This could be because Sana and Taz increased the selling prices of their goods. They could have decreased the cost of sales by changing to a cheaper supplier.

• Comment on the profit for the year as a percentage of revenue

Final answer: The profit for the year as a percentage of revenue has improved from 9.43% to 10.31%. This could be due to a higher gross profit, but it could also be due to an increase in other income.

• Comment on the differences between the percentages

Final answer: In 2022, the difference between the gross profit percentage and the profit for the year as a percentage of revenue was 22.82%. In 2023, this difference was 33.44%. The difference worsened, which could be because Sara and Taz had worse control over their expenses.

• Comment on the return on capital employed

Final answer: The return on capital employed worsened from 21.08% to 10.45%. This could be due to an increase in the capital employed. This may have involved more capital being introduced by the partners or a long-term loan.

• Give an overall comment

Final answer: Overall, profitability has worsened.