Accounting Ratios (Edexcel IGCSE Business)

An introduction to ratio analysis

Spec point — 3.5.1 · Calculating and analysing accounting ratios

• Ratio analysis involves extracting information from financial accounts to assess business performance

• It helps managers to answer key questions including

  • Why is one business more profitable than another one in the same industry?
  • Is a business growing?
  • How effectively is a business using assets and capital invested?
  • What return on investment is expected?
  • How risky is the financial structure of the business?

• Ratios can be compared over time and between businesses or functions to determine how well financial objectives are being met

Exam Hint Formulas to calculate profit margins, mark up, RoCE and liquidity are provided on page 2 of your exam paper.

Profit margins

Spec point — 3.5.1 · Calculating and analysing accounting ratios: • gross profit margin • operating profit margin

Profit margins

• Profit margins measure of how effectively a business converts revenue into profit

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

  • Higher and increasing profit margins are preferable, as it means that more revenue is being converted to profit

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 $\mathrm{Gross} \mathrm{profit} \mathrm{margin}=\frac{\mathrm{Gross} \mathrm{profit}}{\mathrm{Revenue}}\times100$

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} }{Revenue} \times 100

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

= 0.8482$ [1 mark]

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

$= 0.8482 \times 100

= 84.82 %$ [1 mark]

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

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

Ways to increase the gross profit margin

The Operating Profit Margin

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

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

$\text{Operating profit margin =}\frac{\mathrm{Operating} \mathrm{profit}}{\mathrm{Revenue}}\times100$

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

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

[2]

Step 1: Substitute the values into the formula

$\text{Operating \text{profit} \text{margin} = } \frac{Operating profit}{Revenue} \times 100

= \frac{$ 65 , 864}{$ 124 , 653}

= 0.5284$ **[1 mark]

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

$= 0.5284 \times 100

= 52.84 %$** [1 mark]

In 2022, 52.84% of Head to Toe Wellbeing’s revenue was converted into operating profit

Improving the operating profit margin

• The profit margin can be improved in two ways

  • Increase the gross profit margin (see above)

  • Reduce expenses by cutting staffing levels, relocating to cheaper premises or changing utility companies

  • Reducing staffing levels may affect staff morale and negatively affect productivity

    • Relocation costs may outweigh some of the benefits of moving to a cheaper location
    • Replacing inefficient or outdated equipment may require staff training

Mark-up

Spec point — 3.5.1 · Calculating and analysing accounting ratios: • markup

Mark-up

• The mark-up is a measure of profit made on each item sold

• Some businesses calculate the markup in order to determine the price at which they should sell their products

  • This methods ensures that all costs are covered and that a profit will be made on every item they sell

• Mark-up is expressed as a percentage and calculated using the formula

$\mathrm{Markup}=\frac{\mathrm{Profit} \mathrm{per} \mathrm{item}}{\mathrm{Cost} \mathrm{per} \mathrm{item}}x100$

Worked Example Evolve Boards' best-selling penny skateboard costs $12.13 to produce. Each board is sold for $20.

Calculate the percentage markup on each penny skateboard sold [2 marks]

Step 1: Calculate the profit per item

= \ 20 - $ 12.13

= $ 7.87$ [1 mark]

Step 2: Divide profit per item by cost per item

= \ 7.87 \div $ 12.13

= 0.6488$

Step 3: Multiply the outcome by 100

$= 0.6488 \times 100

= 64.88 %$[1 mark]

Return on capital employed

Spec point — 3.5.1 · Calculating and analysing accounting ratios: • return on capital employed (ROCE)

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

$\mathrm{Return} \mathrm{on} \mathrm{capital} \mathrm{employed}=\frac{\mathrm{Operating} \mathrm{profit}}{\mathrm{Capital} \mathrm{employed}}\times100$

• RoCE can 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

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

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
Operating profit	€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 mark]

Step 2: Divide Operating Profit by Capital Employed

$= \frac{ \text{Operating} profit}{Capital employed}

= \frac{\text{€} 2.2 \mathrm{m} }{\text{€} 16.9 \mathrm{m} }

= 0.13$[1 mark]

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

$= 0.13 \times 100

= 13 %$[1 mark]

The capital employed in Keals Cosmetics has generated a return of 13%

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

• 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

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 real estate 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

$RoCE = \frac{Operating Profit}{Capital Employed} \times 100 > > RoCE Sevenoaks = \frac{\pounds 0.37 \mathrm{m} }{\pounds 2.4 \mathrm{m} } \times 100 = 15.42 \% [ 1 \text{mark} ] > > RoCE Whitstable = \frac{\pounds 0.57 \mathrm{m} }{\pounds 3.1 \mathrm{m} } \times 100 = 18.39 \% [ 1 \text{mark} ] > > RoCE Rochester = \frac{\pounds 0.51 \mathrm{m} }{\pounds 2.9 \mathrm{m} } \times 100 = 17.59 \% [ 1 \text{mark} ] >$

Step 2: Identify the least profitable branch for closure

• Sevenoaks ****[1 mark], with a RoCE of 15.42%[1 mark] and should be the branch selected for closure

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