ZIMSEC O Level Business Studies Notes: Business Finance and Accounting: Ratio Analysis:Profitability Ratios

• These measures indicate how well a business is performing in terms of its ability to generate profit
• The ratios relate profits to sales and assets
• There are three commonly used ratios:
• Return on Capital Employed (ROCE)
• Profit Margin and
• Profit Markup

Return on Capital Employed

• Is normally expressed as a percentage
• The formula for finding Return on Capital Employed is:
• $\dfrac{\mathrm{Net \quad Profit}}{\mathrm{Capital \quad Employed}}\quad\mathrm{x} \quad 100$
• Capital Employed can be obtained using the formula
• $\mathrm{Working \quad Capital(Current \quad Assets-Current \quad Liabilities)+Fixed \quad Assets}$
• Alternatively Capital employed can be given using the formula:
• $\mathrm{Equity (Capital+Retained \quad Earnings)+ Long Term Liabilities}$
• All these figures can be obtained from the Balance Sheet and Income statement
• For example a business made a profit of $5 000, it has Fixed Assets of$30 000, Current Assets of 15 000 and Current Liabilities of $5 000 • The Capital Employed would be: • $\mathrm{30 000+15 000-5 000 = 40 000}$ • The return on capital employed would be: • $\mathrm{\dfrac{5000}{40000}\quad x\quad 100}$ • 12.5% • The higher the return on capital employed the better for example if the business had ROCE of 10% the previous year then we say ROCE has improved by 2.5% • ROCE is a measure of operational efficiency i.e. how well is the business turning invested assets into profit Margin • Margin is the difference between the selling price (sales) and cost price (cost of sales) • There are two margin ratios i.e. Gross Profit Margin and Net Profit Margin • The formula for Gross Profit Margin is: • $\mathrm{\dfrac{Gross\quad Profit}{Sales\quad Revenue}\quad x\quad 100}$ • It can also be expressed as a fraction in its lowest terms • $\mathrm{\dfrac{Gross\quad Profit}{Sales\quad Revenue}}$ • Net Profit Margin is given using the formula: • $\mathrm{\dfrac{Net\quad Profit}{Sales\quad Revenue}\quad x\quad 100}$ • It can also be expressed as a fraction in it’s lowest terms • $\mathrm{\dfrac{Net\quad Profit}{Sales\quad Revenue}}$ • The ratio shows the percentage of sales that goes towards profit • The higher the percentage the better • If the gross profit margin is falling over time it might mean the costs are increasing but the business is not passing them to customers • It might also mean the business is has reduced it’s selling price • Here is an example: • Chinembiri Ltd had the following results after trading for a year: • Sales$ 30 000, Cost of Sales $24 000, Operating Expenses$ 3 000
• Gross Profit Margin would be:
• $\mathrm{\dfrac{6000}{30000}\quad x\quad 100}$
• 20%
• Remember to calculate gross profit first which is found by Sales-Cost of Sales
• Alternatively this can be expressed as:$\mathrm{\dfrac{1}{5}}$
• The Net Profit Margin would be:
• $\mathrm{\dfrac{3000}{30000}\quad x\quad 100}$
• 10%
• Alternatively this can be expressed as:$\mathrm{\dfrac{1}{10}}$
• Remember Net Profit can be calculated using the formula: Gross Profit – Operating Expenses

Markup

• This is the amount of profit added to the cost price to arrive at the selling price
• The ratio is obtained by dividing profit by cost of sales
• $\mathrm{\dfrac{Gross\quad Profit}{Sales\quad Revenue}}$
• It can also be expressed as a fraction
• In example above the Gross Profit mark up is:
• $\mathrm{\dfrac{6000}{24000}\quad x\quad 100}$
• 25%
• Or:$\mathrm{\dfrac{1}{4}}$
• The higher the mark up the better

Relationship between mark up and margin

• When you have the markup you can calculate the margin
• This can be done using the formula
• $\dfrac{x}{y+x}$
• For example if the mark up as above is:$\mathrm{\dfrac{1}{4}}$
• Then the margin would be calculated as follows:
• $\dfrac{1}{4+1}$
• $\mathrm{\dfrac{1}{4}}$
• Conversely if we have the margin we can calculate the markup
• This can be done using the formula
• $\dfrac{x}{y-x}$
• For example if the margin is: $\mathrm{\dfrac{1}{5}}$
• Then the markup is:
• $\dfrac{1}{5-1}$
• $\mathrm{\dfrac{1}{4}}$
• If you are given one of this as a percentage and are tasked with finding the other
• You need to first convert the given percentage into a fraction and then use the formula above
• For example given that the markup is 20% find the margin
• The margin can be calculated as follows:
• $\mathrm{\dfrac{20}{100}}$
• Now add the numerator to the denominator
• $\mathrm{\dfrac{20}{100+20}}$
• The result is:
• $\mathrm{\dfrac{20}{120}}$
• Reduce the fraction to it’s lowest terms and you get:
• $\mathrm{\dfrac{1}{6}}$
• Or as a percentage:
• $\mathrm{16\dfrac{2}{3}\%}$

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