ZIMSEC O Level Principles of Accounts Notes: Profitability Ratios

• So we have already introduced you to accounting ratios
• These ratios include a group of ratios that are known as profitability ratios
• Such ratios measure how well a business performed in profit terms in a given period
• At this level you are required to know how to calculate three profitability ratios:
1. Markup
2. Margin
3. Net Profit (percentage)
• As shown by the Income Statement (and Trading and Profit and Loss Accounts) there are two major types of profit:
1. Gross Profit i.e. Sales (Net Turnover) – Cost of Sales and
2. Net Profit i.e. Gross Profit – Operating Costs
• Traditionally markup and margin are calculated using Gross Profit
• For this reason they are often called gross profit margin and gross profit markup

Markup

• Is the amount added to the cost of an item to obtain its selling price
• Markup= Selling Price-Cost of Sales
• As you can tell markup is usually similar to Gross Profit
• Markup as a ratio is calculated using the formula:$\mathrm{\frac{Profit}{Cost \quad of \quad Sales}}$
• For example a business has:
1. Sales of 10 000
2. Cost of Sales 8 000
• In a given period
• Calculate the markup:
• Gross Profit = $10 000-$8 000
• $2 000 • Markup= $\frac{2 000}{8 000}$ • $\frac{1}{4}$ • Typically markup is expressed as a fraction in its lowest terms or as a percentage • In the above example the markup will be: • 25% • Bear in mind that markup can be calculated either for entire sales or for each unit Margin • This is when profit is expressed in terms of the selling price • It is calculated using the formula: • $\mathrm{\frac{Profit}{Sales}}$ alternatively this can be expressed as • $\mathrm{\frac{Profit Per Unit}{Selling Price}}$ • In the above example the margin would thus be: • $\frac{2000}{10000}$ • $\frac{1}{5}$ • In percentage terms this would be: • 20% Relationship between Markup and Margin • Because they are essentially derived from the same forumulae and items • There is a relationship between markup and margin • When given the margin $\frac{1}{x}$ markup can be calculated using the formula: • $\frac{1}{x-1}$ • For example if the margin is $\frac{1}{5}$ • The markup would be: • $\frac{1}{5-1}$ i.e. • $\frac{1}{4}$ • Conversely given the markup $\frac{1}{y}$ the margin can be calculated as a formula: • $\frac{1}{y+1}$ • For example if the margin is $\frac{1}{4}$ • Then the markup would be: • $\frac{1}{4+1}$ i.e. • $\frac{1}{5}$ • You should be mindful of this relationship when it is needed e.g. during accounting using incomplete records Net Profit Percentage • This is when the net profit is expressed in terms of Sales • It is sometimes known as Net Profit Margin for obvious reasons • The ratio is expressed and presented in percentage terms • The formula is: $\mathrm{\frac{Net Profit}{Sales} x \frac{100}{1}}$ • For example a Business had Sales of$25 000 and a net profit of \$5 000 calculate the Net Profit Percentage
• $\mathrm{\frac{5000}{25000} x \frac{100}{1}}$
• 20%

Where to get the figures/amounts

• Profitability ratios as already pointed out involve the analysis of profit figures
• Figures/Amounts used in the calculation of these ratios can be obtained from Income Statement/Trading and Profit and Loss Accounts

To access more topics go to the Principles of Accounting Notes.