Profitability Ratios

Profitability Ratios

There are three main ratios that can be used to measure the profitability of a business:

  1. The gross profit margin.
  2. The net profit margin.
  3. Return on Capital Employed (R.O.C.E).

This measures the gross profit of the business as a proportion of the sales revenue. It is calculated using the following formula:

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For example, if a business has gross profit of £4 million and sales revenue of £6 million, then the gross profit margin would be:

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This means that for every £1 of sales revenue, £0.67 remains after all direct expenses have been deducted. This money then contributes towards covering the other expenses of the business.

The business would want this margin to be as high as possible, since a high margin will leave more profit for covering the remaining expenses and, if the business is a 'company', for covering the dividend payments to shareholders.

This measures the net profit of the business as a proportion of the sales revenue. It is calculated using the following formula:

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For example, if a business has gross profit of £1 million and sales revenue of £6 million, then the net profit margin would be:

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This means that for every £1 of sales revenue, 16.7 pence remains after all direct and indirect expenses have been deducted. This money then contributes towards covering the corporation tax that must be paid on profits to the Inland Revenue and, if the business is a 'company', covering the dividend payments to shareholders.

Any profit which remains is kept in the business for re-investment and is called 'retained profit'. Again, the business would want this margin to be as high as possible, allowing both large dividend payments to shareholders and a significant amount of profit to be retained for growth.

This is often referred to as the 'primary accounting ratio' and it expresses the annual percentage return that an investor would receive on their capital. It basically relates the profit to the size of the business and it is calculated using the following formula:

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For example, if a business had a net profit of £2.2m and a capital employed of £7.6m, then the Return on Capital Employed figure would be:

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This means that for every £1 of capital invested in the business, the annual return would be 28.9 pence. Capital employed is equal to shareholders' funds plus long-term liabilities, and it is the final line in the balance sheet (remember that it is the same value as 'assets employed').

Clearly an investor would like to receive as high a R.O.C.E. as possible, although the figure would need to be compared to last year's return, to competitors' returns and to the returns on other investments.

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