Profitability ratios

Profitability ratios used to measure how well a business is doing deal with such financial indicators as gross profit margin, net profit margin, and return on capital employed (ROCE).

The gross profit margin is a measure of how much total profit is made as a percentage of sales. The ratio is a measure of trading efficiency. The higher the percentage, the better the business trading performance.

Gross Profit Margin (%) = Gross Profit x 100 / Turnover

Net profit is arrived at after overhead expenses, such as electricity, telephone, and gas, have been paid out from gross profit. The difference between gross and net profit therefore gives an indication of a firm’s ability to control its costs. The higher the net profit margin, the smaller the difference between costs and revenues.

Net profit Margin (%) = Net Profit x 100 / Turnover

The net and gross profit margins provide a useful means of judging business performance when comparing business performance across two or more years. If gross margins stay constant but net margins decrease, this means that overheads must have increased during the year. With this information, management may wish to investigate cost control and budgeting for overhead costs.

For example, sales staff may spend increasing amounts on entertaining clients with expensive lunches in order to generate sales and earn more commission. Whilst gross profits will stay high due to extra sales, net profits may begin to fall, because of the increased expense involved in earning these extra sales. In this case, the self-interest of sales staff in earning high commission works against the good of the firm, because it leads to lower net profits. By monitoring changes in net profit margins over time, business managers can identify any potential future problems and take corrective measures.

Return On Capital Employed (ROCE) expresses the net profit of a business as a percentage of the total value of its capital invested in fixed and current assets.

Return On Capital Employed = Net Profit x 100 / Total Assets

The return on capital should ideally be higher than the rate of interest a business could earn by placing money in a bank account. If not, then the business might just as well convert its assets to cash and put the money into an interest-earning account.

In limited companies, the business owners are its shareholders and they expect to be paid a dividend from company profit. They will clearly be interested in earning more from their money invested in shares than they would get from an interest-earning account, or from investing their money in another business venture. The ROCE ratio allows them to compare these alternatives.

The higher the ROCE, the better it is for business owners. Profits are high, and therefore the dividends on their shares will be healthy.

Return on net assets is very similar to ROCE, but measures the ratio on long-term capital only. Short-term sources of capital, such as creditors, are excluded. Deducting current liabilities from total assets in the balance sheet gives a figure for net capital employed or net assets.

Return on Net Assets (%) = Net Profit x 100 / Net Assets

This ratio should be higher than ROCE, because net assets will be less than total capital employed.

Дата добавления: 2015-12-08