Profitability Ratios (Cambridge (CIE) A Level Business): Revision Note

The meaning and importance of profitability

• Profitability is a measure of how effectively a business converts revenue into profit or how well capital invested in a business is used to generate profit

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

• Higher and increasing profit margins are preferable

  • More revenue is being converted to profit

  • Capital invested is being used more effectively to generate profit

Why is profitability important?

1. Profitability shows business success

   • It indicates whether a business is generating more income than it spends, which is a key measure of financial health

2. Profits provide internal finance

   • Retained profit can be reinvested in the business, reducing the need for external borrowing

3. Profitability attracts investors and lenders

   • A profitable business is more likely to secure funding, as it shows the business can generate returns and repay debts

Return on capital employed

• The return on capital employed compares the profit made by a business to the amount of capital invested in the business

  • It is a measure how how effectively a business uses the capital invested in the business to generate profit

• Return on capital employed is a key performance indicator that can be compared over time and also with competitors and other potential capital investments

• Return on capital employed is expressed as a percentage and can be calculated using the formula

$\mathrm{Return}\mathrm{on}\mathrm{capital}\mathrm{employed}=\frac{\mathrm{Profit}\mathrm{from}\mathrm{operations}}{\mathrm{Capital}\mathrm{employed}}\times 100$

• Capital employed is calculated using the formula

$\mathrm{Capital}\mathrm{employed}=\mathrm{Issued}\mathrm{shares}+\mathrm{Reserves}+\mathrm{Non}-\mathrm{current}\mathrm{liabilities}$

Interpreting ROCE

• The ROCE rate differs between industries, so comparison across different sectors is not recommended

  • It can be compared with other forms of return, such as:

    • interest rates on savings and

    • with other businesses within the same industry

• The higher the ROCE 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

  • A ROCE of at least 20 per cent is usually a good sign that the company is in a good financial position

Gross profit margin

• The gross profit margin measures the proportion of revenue that is converted into gross profit

  • A higher and increasing gross profit margins is preferable, as it means more revenue is being converted to gross profit

Using the gross profit margin

• Pricing and product mix

  • A high gross margin gives scope to discount or bundle products

  • A low gross profit margin signals the need for higher prices or cheaper materials and components

• Supplier negotiations

  • A falling gross profit margin can be a trigger for discussing better raw material prices with suppliers or switching to alternative suppliers

• Changes in the gross profit margin indicate how well managers are keeping direct costs low or encouraging sales

  • A rising gross profit margin indicates increasing levels of sales revenue and/or falling cost of sales

  • A falling gross profit margin indicates lower sales revenue and/or a rising cost of sales

Calculating the gross profit margin

• Gross profit margin is expressed as a percentage and calculated using the formula

$\mathrm{Gross}\mathrm{profit}\mathrm{margin}=\frac{\mathrm{Gross}\mathrm{profit}}{\mathrm{Sales}\mathrm{revenue}}\times 100$

Profit margin

• The profit margin shows the proportion of revenue that is turned into profit from operations

• Changes in the profit margin indicate how well managers are keeping indirect costs low or encouraging sales

  • A rising profit margin indicates increasing levels of sales revenue and/or falling indirect costs

  • A falling profit margin indicates lower sales revenue and/or rising indirect costs

Using the profit margin

• Cost structure reviews

  • A falling profit margin highlights rising overheads (e.g. logistics, energy or wages) and may require managers to take steps to improve efficiency

• Expansion or cutbacks

  • Steady profit margins support store openings or marketing campaigns, while falling margins may delay these plans

Calculating the profit margin

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

$\mathrm{Profit}\mathrm{margin}=\frac{\mathrm{Profit}\mathrm{from}\mathrm{operations}}{\mathrm{Sales}\mathrm{revenue}}\times 100$

Methods of improving profitability

Ways to increase ROCE

• Make more profit without spending more money

  • If a business earns more money (profit) but doesn't take on extra loans or investment, it will get more return from the same amount of capital

  • Example: A shop sells more products without having to buy new equipment

• Use less capital to make the same profit

  • If a business keeps profit the same but uses less money overall (e.g. sells off unused equipment or pays off debt), it will be more efficient with what it has

  • Example: A company stops renting a second office and saves money, but still keeps sales and profit steady

Ways to improve the gross profit margin

• The gross profit margin can be improved in two ways

  • They can increase their sales revenue

  • They can reduce their direct costs

1. Increase sales revenue

• Increase the value of sales

  • Raise prices

    • If costs remain the same, raising prices will increase profitability

    • The gap between selling price and costs becomes larger, resulting in more profit per unit sold

  • Sell premium products

    • Offering higher-end or luxury products can increase the profit earned per item

    • If customers are willing to spend more, the business benefits from higher revenue per sale

• Increase the volume of sales

  • Price tactics

    • Use promotional pricing strategies to encourage customers to buy more or buy more often

    • For example, a "buy one get one half price" offer may double the number of items purchased, increasing total revenue

  • Increase marketing activities

    • Run more promotional campaigns or advertising to raise awareness and drive sales volume

    • Greater exposure can lead to more customers and more frequent purchases

2. Reduce direct costs

• Reduce variable costs

  • Look for ways to cut the cost of raw materials or components

    • This might involve purchasing cheaper alternatives, negotiating better deals with suppliers, or buying in bulk

    • Care must be taken to ensure that reducing costs does not harm product quality or customer satisfaction

    • Bulk buying may also require more storage space, which could reduce the overall cost savings

  • Businesses can also reduce waste in the use of materials and components to further cut costs

Ways to improve the profit margin

• The profit margin can be improved in two ways

  • Increasing the gross profit margin (see above)

  • Reducing overhead costs

Reduce overhead costs

• Reducing staffing levels, relocating to cheaper premises or changing utility companies can reduce expenses

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

  • Relocation costs can outweigh some benefits of moving to a cheaper location

  • Replacing inefficient or outdated equipment may require staff training