Profitability Ratios (DP IB Business Management): Revision Note

An introduction to ratio analysis

• Ratio analysis involves extracting information from financial accounts to assess business performance and answer key questions including 

  • Why is one business more profitable than another in the same industry?

  • Is a business growing?

  • How effectively is a business using assets and capital invested?

  • What returns on investment are expected?

  • How risky is the financial structure of the business?

 Information extracted from the financial statements

• Ratio analysis supports evidence-based decision making, as it provides measurable data that can be used to support judgements and compare performance against objectives

The ratio analysis process

• The three main profitability ratios are

  • The Gross Profit Margin

  • The Profit Margin

  • Return on Capital Employed (RoCE)

• The two main liquidity ratios are

  • The Current Ratio

  • The Acid Test Ratio

Profit margins

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

• Profit margins can be compared to previous years to better understand business performance

  • Higher and increasing profit margins are preferable, as it means that more revenue is being converted to profit

Gross profit margin 

• This shows the proportion of revenue that is turned into gross profit and is expressed as a percentage

  • It is calculated using the formula below 

Profit margin

• The profit margin shows the proportion of revenue that is turned into profit before interest and tax

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

Return on capital employed

• The Return on Capital Employed (RoCE) is also known as the primary ratio

• It compares the profit made by a business to the amount of capital invested in the business

• It is a measure 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
   

• Capital employed is usually provided for you

• If required, it is calculated using the formula

  

Improving profitability ratios

• Businesses aim to improve their profit margins over time

• Whilst profit margins may fall as a result of external factors (for example, the cost of raw materials may rise as a result of poor weather damaging raw materials) there are a number of internal steps a business can take to improve its profit margins

Improving 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

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

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

Improving 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

Understanding return on capital employed (RoCE)

• RoCE differs between industries so comparison across sectors is not recommended

  • However, RoCE can be compared with other forms of return, such as interest rates on savings in a bank account, and with other businesses within the same industry

• RoCE can be used to support strategic decisions (e.g. investment or divestment decisions) to determine the most profitable option given the level of capital employed

• With RoCE, the higher the 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

• To increase the RoCE level, a business can

  • Increase the level of profit generated without introducing new capital into the business

  • Maintain the level of profit generated whilst reducing the amount of capital in the business