Accounting Ratios (Edexcel IGCSE Business): Revision Note

An introduction to ratio analysis

• Ratio analysis involves extracting information from financial accounts to assess business performance 

• It helps managers to answer key questions including 

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

  • Is a business growing?

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

  • What return on investment is expected?

  • How risky is the financial structure of the business?

• Ratios can be compared over time and between businesses or functions to determine how well financial objectives are being met

Profit margins

• Profit margins measure of how effectively a business converts revenue into profit

• They 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

The gross profit margin

• This calculation shows the proportion of revenue that is turned into gross profit

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

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

Improving the gross profit margin

• The gross profit margin can be improved in two ways

  • The business can increase its sales revenue

  • The business can reduce its direct costs

Ways to increase the gross profit margin

The Operating Profit Margin

• This calculation shows the proportion of revenue that is turned into operating profit 

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

$\text{Operating profit margin = }\frac{\mathrm{Operating}\mathrm{profit}}{\mathrm{Revenue}}\times 100$

Improving the operating profit margin

• The profit margin can be improved in two ways

  • Increase the gross profit margin (see above)

  • Reduce expenses by cutting staffing levels, relocating to cheaper premises or changing utility companies

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

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

    • Replacing inefficient or outdated equipment may require staff training

Mark-up

• The mark-up is a measure of profit made on each item sold

• Some businesses calculate the markup in order to determine the price at which they should sell their products

  • This methods ensures that all costs are covered and that a profit will be made on every item they sell

• Mark-up is expressed as a percentage and calculated using the formula

$\mathrm{Markup}=\frac{\mathrm{Profit}\mathrm{per}\mathrm{item}}{\mathrm{Cost}\mathrm{per}\mathrm{item}}\mathrm{x}100$

Return on capital employed

• The Return on Capital Employed (RoCE) measures how how effectively a business uses the capital invested in the business to generate profit

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

$\mathrm{Return}\mathrm{on}\mathrm{capital}\mathrm{employed}=\frac{\mathrm{Operating}\mathrm{profit}}{\mathrm{Capital}\mathrm{employed}}\times 100$

• RoCE can be compared over time and with competitors

  • It can also be compared with other potential capital investments, such as savings rates

• The capital employed figure is usually provided for you

  • If required, it is calculated using the formula

$\mathrm{Capital}\mathrm{employed}=\mathrm{Non}-\mathrm{current}\mathrm{liabilities}+\mathrm{Equity}$

Improving RoCE

• When analysing the 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

• To increase the RoCE, 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

Using RoCE to make decisions

• 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