Profitability Ratios

Learning Objective

5.4.1 Understand the purpose of the following key ratios: return on capital employed (ROCE); asset turnover; net profit margin; gross profit margin

Profitability ratios are used to assess the effectiveness of a company’s management in employing the company’s assets to generate profit and shareholder value. A wide range of ratios is used, but in this section we will just consider return on capital employed, asset turnover and profit margins.

4.1.1 Return on Capital Employed (ROCE)

First, we will look at return on capital employed (ROCE). ROCE is a key measure of a company’s profitability and looks at the returns that have been generated from the total capital employed in a company – that is, debt as well as equity.

It expresses the income generated by the company’s activities as a percentage of its total capital.

This percentage result can then be used to compare the returns generated to the cost of borrowing, establish trends across accounting periods and make comparisons with other companies.

It is calculated as follows:

Return on capital employed = Profit before interest and tax x 100 = x%

Capital employed

The component parts of capital employed are shown below in an expanded version of the formula:

ROCE = Profit before interest and tax x 100 = x%

(Total assets – Current liabilities + Short-term borrowing)

When looking at ROCE, capital employed takes into account the financing available to a company that is used to generate profit and so includes shareholder funds, loan capital and bank overdrafts. Although bank overdrafts are a current liability they are also normally considered financing activities similar to long-term borrowings and that is why bank overdrafts are added back in.

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Capital employed can be calculated by looking at either the assets or liabilities side of the balance sheet and so the formula can be seen as either:

• capital employed = total assets – current liabilities + bank overdrafts; or

• capital employed = shareholder funds + loan capital +bank overdrafts.

It should be noted that the result can be distorted in the following circumstances:

• The raising of new finance at the end of the accounting period, as this will increase the capital employed but will not affect the profit figure used in the equation.

• The revaluation of fixed assets during the accounting period, as this will increase the amount of capital employed while also reducing the reported profit by increasing the depreciation charge.

• The acquisition of a subsidiary at the end of the accounting period, as the capital employed will increase but there will not be any post-acquisition profits from the subsidiary to bring into the consolidated profit and loss account.

4.1.2 Asset Turnover and Profit Margin

A more detailed analysis of ROCE can be undertaken by breaking this formula down further into two secondary ratios: asset turnover and profit margin.

Asset turnover looks at the relationship between sales and the capital employed in a business. It describes how efficiently a company is generating sales by looking at how hard a company’s assets are working.

Profit margin looks at how much profit is being made for each pound’s worth of sales. Clearly, the higher the profit margin, the better.

The relationship between ROCE and each of these can be shown as follows:

ROCE = Profit before interest and tax

Capital employed

Profit margin = Profit before interest and tax Asset turnover = Sales

Sales Capital employed

Example

Assume ABC Ltd has sales of $5m, a trading profit of $1.5m and the following items on its balance sheet:

• Share capital $1.0m

• Reserves $5.0m

• Loans $1.0m

• Overdraft $0.5m

So its ROCE, profit margin and asset turnover can be calculated as follows:

Return on Capital Employed:

Profit before interest and tax or $1.5m x 100 = 20%

Capital employed ($1.0m + 5.0m + $1.0m + $0.5m) Profit Margin:

Profit before interest and tax = $1.5m x 100 = 30%

Sales $5m Asset Turnover:

Sales = $5m = 0.67 times Capital employed $7.5m

Profit margin and asset turnover can therefore be used in conjunction with ROCE to gain a more comprehensive picture of how a company is performing. The results of the calculations will then need interpreting to determine whether they represent a positive picture, which will depend upon the returns being achieved by comparable firms operating in the same or similar industries.

Asset turnover measures how efficiently the company’s assets have been utilised over the accounting period, while the company’s profit margin measures how effective its price and cost management has been in the face of industry competition. High or improving profit margins may, of course, attract other firms into the industry, depending on the existence of industry barriers to entry, thereby driving down margins in the long run.

4.1.3 Gross, Operating and Net Profit Margin

Various profit margins can be looked at to analyse the profitability of a company in order to determine if it is both liquid and being run efficiently.

The gross profit margin shows the profit a company makes after paying for the cost of goods sold.

It shows how efficient the management is in using its labour and raw materials in the process of production. The formula for gross profit margin is:

Gross profit margin (%) = (Gross profit/revenues) x 100

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Firms that have a high gross profit margin are more liquid and so have more cash flow to spend on research and development expenses, marketing or investing. Gross profit margins need to be compared with industry standards to provide context and should be analysed over a number of accounting periods.

The operating profit margin shows how efficiently management is using business operations to generate profit. It is calculated using the formula:

Operating profit margin (%) = (Operating profit/revenues) x 100

The higher the margin the better, as this shows that the company can keep its costs under control and can mean that sales are increasing faster than costs and the firm is in a relatively liquid position.

The difference between gross and operating profit margin is that the gross profit margin accounts for just the cost of goods sold, whereas the operating profit margin accounts for the cost of goods sold and administration/selling expenses.

The net profit margin analyses profitability further by taking into account interest and taxation. Again it needs to be compared to industry standards to provide context. The formula for calculating it is:

Net profit margin (%) = (Net income/revenues) x 100

With net profit margin ratio all costs are included to find the final benefit of the income of a business and so measures how successful a company has been at the business of marking a profit on each sale.

It is one of the most essential financial ratios as it includes all the factors that influence profitability whether under management control or not. The higher the ratio, the more effective a company is at cost control. Compared with industry average, it tells investors how well the management and operations of a company are performing against its competitors. Compared with different industries, it tells investors which industries are relatively more profitable than others.