Profitability ratios

Ratio Formula What it shows

This ratio shows the % return a business is making from the capital invested in the business. A ROCE of 5% means
Return on Capital Profit x 100 that for every £100 invested, the business is generating £5 profit.
Current and potential investors will be interested in ROCE to compare against other investment opportunities.
Employed (ROCE) Capital employed

This ratio looks at how well a business is controlling its cost of sales. A GPM of 80% means that for every £100 of
Gross profit x 100 revenue, £80 is gross profit from which expenses will be paid. The higher the GPM, the more value the business is
Gross profit margin adding to the bought in components.
Sales revenue

This ratio looks at how well a business is controlling all costs and expenses. A profit margin of 20% means that for
Profit x 100 every £100 of revenue, the business makes £20 profit to be reinvested in the business or paid out to owners/
Profit margin Sales revenue shareholders once tax has been paid.

This ratio looks at what % has been added to cost of goods sold to reach the selling price. A 25% mark-up means
Gross profit x 100 that if cost of goods sold was £2, the selling price is £2.50.
Mark-up
Cost of goods sold

Liquidity ratios
Current ratio This ratio measures liquidity ie how easily a business can pay its short term debts. If the ratio value is 1, this means
Current assets it could use its current assets to pay off all its short term debt. If it falls below 1, then it has more debt than current
assets which could be higher risk. An ideal value would be between 1 and 1.5.
Current liabilities

Liquid capital ratio This ratio is a more severe test of liquidity as it excludes inventory from the calculation. This is because inventory
(acid test) Current assets - inventory is thought to be harder to turn into cash quickly if needed. Again, ideally the value should be above 1 although in
some industries businesses will carry higher levels of stock and the values might all be lower.
Current liabilities

Efficiency ratios
Trade receivable This ratio measures on average how long it takes debtors to settle their bills. The value should always be rounded
days Trade receivables x 365 up to whole days. A trade receivable days figure of 60 days means that on average customers take 2 months to pay
their bills – this could be a source of cash flow problems to a business.
Credit sales*
 Use the sales figure if credit sales not given
Trade payable days This ratio shows on average how long it takes a business to pay for goods and services bought on credit. The value
Trade payables x 365 should always be rounded up to whole days. A trade payable days figure of 30 days means that on average the
business takes a month to pay its suppliers. A business with cash flow problems would look to negotiate to
Credit purchases*
lengthen this but the business would need to be careful of gaining a poor credit rating if it failed to pay promptly.
 Use the purchases figure if credit purchases not given
Inventory turnover This ratio looks at how many day’s worth of stock a business is holding on average. If the inventory turnover figure
Average inventory* x 365 is 7 days, this means that the business has on average one week’s worth of stock. The higher the figure, the higher
cost of stock holding and this could be contributing to cash flow problems. However, the inventory turnover may
Cost of goods sold
also depend on the nature of the stock ie whether it is perishable, and where the suppliers are.
 (Opening inventory + closing inventory) ÷ 2