Ratio analysis

Profitability ratio I

Profitability ratios:
 Two ratios can be calculated from the income statement
o Gross profit margin
o Net profit margin

Gross profit margin:

 It is calculated by
o GPM (%)= GP/SR X 100
 It is a good indicator of how effectively managers have added value to the cost of sales.
 It is misleading to compare the ratios of firms in different industries because the level of
risk and gross profit margin will differ greatly.

Net profit margin:

 NPM (%)= NP/SR X 100
 This ratio gives a more complete analysis of the level of management performance
 That is the ne profit margin and the trend in this ratio over time is a good indicator of
management effectiveness at converting sales revenue into net profits.
 As with all ratios, a comparison of results over time and with other firms (in the same
industry) would indicate whether the performance and profitability of a company were
improving or worsening.
o However, as like GMP, firms in different industry will have different risk and net
profit margin.

Ways to increase profit:

 Increase gross and net profit margin by reducing direct costs:
o Using cheaper materials (poor image of quality)
o Cutting direct labour cost e.g.
 Relocating to a cheap labour country (quality and communication
problems)
 Introducing capital intensive techniques to increase productivity
(increase in overhead costs thus increasing gross profit but reducing
net profit; staff training)
o Cutting wage costs by reducing wage rate
 Motivation level might fall, which could reduce productivity and quality
 Increase gross and net profit margin by increasing price (total profit might fail if
consumers switch to competitors; long term image can be damaged)
 Increase net profit margin by reducing overhead costs e.g.
o Moving to a cheaper location (image can be damaged)
o Reducing promotion cost (might lead to fall in sales)
o Delayering the organisation (fewer managers might reduce efficient operation)

Return on capital employed

 Return on capital employed (ROCE)= Net or operating profit X100
Capital employed
 Capital employed= (NCA+CA) – CL or NCL + shareholder’s equity
 Most commonly used means of assuring the profitability of ratios.
 Compares profit with capital invested.
 The higher value the greater the return on capital investment.
 Can be compared with previous years and interest on savings.
 Should be compared with the interest cost of borrowing finance.
 If less than the interest rate, any increase in borrowing will reduce returns to
shareholders.
 ROCE can be raised by increasing the profitable efficient use of the assets owned and
employed in the business.
 ROCE is not related to the risks involved in the business. A high return may be successful
undertakings with high risk rather than true business or managerial ‘efficiency’

# Possible steps to increase ROCE

 Increase operating profit without increasing capital. E.g.
- Raise price (customers might move away)
- Reduce variable costs per unit (cheaper materials could cut back on quality)
- Reduce overheads (efficiency might fall)
 Reduce capital employed
- Sell unused assets (future needs may arise)