Profitability Ratios (Cambridge International A-Level Accounting)

What are profitability ratios?

• Profitability ratios assess a company's ability to earn profits from sales, operations or assets

  • They compare profits to other values such as revenue, costs and capital employed

• The main profitability ratios are:

  • Gross profit margin
  • Mark-up
  • Expenses to revenue ratio
  • Profit margin
  • Return on capital employed

Gross profit margin

Spec point — how to calculate key accounting ratios to measure profitability – profitability ratios: gross profit margin, mark-up, profit margin, return on capital employed, expenses to revenue ratio (operating expenses to revenue ratio)

Gross profit margin

What is the gross profit margin?

• If the gross profit margin decreases then this suggests that:

  • The goods are being sold at a cheaper price than in previous years

    • Allowing more trade discounts has the same effect

  • The costs of goods have increased but their selling price has remained the same

Exam Hint The gross profit margin must be less than 100%. If you get an answer bigger than 100% then check your working.

Worked Example Kaley is a sole trader. She provides the following information for the year ended 31 December 2023.

	$
Revenue	128 000
Purchases	52 000
Inventory at 1 January 2023	8 000
Inventory at 31 December 2023	6 000

Calculate Kaley's gross profit margin. Your answer should be correct to two decimal places.

Answer:

• Calculate the cost of sales

  • Opening inventory + Purchases - Closing inventory

$8 000 + $52 000 - $6 000 = $54 000

• Calculate the gross profit

  • Revenue - Cost of sales

$128 000 - $54 000 = $74 000

• Calculate the gross profit margin

  • $\frac{\mathrm{Gross} \mathrm{profit}}{\mathrm{Revenue}}\times100$

$\frac{74000}{128000}\times100=57.8125$

• Round to two decimal places

Final answer: Gross profit margin = 57.81%

Mark-up

Spec point — how to calculate key accounting ratios to measure profitability – profitability ratios: gross profit margin, mark-up, profit margin, return on capital employed, expenses to revenue ratio (operating expenses to revenue ratio)

Mark-up

What is the mark-up?

• The mark-up is normally a fixed percentage applied to the cost of the goods

  • The percentage can be raised to increase profits

Exam Hint The mark-up can be bigger than 100% so do not worry if your answer is bigger than 100%.

Worked Example Kaley is a sole trader. She provides the following information for the year ended 31 December 2023.

	$
Revenue	128 000
Purchases	52 000
Inventory at 1 January 2023	8 000
Inventory at 31 December 2023	6 000

Calculate Kaley's mark-up. Your answer should be correct to two decimal places.

Answer:

• Calculate the cost of sales

  • Opening inventory + Purchases - Closing inventory

$8 000 + $52 000 - $6 000 = $54 000

• Calculate the gross profit

  • Revenue - Cost of sales

$128 000 - $54 000 = $74 000

• Calculate the mark-up

  • $\frac{\mathrm{Gross} \mathrm{profit}}{\mathrm{Cost} \mathrm{of} \mathrm{sales}}\times100$

$\frac{74000}{54000}\times100=137.0370...$

• Round to two decimal places

Final answer: Mark-up = 137.04%

Expenses to revenue ratio

Spec point — how to calculate key accounting ratios to measure profitability – profitability ratios: gross profit margin, mark-up, profit margin, return on capital employed, expenses to revenue ratio (operating expenses to revenue ratio)

Expenses to revenue ratio

What is the expenses to revenue ratio?

• A business aims to reduce this ratio

• If the expenses to revenue ratio increases then this suggests that:

  • The goods are being sold at a cheaper price than in previous years

    • Allowing more trade discounts has the same effect

  • The expenses have increased

Worked Example Kaley is a sole trader. She provides the following information for the year ended 31 December 2023.

	$
Revenue	128 000
Expenses	46 000

Calculate Kaley's gross profit margin. Your answer should be correct to two decimal places.

Answer:

• Calculate the expenses to revenue ratio

  • $\frac{\mathrm{Expenses}}{\mathrm{Revenue}}\times100$

$\frac{46000}{128000}\times100=35.9375$

• Round to two decimal places

Final answer: Expenses to revenue ratio = 35.94%

Profit margin

Spec point — how to calculate key accounting ratios to measure profitability – profitability ratios: gross profit margin, mark-up, profit margin, return on capital employed, expenses to revenue ratio (operating expenses to revenue ratio)

Profit margin

What is the profit margin?

• A decreasing profit margin suggests that:

  • Gross profit has decreased from previous years
  • The business is paying more for expenses
  • The business is not earning as much other income as in previous years

Worked Example Kaley is a sole trader. She provides the following information for the year ended 31 December 2023.

	$
Revenue	128 000
Gross profit for the year	74 000
Other income	9 000
Expenses	46 000

Calculate Kaley's profit margin. Your answer should be correct to two decimal places.

Answer:

• Calculate the profit for the year

  • Gross profit + Other income - Expenses

$74 000 + $9 000 - $46 000 = $37 000

• Calculate the profit margin

  • $\frac{\mathrm{Profit} \mathrm{for} \mathrm{the} \mathrm{year}}{\mathrm{Revenue}}\times100$

$\frac{37000}{128000}\times100=28.90625$

• Round to two decimal places

Final answer: Profit margin = 28.91%

Return on capital employed (ROCE)

Spec point — how to calculate key accounting ratios to measure profitability – profitability ratios: gross profit margin, mark-up, profit margin, return on capital employed, expenses to revenue ratio (operating expenses to revenue ratio)

Return on capital employed (ROCE)

What is the return on capital employed (ROCE)?

• A business aims to increase the return on capital employed

  • The business should consider whether it can use more short-term sources of finance rather than long-term loans

Exam Hint Notice that this profitability ratio uses the operating profit rather than the profit for the year. This means you need to use the profit before finance costs (loan interest or debenture interest).

Worked Example The equity and liabilities of Khazam Ltd at 31 December 2023 are listed below.

	$
Ordinary share capital	140 000
General reserve	40 000
Retained earnings	50 000
5% Debentures	30 000
Trade payables	25 000

The profit for the year ended 31 December 2023 was $35 000 after charging debenture interest.

Calculate the return on capital employed for the year ended 31 December 2023. The calculation should be correct to two decimal places.

Answer:

• Calculate the debenture interest for the year

5% × $30 000 = $1 500

• Calculate the profit for the year before interest

  • Add the debenture interest back onto the profit for the year

$1 500 + $35 000 = $36 500

• Calculate the capital employed

  • Equity (Issued share capital + Reserves + Retained earnings) + Non-current liabilities

$140 000 + $40 000 + $50 000 + $30 000 = $260 000

• Calculate the return on capital employed

  • $\frac{\mathrm{Profit} \mathrm{for} \mathrm{the} \mathrm{year} \mathrm{before} \mathrm{interest}}{\mathrm{Capital} \mathrm{employed}}\times100$

$\frac{36500}{260000}\times100=14.0384...$

• Round to two decimal places

Final answer: ROCE = 14.04%