Profitability Ratios (Cambridge International IGCSE 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 margin
  • Mark-up
  • Profit margin
  • Return on capital employed

Gross margin

Spec point — 6.1.1

What is the gross margin?

• If the gross 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 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 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 margin

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

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

• Round to two decimal places

Final answer: Gross margin = 57.81%

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%.

Profit margin

Spec point — 6.1.2

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 — 6.1.3

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 operating profit for the year

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

$1 500 + $35 000 = $36 500

• Calculate the capital employed

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

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

• Calculate the return on capital employed

  • $\frac{\mathrm{Operating} \mathrm{profit} \mathrm{for} \mathrm{the} \mathrm{year}}{\mathrm{Capital} \mathrm{employed}}\times100$

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

• Round to two decimal places

Final answer: ROCE = 14.04%

Evaluating profitability

How do I evaluate the profitability of a business?

• It is best to look at multiple profitability ratios together to get a better understanding

  • The gross margin might be high but the profit margin might be low

    • This suggests that gross profit is not an issue
    • The business needs to look at other income and expenses

  • The difference between the gross margin and profit margin is the proportion of revenue that is spent on expenses after deducting other income

    • A smaller difference indicates that a business has better control of expenses

• Consider actions which have a positive and negative effect

  • For example, if a business finds a cheaper supplier:

    • The gross margin might increase as a result of lower cost of sales
    • However, the quality of the goods might not be as good, which could cause customers to shop elsewhere, reducing sales revenue

How do I compare the profitability of a business between years?

• Compare the ratios to the same ratios from previous years

• For each ratio

  • Make a general comment

    • State whether it has improved or gotten worse
    • State the percentages

  • Give possible reasons for the change

• Calculate the difference between the gross margin and the profit margin to see if the business has gotten better at controlling expenses

Worked Example Sana and Taz are business partners. They provide information for the financial years ending 31 December 2022 and 31 December 2023.

	Year ended
31 December 2022	31 December 2023
Gross margin	32.25%	43.75%
Profit margin	9.43%	10.31%
Return on capital employed	21.08%	10.45%

Comment on the performance of the business over the two years.

Answer:

• Comment on the gross margin

Final answer: The gross margin has improved from 32.25% to 43.75%. This could be because Sana and Taz increased the selling prices of their goods. They could have decreased the cost of sales by changing to a cheaper supplier.

• Comment on the profit margin

Final answer: The profit margin has improved from 9.43% to 10.31%. This could be due to a higher gross profit, but it could also be due to an increase in other income.

• Comment on the differences between the gross and profit margins

Final answer: In 2022, the difference between the gross and profit margins was 22.82%. In 2023, this difference was 33.44%. The difference worsened, which could be because Sara and Taz had worse control over their expenses.

• Comment on the return on capital employed

Final answer: The return on capital employed worsened from 21.08% to 10.45%. This could be due to an increase in the capital employed. This may have involved more capital being introduced by the partners or a long-term loan.