IGCSEBusinessCIERevision Notes5. Financial Management5.5 Analysing the AccountsUsing Profitability Ratios to Analyse Performance

Using Profitability Ratios to Analyse Performance (CIE IGCSE Business)

Revision Note

Lisa Eades

The Gross Profit Margin

  • This calculation shows the proportion of revenue that is turned into gross profit
    • It is calculated using the following formula and is expressed as a percentage

 Gross space Profit space Margin space equals space fraction numerator Gross space Profit over denominator Sales space Revenue end fraction cross times space 100 space space space space space space

Improving the gross profit margin

  • The gross profit margin can be improved in two ways
    • The business can increase its sales revenue
    • The business can reduce its direct costs
       

How to Increase the Gross Profit Margin


Method


Explanation

Increase the sales revenue

1. Increase the value of sales

    • Raise prices
      • If costs remain the same, this will improve profitability as the difference between the selling price and costs is now greater
    • Sell premium products
      • If customers are willing to spend money on these goods, the business could earn more profit per item sold
         

2. Increase the volume of sales

    • Price tactics 
      • Use price tactics to encourage higher quantity or more frequent purchases
        • E.g. 'Buy one get one half price' doubles the number of items a customer purchases, increasing revenue
    • Increase marketing activities
      • Engage in more marketing activities to increase sales volume

Reduce the direct costs
  • Reduce variable costs 
    • This may involve purchasing cheaper/alternative resources, negotiating with suppliers or purchasing in bulk
    • Businesses must ensure that reducing variable costs will not have an adverse effect on the quality or desirability of products
    • Buying stock in greater quantities may require investment in increased storage space which will reduce the impact of the cost savings made
       
  • Businesses may also be able to reduce wastage of raw materials and components 

Worked example

Head to Toe Wellbeing’s revenue in 2022 was $124,653. Its gross profit was $105,731

Calculate Head to Toe Wellbeing Ltd’s Gross Profit Margin in 2022 [2 marks]

 

Step 1: Substitute the values into the formula

Gross space profit space equals space fraction numerator Gross space profit space over denominator Sales space revenue end fraction space cross times space 100 space space space equals space fraction numerator $ 105 comma 731 over denominator space $ 124 comma 653 space end fraction equals space space 0.8482 space   [1 mark]

  

Step 2: Multiply the outcome by 100 to find the percentage

equals space 0.8482 space cross times space 100 equals space 84.82 percent sign        [1 mark]

84.82% of Head to Toe Wellbeing’s revenue was converted into gross profit during 2022

The Net Profit Margin

  • The Net Profit Margin shows the proportion of revenue that is turned into profit before interest and tax
    • It is calculated using the formula below and the outcome is expressed as a percentage

text Net Profit Margin =  end text fraction numerator Profit space Before space Interest space and space Tax over denominator Sales space Revenue end fraction cross times 100

Improving the net profit margin

  • The profit margin can be improved in two ways
    • Increasing the gross profit margin (see above)
    • Reducing overhead costs by reducing staffing levels, relocating to cheaper premises or changing utility companies
      • Reducing staffing levels may affect staff morale and negatively affect productivity
      • Relocation costs can outweigh some of the benefits of moving to a cheaper location
      • Replacing inefficient or outdated equipment may require staff training

Worked example

Head to Toe Wellbeing’s revenue in 2022 was $124,653. Its profit before interest and tax was $65,864

Calculate Head to Toe Wellbeing Ltd’s Profit Margin in 2022

[2 marks]

Step 1: Substitute the values into the formula

text Net Profit Margin =  end text fraction numerator Profit space Before space Interest space and space Tax over denominator Sales space Revenue end fraction cross times 100 equals space fraction numerator $ 65 comma 864 over denominator $ 124 comma 653 end fraction equals space 0.5284    [1 mark]

 

Step 2: Multiply the outcome by 100 to find the percentage

 

equals space 0.5284 space cross times space 100 equals space 52.84 percent sign                  [1 mark]

In 2022, 52.84% of Head to Toe Wellbeing’s revenue was converted into profit before interest and tax

Return on Capital Employed

  • The Return on Capital Employed (RoCE) measures how how effectively a business uses the capital invested in the business to generate profit
    • It is calculated using the formula below and is expressed as a percentage
       

Return space on space Capital space Employed space equals space fraction numerator Profit space Before space Interest space and space Tax over denominator Capital space Employed end fraction space space cross times space 100

  • RoCE be compared over time and with competitors
    • It can also be compared with other potential capital investments, such as savings rates

  • The Capital Employed figure is usually provided for you
    • If required, it is calculated using the formula

Capital space Employed space equals space Non minus current space Liabilities space plus space Equity

Improving RoCE

  • When analysing the RoCE, the higher the rate the better, as it indicates that the business is profitable and using its capital efficiently
    • Investors prefer businesses with stable and rising levels of RoCE, as this indicates low-risk growth is being achieved
    • A ROCE of at least 20 per cent is usually a good sign that the company is in a good financial position
       
  • To increase the RoCE, a business can
    • Increase the level of profit generated without introducing new capital into the business
    • Maintain the level of profit generated whilst reducing the amount of capital in the business

Worked example

The table shows an extract from the company accounts of Keals Cosmetics.

Non-current Liabilities €1.5 million
Revenue €7 million
Equity €15.4 million
Profit before Interest & Tax €2.2 million

 

Calculate Keals Cosmetics' Return on Capital Employed.         

[3 marks]

 
Step 1: Calculate the capital employed   

begin mathsize 16px style Capital space employed space equals space Non minus current space liabilities space plus space Equity Capital space employed space equals space € 1.5 space straight m space plus space € 15.4 space straight m Capital space employed space equals space € 16.9 space straight m end style   [1 mark]
  

 

Step 2: Divide Operating Profit by Capital Employed

RoCE space equals fraction numerator space Profit space Before space Interest space and space Tax over denominator Capital space Employed end fraction space cross times space 100 equals space fraction numerator € 2.2 space straight m over denominator € 16.9 space straight m end fraction space cross times space 100 equals space 0.13    [1 mark] 

Step 3: Multiply the result by 100 and express the outcome as a percentage

      

equals space 0.13 space cross times space 100 equals space 13 percent sign   [1 mark]

The capital employed in Keals Cosmetics has generated a return of 13%         

Using RoCE to make decisions

  • RoCE can be used to support strategic decisions (e.g. investment or divestment decisions) to determine the most profitable option given the level of capital employed

Worked example

Faced with increasing costs, Kent & Medway Properties Ltd is looking to close one of its three high street estate agency branches.

The table below shows some key data for each of the branches.

Branch Capital Employed  Profit Before Interest & Tax
Sevenoaks £2.4m £0.37m
Whitstable £3.1m £0.57m
Rochester £2.9m £0.51m

 

Calculate the Return on Capital Employed (RoCE) for each branch and recommend which branch, on profitability terms, should close  

[5 marks]

 

Step 1: Apply the formula to calculate the RoCE for each branch

      RoCE equals space fraction numerator Profit space Before space Interest space and space Tax over denominator Capital space Employed end fraction space space cross times space 100 RoCE space Sevenoaks space equals space fraction numerator £ 0.37 straight m over denominator £ 2.4 straight m end fraction space space cross times space 100 space equals space 15.42 percent sign space space space bold left square bracket bold 1 bold space bold mark bold right square bracket bold space bold space space RoCE space Whitstable space equals space fraction numerator £ 0.57 straight m over denominator £ 3.1 straight m end fraction space space cross times space 100 space equals space 18.39 percent sign space space bold left square bracket bold 1 bold space bold mark bold right square bracket RoCE space Rochester space equals space fraction numerator £ 0.51 straight m over denominator £ 2.9 straight m end fraction space space cross times space 100 space equals space 17.59 percent sign space space bold left square bracket bold 1 bold space bold mark bold right square bracket

 

Step 2: Identify the least profitable branch for closure

Sevenoaks is the least profitable branch with a RoCE of 15.42% and should be the branch selected for closure  [2 marks]

Exam Tip

When calculating financial ratios check that you are using the correct units.

In some cases financial data is presented as raw figures (e.g. £14,520) but in most cases, you will be working in thousands (£000) or millions (£m).

  • Ensure that you convert correctly, e.g. £0.39 million is equal to £390,000 and £34.9 (000) is equal to £34,900
  • Make sure the decimal place is in the correct place
  • Calculate to two decimal places unless stated otherwise

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    Lisa Eades

    Author: Lisa Eades

    Lisa has taught A Level, GCSE, BTEC and IBDP Business for over 20 years and is a senior Examiner for Edexcel. Lisa has been a successful Head of Department in Kent and has offered private Business tuition to students across the UK. Lisa loves to create imaginative and accessible resources which engage learners and build their passion for the subject.