Accounting Ratios (Edexcel IGCSE Business)

Revision Note

Author

Lisa Eades

An Introduction to Ratio Analysis

Ratio analysis involves extracting information from financial accounts to assess business performance
It helps managers to answer key questions including
- Why is one business more profitable than another one in the same industry?
- Is a business growing?
- How effectively is a business using assets and capital invested?
- What return on investment is expected?
- How risky is the financial structure of the business?
Ratios can be compared over time and between businesses or functions to determine how well financial objectives are being met

Exam Tip

Formulas to calculate profit margins, mark up, RoCE and liquidity are provided on page 2 of your exam paper.

Profit Margins

Profit margins measure of how effectively a business converts revenue into profit
Profit margins can be compared to previous years' to better understand business performance
- Higher and increasing profit margins are preferable, as it means that more revenue is being converted to profit

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

$Gross Profit Margin = \frac{Gross Profit}{Revenue} \times 100$

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

$Gross profit = \frac{Gross profit}{Revenue} \times 100 = \frac{$ 105, 731}{$ 124, 653} = 0.8482$ [1 mark]

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

$= 0.8482 \times 100 = 84.82 %$ [1 mark]

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

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

Ways to Increase the Gross Profit Margin

Method

Explanation

Increase revenue

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
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 direct costs

Purchase cheaper/alternative resources
- Negotiate with suppliers or find new suppliers
  - However businesses must ensure that reducing variable costs will not have an adverse effect on the quality or desirability of products
Buy stock in greater quantities
- Purchase in bulk amounts less frequently
  - Investment in increased storage space may be needed, which will reduce the impact of cost savings made
Reduce wastage of raw materials and components

The Operating Profit Margin

This calculation shows the proportion of revenue that is turned into operating profit
- It is calculated using the formula below and the outcome is expressed as a percentage

$Operating Profit Margin = \frac{Operating Profit}{Revenue} \times 100$

Worked example

Head to Toe Wellbeing’s revenue in 2022 was $124,653. Its operating profit was $65,864

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

[2 marks]

Step 1: Substitute the values into the formula

$Operating Profit Margin = \frac{Operating Profit}{Revenue} \times 100 = \frac{$ 65, 864}{$ 124, 653} = 0.5284$ [1 mark]

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

$= 0.5284 \times 100 = 52.84 %$ [1 mark]

In 2022, 52.84% of Head to Toe Wellbeing’s revenue was converted into operating profit

Improving the Operating Profit Margin

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

Mark-up

The mark-up is a measure of profit made on each item sold
Some businesses calculate the markup in order to determine the price at which they should sell their products
- This methods ensures that all costs are covered and that a profit will be made on every item they sell
Mark-up is expressed as a percentage and calculated using the formula

$Markup = \frac{Profit per item}{Cost per item} x 100$

Worked example

Evolve Boards' bestselling penny skateboard costs $12.13 to produce. Each board is sold for $20.

Calculate the percentage markup on each penny skateboard sold [2 marks]

Step 1: Calculate the profit per item

$= $ 20 - $ 12.13 = $ 7.87$ [1 mark]

Step 2: Divide profit per item by cost per item

$= $ 7.87 \div $ 12.13 = 0.6488$

Step 3: Multiply the outcome by 100

$= 0.6488 \times 100 = 64.88 %$ [1 mark]

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

$Return on Capital Employed = \frac{Operating Profit}{Capital Employed} \times 100$

RoCE can 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

$Capital Employed = Non - current Liabilities + Equity$

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
Operating Profit	€2.2 million

Calculate Keals Cosmetics' Return on Capital Employed.

[3 marks]

Step 1: Calculate the capital employed

$Capital employed = Non - current liabilities + Equity Capital employed = € 1.5 m + € 15.4 m Capital employed = € 16.9 m$ [1 mark]

Step 2: Divide Operating Profit by Capital Employed

$= \frac{Operating Profit}{Capital Employed} = \frac{€ 2.2 m}{€ 16.9 m} = 0.13$ [1 mark]

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

$= 0.13 \times 100 = 13 %$ [1 mark]

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

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

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

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 real estate branches.

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

Branch	Capital Employed	Operating Profit
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

$RoCE = \frac{Operating Profit}{Capital Employed} \times 100 RoCE Sevenoaks = \frac{£ 0.37 m}{£ 2.4 m} \times 100 = 15.42 % [1 mark] RoCE Whitstable = \frac{£ 0.57 m}{£ 3.1 m} \times 100 = 18.39 % [1 mark] RoCE Rochester = \frac{£ 0.51 m}{£ 2.9 m} \times 100 = 17.59 % [1 mark]$

Step 2: Identify the least profitable branch for closure

Sevenoaks [1 mark] is the least profitable branch with a RoCE of 15.42% [1 mark] and should be the branch selected for closure

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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Accounting Ratios (Edexcel IGCSE Business)

Revision Note

The Gross Profit Margin

Improving the Gross Profit Margin

The Operating Profit Margin

Improving the Operating Profit Margin

Improving RoCE

Using RoCE to make decisions

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Author: Lisa Eades