Accounting - Profitaibility Flashcards
What are the Profitability Ratios
Analyse the return the company generates relative to its revenues.
1) Gross Profit Margin
2) Net Profit Margin
3) ROCE
4) Asset Turnover
5) Operational Gearing Ratio
What is Gross Profit Margin? Ratio and def
Def = GPM looks at % of revenue the company earns after considering COGS
GPM = Gross Profit (Rev - COGS) / Revenue
What is Operating Profit Margin? Ratio and def
Def: OPM looks at % of revenue the company earns after considering COGS AND op expenses
OPM = Operating Profit (EBIT) / Revenue
What is Net Profit Margin? Ratio and def
NPM = Net Profit / Revenue
Relationship between margin and turnover
Low margin and high turnover = good for comp
High margin and low turnover = good for comp
low margin and low turnover = BAD for comp
We want margins to be as high as possible but it does not always mean the company is not profitable if this is not the case
ROCE - Ratio and def
Def: ROCE measures the overall management performance in relation to the capital invested in the company. (Shows operating profit as a percentage of capital employed)
ROCE = Operating Profit (EBIT) / Capital Employed
OR
ROCE = Operating profit / (Total Assets - Current Liabilities)
What is capital employed?
1) Total Assets - Current Liabilities
2) Equity + LT Liabilities
ROCE - what is a good %?
up to 30% - the higher the more profitable.
Asset Turnover- Ratio and def
Def - helps to measure the productivity of a company’s assets and measures the efficient use of assets to produce sales
Link between AT and ROCE - ROCE measures profitability to capital employed, AT measures sales to Capital Employed
AT = Turnover (Revenue) / Capital Employed (Total Assets)
What ratio is good for AT?
Higher is better (e.g ratio of 1.81 = for every £1 of Capital employed £1.81 is generated in sales.
Companies with low profit margins tend to have higher AT
Retail - often has high AT (c2) but companies e.g utilities have a large asset base and therefore a lower AT - cant compare sectors.
Comparing AT??
Comparing within the same sector is useful but may be insufficient as AT within a company can vary year to year due to the cyclical nature of industry
Operational Gearing Ratio and def
Def: Measures the variability of profits as revenue changes. A good measure of operational risk (i.e risk to operating profit)
Op gearing = (revenue - variable costs) / PBIT
What is contribution?
Revenue - variable costs
What does high op gearing mean?
The higher a firm’s fixed costs are as a proportion of total costs, the higher its operational gearing.
High operational gearing makes a firm’s profits more sensitive to a change in sales, which in turn, makes it more difficult to forecast its earnings
Why is Op gearing useful for investors?
Key for evaluating businesses and their sensitivity to a change in demand for the products.
Businesses with high contribution levels are more able to withstand a fall in demand or output
