Chapter 39- profitability ratios

Question 1

Profitability

Answer 1

Ratios included
- gross profit margin
- net profit margin
- return on capital employed
- return on equity

Concerned with
- consider the level of profit in relation to the actual business
- ratios simply consider how profitable the business is in relation to its sales, assets or the capital invested

Question 2

Profitability ratios

Answer 2

• concerned with the level of profit measured against various aspects of the business
• they compare the profitability with the size of the business either by looking at the assets of the business or at its level of sales

Question 3

Gross profit margin

Answer 3

• looks at the level of profit as a percentage of the sales or turnover
• gross profit margin considers only the direct costs and not the indirect costs (overheads)
• gross profit= sales revenue - cost of sales

Question 4

Gross profit margin formula

Answer 4

Gross profit/ sales x 100
Answer will tell you (as a percentage) how many pence from every pound of sales is of sales is gross profit

Question 5

Net profit margin

Answer 5

• measures the net profit as a percentage of sales or turnover
• takes into account the direct and indirect costs
• more realistic measure of the profitability against sales than gross profit margin

Question 6

Net profit margin formula

Answer 6

Net profit margin= net profit (operating profit)/ sales x 100

Question 7

Return on capital employed (ROCE)

Answer 7

• Frequently used ratio for performance
• measures the net profit as a percentage of the capital employed

Question 8

Return on capital employed formula

Answer 8

Return on capital employed= operating profit/ capital employed x 100

• shows the amount of money earned by the business in terms of profits in relation to the amount invested by shareholders
• capital employed refers to the shareholders funds and the profits earned before tax and dividends

Whether this is am efficient return will depend on
- type of product
- how competitive the marker is

Question 9

Capital employed =

Answer 9

Non current liabilties + ordinary share capital + reserves

Question 10

Return on equity

Answer 10

• measures the ability of a business to generate profits from its shareholders investments into the business
• how much profit is generated for every pound of shareholders funds invested

Question 11

Return on equity formula

Answer 11

Return on equity= profit for year/ shareholders equity

Question 12

Difference between return on capital employed and return on equity

Answer 12

• return on equity considers the amount of profits generated from equity (shares) whether return on capital employed is the more comprehensive measure as it takes into consideration shareholders funds and liabilties (Loans)