Profitability

Question 1

Return on Owners Investment (ROI)

Answer 1

ROI assesses profitability from an investors (owners) point of view.
Calculated as:

Net Profit
—————- x100
Average capital

Indicates how much the owner receives for every dollar invested
eg. For every dollar that Carl has put in he receives 20% or 20c

in order for ROI to improve, Net Profit must increase as Average capital goes down, OR if net profit decreases and so does Average capital but capital at a greater proportion

Question 2

Benchmarks

Answer 2

These ratios can be compared to:

• Performance in previous periods
• Budgeted performance
• Performance of other similar firms

Question 3

The Debt Ratio

Answer 3

• The debt ratio measures the percentage of a firms assets that are financed by liabilities and shows how reliant a business was on outside debt rather than the owners funds to purchase assets.
• It has implications for both the risk (long-term stability) and Return (ROI)

Calculated as:

Total liabilities
—————– x100
Total Assets

eg. 60% of the assets are funded by debts/credit

Question 4

A high debt ratio means:

Answer 4

A high debt ratio means a greater reliance on borrowed funds (liabilities) to purchase assets and, consequently, a lower reliance on funds contributed by the owner. This will have implications for the firms Profitability and its Return on Owners Investment. However, the Debt Ratio is also a measure of the firms long-term stability, and can be used to evaluate the level of risk associated with the business.

Question 5

Return on Assets

Answer 5

• assesses profitability from a managers point of view.
• It measures how effectively the business has used its assets to earn profit

Net Profit
———————- x100
Average Total Assets

Question 6

Asset Turnover

Answer 6

The ATO measures how productively a business has used its assets to earn revenue

Average total assets

Question 7

Why Asset Turnover improves

Answer 7

Sales could increase and assets stayed the same or sales stayed the same and assets decreased (reduce idle assets) OR they could both increase/decrease but sales would be proportionally higher.

Question 8

Profitability

Answer 8

Profitability is the ability of the business to earn profit, measured by comparing profit against a base such as sales, assets or owners equity. We don’t just look at the dollar value.

Question 9

Expense Control

Answer 9

-Refers to the firms ability to manage its expenses so that they either decrease, or increase no faster than sales revenue.
-Two indicators that calculate the percentage of each dollar of sales that is retained as profit that evaluate expense control are:
Net Profit Margin
Gross Profit Margin

Question 10

Net Profit Margin (NPM)

Answer 10

-The NPM measures the percentage of sales revenue that is retained as Net Profit.
Net Profit = Revenues - Expenses
————– x 100
Sales Revenue

eg. 20c of every dollar of sales revenue was retained as Net Profit. Alternatively, 80c was consumed by Expenses

Question 11

ATO X NPM = ROA

Answer 11

Sales Revenue❌ Net Profit
——————- X —————
Ave Total Assets Sales Revenue❌

     Net Profit =    ---------------
Ave total assets

This proves that Return on Assets, and therefore profitability, depends on the ability of the firm to use its assets to earn revenue (ATO) and to control its expenses (NPM)

Question 12

Gross Profit Margin

Answer 12

-The GPM measures the percentage of sales revenue that is retained as gross profit
Gross Profit = sales-COGS
————– x 100
Sales Revenue

-Used to assess the adequacy of the firms mark-up

Question 13

A high Gross Profit Margin means a higher mark-up.

This could occur if:

Answer 13

• selling prices increased and cost prices remained constant
• cost prices decreased, and selling prices remained constant
• both increased, but selling prices increased by more
• both decreased, but cost prices decreased by more

Question 14

Non-Financial Information

Answer 14

Refers to any information that cannot be found in the financial statements, and is not expressed in dollars and cents, or reliant on dollars and cents for its calculation. Including:

• The firms relationship with its customers
• The suitability of stock
• The firms relationship with its employees

Question 15

Non-Financial Information
Determining:
The firms relationship with its customers

Answer 15

• Customer satisfaction surveys
• Number of repeat sales
• Number of sales returns
• Number of customer complaints
• Number of sales enquiries / catalogue requests

Question 16

Non-Financial Information
Determining:
The suitability of stock

Answer 16

The level of sales reports how much was sold, but it gives little feedback on whether customers were satisfied with their purchase. Not every customer can be surveyed, but the NUMBER OF SALES RETURNS will provide a useful guide to the suitability of stock, with the firm keeping detailed records on the reasons for those returns. The NUMBER OF PURCHASE RETURNS will provide a good guide as to the quality of stock, as will the NUMBER OF CUSTOMER COMPLAINTS