Profitability

Question 1

State the five different measures the ratios come under and what they signify.

Answer 1

Profitability: How much wealth is created

Efficiency: How efficient is the use of resources

Short-term liquidity: are there enough liquid resources to meet maturing obligations?

Leverage: How much financing is contributed by creditors (i.e how much financial risk is there?)

Investment Return: How much do shareholders benefit?

Question 2

Return on Equity(ROE)

Answer 2

ROE = Net profit/Average Equity

where Net profit(net income) is after taxes and preferred dividends.

-> Measures the rate of return on the ownership interest (shareholders equity) of the common shareholders.

Question 3

Return on capital employed(ROCE)

Answer 3

ROCE = Operating profit/Average capital employed

where capital employed is commonly measured as total assets - current liabilities.

-> Measures the rate of return on the long-term capital invested in the business.

Question 4

Gross Profit Margin(GPM)

Answer 4

GPM = Gross Profit/Sales

-> Relates the cost of sales to revenue

Question 5

Operating profit Margin(OPM)

Answer 5

OPM = Operating profit/Sales

• > Relates operating income to revenue
• > Difference between GPM and OPM shows how well costs are being controlled.