Profitability Ratios

Question 1

1. Return on capital employed (ROCE) (%) or accounting
   rate of return

Answer 1

1. Return on capital employed (ROCE) (%) or accounting
   rate of return calculation….

(Operating profit) ÷ (equity + non-current liabilities
(debt)) x100

or Return on total assets (ROA) (%)

= Operating profit ÷ total assets x 100

Question 2

2. Return on shareholders’ equity (ROE) (%)

Answer 2

2. Return on shareholders’ equity (ROE) (%) calculation…

(Net profit (profit for period)) ÷ total shareholders’
equity × 100

Question 3

3. Operating profit margin (%)

Answer 3

Operating profit margin (%) calculation…

(Operating profit ÷ revenue) × 100

Question 4

4. Gross profit margin (%)

Answer 4

Gross profit margin (%) calculation…

(Gross profit ÷ revenue) × 100

Question 5

5. Net profit margin (%)

Answer 5

Net profit margin (%) calculation…

(Net profit ÷ revenue) × 100

Question 6

6 . What is Gross profit margin ratios?

Answer 6

Gross profit margin ratio

Gross profit margin calculates the ratio of gross profit to revenue. Gross profit refers to the margin that company charges
above cost of goods sold.

It indicates how much the company is earning considering the required costs to produce its goods and services.

The underlying drivers behind this ratio are

a) selling prices,
b) product mix,
c) purchase costs,
d) production costs and
e) inventory valuations.

The formula for calculating gross profit margin ratio is as follows…

(Gross profit ÷ revenue) × 100

Where gross profit = revenue – cost of goods sold.

The higher the ratio, the more favourable it is for the company.

Question 7

7. What is the Return ratios

Answer 7

Return ratios

These represent the company’s ability to generate returns to its investors (including) shareholders. Commonly used return ratios include:

• Return on assets ratio
• Return on capital employed (ROCE) ratio
• Return on shareholders’ equity (ROE) ratio

Question 8

What is operating profit margin ratio?

Answer 8

Operating profit margin ratio

Operating profit margin calculates the ratio of operating margin to revenue. Essentially, it is the percentage of profit remaining after accounting for operating expenses.

Companies with higher operating profit margins can comfortably
cover their fixed costs including interest charges.

Several factors such as

a) employment policy,
b) depreciation methods,
c) write-offs of bad debts,
d) selling and
d) marketing expenses

All of the above may impact on this ratio.

The formula for calculating operating profit margin ratio is as follows…

(Operating profit ÷ revenue) × 100

Where operating profit = revenue – cost of goods sold – operating expenses

The higher the ratio, the more favourable it is for the company

Question 9

What is Net profit margin ratio?

Answer 9

Net profit margin ratio

Like the operating profit margin ratio, net profit margin ratio evaluates the company’s ability to generate earnings after
taxes.

This ratio reflects the strength of the management, since visionary management strives to improve the profitability of a company above all its costs.

It also checks how effectively the company has administered the process.

The formula for calculating net profit margin ratio is as follows…..

(Net profit ÷ revenue) × 100

Where net profit = revenue – cost of goods sold – operating expenses – non-operating expenses + non-operating income – income tax.

As an alternative, the net profit margin ratio may use profit before tax.

The higher the ratio, the more favourable it is for the company

Question 10

if Revenue grows a mere 2% in 20X9, compared to previous period’s growth rate of 46% what does this mean?

Answer 10

The revenue growth rate could have slowed down for reasons such as a new competitor in the market offering product/services at competitive prices, loss of key employees, a stagnant market, low productivity and so on.

Question 11

If Gross profit and operating profit margin decreases between periods what is this a sign off?

Answer 11

It could be due to an increase in cost of goods sold and ongoing incremental sales and marketing expenses.

If the company reduces its non-operating expenses during the period, net profit will increase. Look out for this!

Question 12

If revenue continues to rise but profit continues to fall, what could this be a result of?

Answer 12

This could be a result of various factors such as;

a) an increase in labour or raw material prices,
b) regulatory challenges,
c) changes in accounting policy or
d) changes in sales mix.

Question 13

Limitations of ratio analysis?

Answer 13

Limitations of ratio analysis….

1. Ratio analysis is only the first step towards financial statement analysis. Final conclusions cannot be drawn based on mere percentages shown by the ratios, as they may not reflect the holistic picture about a company’s situation.

One needs to be vigilant while conducting research on the company.

2. Mathematical calculation does not work when the base figure is zero or negative, as it may not reflect the true picture. For example, if bad debts for the base period and the current period are zero and £500, respectively, one cannot calculate the change as a percentage.
3. A time-series analysis that makes use of historical financial information may be distorted with inflation or seasonal factors.
4. Ratios are meaningless without a comparison against trend data or industry data and without looking at the causation factors.
5. There may be window dressing intended to manipulate financial statements.

Question 14

Accounting irregularities and creative accounting?

Answer 14

The major scandals that have affected the accounting profession have usually been as a result of fraud. It is therefore important for auditors and directors to understand their role in the prevention and detection of fraud. Accounting irregularities are not formally defined in GAAP.

(ISA) 240 (the Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statements) recognises that misstatement in the financial statements can arise from either fraud or error (unintentional misstatement).

Fraud can be further split into two types:

• fraudulent financial reporting (intentional misstatement)
• misappropriation of assets (theft)

Question 15

Errors in financial accounting?

Answer 15

Errors are considered to be unintentional misstatement in financial statements, or the lowest level of accounting irregularity.

These are non-fraudulent discrepancies in financial documentation and are corrected by those preparing the next financial statements.

Examples of accounting errors include:

• a mistake in the processing of data (such as data entry error) from which financial statements are prepared;
• an incorrect accounting estimate arising from oversight or misinterpretation of facts; or
• a mistake in the application of accounting principles relating to measurement, recognition, classification, presentation or disclosure

Question 16

Fraudulent financial reporting?

Answer 16

Fraudulent financial reporting is the most severe type of accounting irregularity, usually involving intentional misstatement or omission of amounts or disclosures in financial statements to deceive or mislead the users of the financial information.

It generally involves accounting irregularities, such as:

• manipulation, falsification or alteration of accounting records or supporting documents;
• misrepresentation in, or intentional omission from, the financial statements of events, transactions or other significant information; or
• misapplication of accounting principles relating to amounts, classification, manner of presentation or disclosure.

This is one of the two types of accounting irregularities that are of most concern to auditors (the other one being theft)

Question 17

Misappropriation of assets (theft)?

Answer 17

The other type of fraud is asset misappropriation. This involves theft of a corporation’s assets. It generally involves misstatements due to accounting irregularities, such as:

• stealing tangible or intangible assets;
• embezzling receipts; or
• making payment for the purchase of non-existent goods and services.

Misappropriation of assets is usually supplemented by false documents in order to conceal the fact that the assets are missing, thus causing accounting irregularities in financial statements.

Question 18

Creative accounting?

Answer 18

Creative accounting is the deliberate manipulation of figures for a desired result.

The major consideration for the directors or employees who manipulate results is usually the effect the results will have on the share price of the company.

Creative accounting presents the financial statements of an entity in the best possible or most flattering way. It is a deliberate manipulation of financial statements which is geared towards achieving predetermined results. This occurs due to inherent weaknesses in accounting systems, accounting choices, accounting judgment and accounting transactions.

Question 19

The types of forms of creative accounting?

Answer 19

Creative accounting takes many forms…

1. Cut-off manipulation:

a company may delay invoicing in order to move revenue into the following year.

2. Revaluation of non-current assets:

this is a practice open to manipulation. It can have a significant impact on a company’s statement of financial position.

3. Window dressing:

transactions are passed through the books at the year-end to make figures look better, often to be reversed after the year-end. An example is a loan repaid just before the year-end and taken out again at the beginning of the next year

4. Off-balance sheet financing:

is a form of financing in which large capital expenditures and the associated liability (such as leases and partnerships) are kept out of a company’s statement of financial position. It impacts a company’s level of debt and gearing and has serious implications

5. Manipulation of accruals, prepayments and contingencies:

this can be very subjective, particularly in relation to contingencies as a contingent liability (for example, the outcome of a pending lawsuit) is difficult to estimate. In such cases, companies will often only disclose the possibility of such a liability, even though the eventual costs may be substantial.

Question 20

Regulations to prevent creative accounting?

Answer 20

International Accounting Standard 27 ensures consolidation of financial statements of subsidiaries with that of
parent company.

1. International Accounting Standard 27 ensures consolidation of financial statements of subsidiaries with that of
   parent company.

Question 21

What does gross profit refer to?

Answer 21

Gross profit refers to the margin that a company charges above cost of goods sold.

It indicates how much a company is earning, considering the required cost to the produce its goods and services.

Underlying drives behind gross profit ratio are:

1. selling prices
2. product mix
3. purchase cost
4. production costs
5. inventory valuations

Question 22

Operating profit margin

Answer 22

Operating profit margin

This is profit remaining after accounting for expenses. Companies with higher profit margins can comfortably pay for costs and interests.

The factors that influences this ratio:

1. Employment policy
2. Depreciation methods
3. Write offs of bad debt
4. Selling and Marketing (distribution) expenses

Trend analysis may help analyse and interpretate this info.