Using Profitability Ratios to Analyse Performance | Business Studies for GCSE/IGCSE - Year 11 PDF Download

The Gross Profit Margin

• This computation demonstrates the percentage of revenue converted into gross profit.

• It's determined by the following formula and presented as a percentage.
  

Improving the Gross Profit Margin

Enhancing the gross profit margin is achievable through two avenues:

• Increasing Sales Revenue: Enhancing sales revenue is vital for a business's financial health. By implementing effective marketing strategies, a company can attract more customers and boost its income. For example, offering promotions or launching new products can stimulate sales growth.
• Reducing Direct Costs: Cutting down on direct costs is another strategy to enhance profitability. This involves minimizing expenses related to producing goods or services. For instance, a business can negotiate better deals with suppliers or improve operational efficiency to lower production costs.

How to Improve the Gross Profit Margin

Net Profit Margin

• The net profit margin indicates the percentage of revenue that translates into profit before deducting interest and taxes.
• It is computed using a specific formula and the result is presented as a percentage:
  

Improving the Net Profit Margin

Improving the profit margin entails two approaches:

• Enhancing the gross profit margin, as discussed earlier.
• Reducing overhead costs through measures such as:
  • Decreasing staffing levels, which may impact staff morale and productivity adversely.
  • Relocating to more economical premises, although relocation expenses may offset some cost benefits.
  • Upgrading inefficient or obsolete equipment, which may necessitate staff training.

Return on Capital Employed

• The Return on Capital Employed (RoCE) assesses how effectively a business utilizes its invested capital to generate profits. It is calculated as a percentage.
• RoCE is calculated using the following formula:
  
• Return on Capital Employed (RoCE) can be evaluated across different time periods and against competitors. Additionally, it can be compared with alternative capital investments, such as savings rates.
• The Capital Employed figure is typically available or provided. If needed, it can be calculated using the formula:
  Capital Employed = Non-current Liabilities + Equity.

Improving RoCE

• When scrutinizing RoCE, a higher rate is preferable, as it signifies profitable operations and efficient capital utilization. 
  • Investors favor businesses with consistent or escalating RoCE figures, as this suggests achieving growth with minimal risk. 
  • Typically, a RoCE of at least 20 percent is indicative of a strong financial standing.
• To boost RoCE, businesses can:
  • Augment profit levels without injecting new capital.
  • Sustain existing profit levels while trimming the capital employed in the business.

Using RoCE to make decisions

• RoCE aids in strategic decision-making, such as investment or divestment choices, by identifying the most lucrative option relative to the capital employed.