0264 · 5.5.1Profitability

Profitability concepts and business figures

0:00Revenue is the income a business receives from selling goods or services, while profit is total revenue minus total costs. A large business can earn more dollars of profit than a smaller competitor, yet achieve weaker financial performance. Understanding that difference helps you judge how successfully a business uses its sales and investment. Profitability is how well a business turns its revenue or the capital invested in it into profit, measured as a percentage.

0:27Profit gives an amount in dollars, while profitability relates that amount to the resources used to earn it. The three profitability ratios are gross profit margin, profit margin and return on capital employed, or R O C E. Each one is worked out with the same set of figures from one business. A percentage puts differently sized businesses onto a common scale. Comparing profit with revenue tells us how much of each sales dollar remains after particular costs.

0:53Using capital employed instead shows the return generated by the long-term finance committed to the business. Each ratio answers a different question, so we need to choose the measure that fits our purpose. Cost of sales is the cost of producing or buying the goods that were sold, and gross profit is revenue minus cost of sales. Expenses are the other costs of running the business, such as rent, salaries and advertising.

1:16Taking expenses away from gross profit gives profit, so this remaining amount reflects both groups of costs. Capital employed is the total long-term finance used in the business. That finance supports activities such as buying equipment and maintaining operations. A business needs to generate a return from the money committed to it. Comparing profit with capital employed helps us judge how successfully that finance has been used over the period.

1:41Bramble Supplies sells garden tools to shops. Its annual revenue is two hundred and fifty thousand dollars, and cost of sales is one hundred and fifty thousand dollars. Gross profit is one hundred thousand dollars. Expenses are seventy-five thousand dollars, while the remaining profit is twenty-five thousand dollars. Capital employed is one hundred and twenty-five thousand dollars. The figures follow the sequence in a statement of profit or loss. Two hundred and fifty thousand dollars minus one hundred and fifty thousand dollars gives one hundred thousand dollars of gross profit.

2:12Taking away seventy-five thousand dollars of expenses leaves twenty-five thousand dollars of profit. Each ratio compares one of these results with a different total.

Calculating gross profit margin

2:21Gross profit margin is gross profit as a percentage of revenue. It shows the share of sales income remaining after cost of sales. This amount is available to cover expenses and leave profit. A higher percentage means the business keeps more gross profit from each dollar of revenue. Gross profit margin equals gross profit divided by revenue, times one hundred. We divide because we want the share of sales income remaining after cost of sales.

2:46Multiplying by one hundred expresses that share as a percentage. For Bramble Supplies, the numerator is one hundred thousand dollars and the denominator is two hundred and fifty thousand dollars. One hundred thousand divided by two hundred and fifty thousand gives zero point four. Zero point four times one hundred gives forty per cent. For every one hundred dollars of revenue, Bramble Supplies generates forty dollars of gross profit. The business still has expenses to cover from that amount, so we need another measure to see what ultimately remains.

Profit margin and ROCE

3:16Profit margin is profit as a percentage of revenue. This measures the share of sales income remaining after cost of sales and expenses. The calculation uses the same denominator as gross profit margin because both measures examine revenue. Its numerator is smaller because expenses have also been deducted. Profit margin equals profit divided by revenue, times one hundred. Twenty-five thousand divided by two hundred and fifty thousand gives zero point one.

3:43Multiplying zero point one by one hundred gives ten per cent. Bramble Supplies therefore earns ten dollars of profit from every one hundred dollars of revenue. The gross profit margin was forty per cent, while the profit margin is ten per cent. Forty minus ten gives a difference of thirty percentage points. Expenses therefore absorb thirty dollars from every one hundred dollars of revenue. Reading the margins together reveals how sales income is divided between cost of sales, expenses and the final profit.

4:12Return on capital employed is profit as a percentage of the total long-term finance used in the business. Here, our attention moves from sales income to investment. The ratio tells us how much profit the business generates relative to its capital employed. Owners and lenders use R O C E to judge whether their finance is earning enough. R O C E equals profit divided by capital employed, times one hundred.

4:36Twenty-five thousand divided by one hundred and twenty-five thousand gives zero point two. Zero point two times one hundred gives twenty per cent. Over the year, Bramble Supplies generates twenty dollars of profit for every one hundred dollars of capital employed. All three results are percentages, but each has a specific meaning. Gross profit margin examines what remains after cost of sales, while profit margin also reflects expenses. R O C E measures the profit generated from long-term finance.

5:05A higher result indicates stronger performance on that particular measure when the comparison is suitable.

Comparing profitability over time

5:11In a later annual period, Bramble Supplies earns revenue of three hundred thousand dollars and gross profit of one hundred and twenty thousand dollars. Profit is twenty-four thousand dollars, and capital employed is one hundred and sixty thousand dollars. The resulting gross profit margin is forty per cent. Profit margin is eight per cent, while R O C E is fifteen per cent. Revenue has increased from two hundred and fifty thousand dollars to three hundred thousand dollars.

5:37Gross profit has also risen, from one hundred thousand dollars to one hundred and twenty thousand dollars. Yet the gross profit margin remains forty per cent because both amounts increased in the same proportion. The larger gross profit figure represents the same share of revenue. Profit margin has fallen from ten per cent to eight per cent, although gross profit margin stayed unchanged. In the later period, one hundred and twenty thousand dollars minus twenty-four thousand dollars gives ninety-six thousand dollars of expenses.

6:05Ninety-six thousand divided by three hundred thousand, times one hundred, gives thirty-two per cent. Expenses have grown from thirty per cent of revenue to thirty-two per cent, so less of each sales dollar is left as profit. The return on capital employed falls from twenty per cent to fifteen per cent. Long-term finance increased from one hundred and twenty-five thousand dollars to one hundred and sixty thousand dollars, while profit declined slightly.

6:29The extra thirty-five thousand dollars of finance has not yet produced any extra profit. Each dollar of capital employed therefore earns a smaller return than before. A falling gross profit margin means cost of sales takes a larger share of revenue. Higher purchase costs can cause this when selling prices remain unchanged. Cutting prices can also reduce the margin if the cost of each item stays constant. Those are possible explanations, so use details from the business to establish the relevant cause.

6:59A lower profit margin alongside an unchanged gross profit margin points towards expenses taking a larger share of revenue. For example, a service business might face higher rent while its sales income remains steady. That additional expense leaves less profit from each sales dollar. Always relate the change to revenue because margins measure proportions. Useful comparisons include the same business over time and competitors operating in similar markets. A premium restaurant and a low-price takeaway may have different pricing approaches and cost structures.

7:30Their ratios need to be interpreted in that context. There is no single percentage that represents good profitability for every kind of business. Interest is the payment made for borrowing money. A bank can also pay a saver interest in return for holding a deposit. Comparing R O C E with that savings rate gives an indication of the alternative return available. The comparison also needs to recognise the greater risk involved in running a business.

7:55For example, a made-up bank offers an annual savings rate of five per cent. Bramble Supplies produces an R O C E of fifteen per cent in its later period. Fifteen minus five gives a difference of ten percentage points. Its business return exceeds the savings rate, although owners must also consider risk and the returns achieved by competitors.

Exam calculations and interpretation

8:16In calculations, match the numerator and denominator to the purpose of the ratio. Use gross profit above revenue for gross profit margin, and profit above revenue for profit margin. For R O C E, place profit above capital employed. Show the division, multiply by one hundred, and label the final answer as a percentage. Profit is measured over a period, so use figures belonging to the period being examined. Cash is the money a business holds as notes and coins and in its bank account.

8:45Profitability ratios measure earning performance, while the cash figure shows money held at a particular time. Keeping those meanings separate helps you interpret financial information precisely. An exam-style question gives Fernbank Retreat, an accommodation business, a gross profit margin that falls from fifty-five per cent to forty-five per cent. It asks you to explain one possible reason for that change. Explain means set out purposes or reasons, say why and how, supported with relevant evidence.

9:13Your answer should connect a business cause to the percentage. Fernbank Retreat may have reduced its room prices while the cost of providing each stay remained unchanged. Each booking would then generate less gross profit relative to its revenue. Cost of sales would absorb a larger proportion of sales income. This would explain the fall in gross profit margin from fifty-five per cent to forty-five per cent. A calculate question asks you to work out from given facts, figures or information.

9:41Show the relevant formula and substitute the figures provided in the question. For interpretation, connect the percentage to the named business and use evidence from its financial information. These skills fit both Paper One Short Answer and Data Response and Paper Two Case Study. Profitability is how well a business turns its revenue or the capital invested in it into profit, measured as a percentage. Gross profit margin is gross profit as a percentage of revenue, while profit margin is profit as a percentage of revenue.

10:10Finally, R O C E is profit as a percentage of the total long-term finance used in the business. The central skill is choosing what to compare profit against. Revenue gives a margin, while capital employed gives a return on long-term finance. Compare suitable businesses or periods, then connect changes to cost of sales, expenses or investment. That turns a percentage into a useful explanation of business performance.