Profitability ratios AO2,AO4
AO2 You need to be able to: Demonstrate application and analysis of knowledge and understanding Command Terms: These terms require students to use their knowledge and skills to break down ideas into simpler parts and to see how the parts relate: Analyse, Apply, Comment, Demonstrate, Distinguish, Explain, Interpret, Suggest
AO4 You need to be able to Demonstrate a variety of appropriate skills. Command Terms These terms require you to demonstrate the selection and use of subject-specific skills and techniques: Annotate, Calculate, Complete, Construct, Determine, Draw, Identify, Label, Plot, Prepare
Profitability brings together the two main accounts, the balance sheet and the profit and loss account. The P&L account gives the quantity of profit, in money terms. The balance sheet enables it to be expressed as percentages.
We have two terms to remember here,
- Profit - shows how much profit has been made
- Profitability - shows the rate of profit
Profit (Revenue minus Costs) is shown in the profit and loss account in a number of ways. Profitability ratios show how profitable a firm is.
Remember the ratio formulae are given on page 87 of the IB BM Syllabus (Guide). This is provided in the examination so you do not need to memorise these. Instead focus on how they are calculated, used and interpreted and how they can be improved.
The following profitability ratios:
• gross profit margin
• net profit margin
We can compare profits with sales revenue in two main ways:
Gross Profit margin.
This ratio compares the gross profit (see P&L Statement) achieved by a firm to its sales revenue; in other words the percentage of the selling price that is gross profit. The figure is expressed as a percentage. A figure of 20% is a benchmark for most industries, but will vary from industry to industry. Gross profit margin is basically the firms mark up on the items it buys in.
Firms that can turn stock over quickly and in large volume may
operate with relatively low gross profit margins. For example a
hypermarket will have lower gross profit nargins than a small
If the ratio is falling over time this could be because of failing
to pass on increases in the cost of sales to customers in higher prices
or ther may have been a change in the mix of goods on sale to more
lower margin products.
A firm may improve its margin by reducing the direct costs of sales (possibly by buying in bulk or changing suppliers) or by increasing price. However, increasing prices may lead to a significant fall in sales volume if customers are price sensitive
Net profit margin
This ratio calculates the percentage of a product's selling price that is net profit. Again it is expressed as a percentage. It may be regarded as a better measure of a firm's performance than gross profit margin as it includes all of the firm's operating expenses. It can measure how successful the firm is in controlling its expenses. A higher percentage is, therefore, preferable. This may be achieved by raising sales revenue, while maintaining existing expenses levels or simply reducing expenses.
A comparison of the two profit margins can raise questions about management efficiency. If, for instance, the gross profit was improving at the same time as the net profit margin declined, this would point to poor control of expenses (or increasing overhead costs) as an issue worthy of investigation.
REMEMBER: profit and cash are not the same.