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Profitability ratios

Making profit is the main purpose for most business organisations, but what level of profit is acceptable?

Stakeholders look at profit for a number of reasons, but primarily to see if their investment is worth it. There are alternatives, such as depositing funds in the bank, so profit has to be compared in some way with bank interest.

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
  • Profitability


Write down the definitions of profit and profitability. See if you can explain the difference, then click Profit to compare your answer with ours.

Profit is shown in the profit and loss account in a number of ways. Profitability ratios show how profitable a firm is.

Profit margins

We can compare profits with sales revenue in two main ways:

Gross Profit margin.

This ratio compares the gross profit achieved by a firm to its sales revenue; in other words the percentage of the selling price that is gross profit and available to pay for the firm's overheads. 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 may operate with relatively low gross profit margins. For example in a hypermarket, the gross profit margin on clothing is higher than on food sales.

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 a change in the mix of goods on sale to 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 measures 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.

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REMEMBER: profit and cash are not the same.