10.2 Analysis of Published Accounts – Profitability Ratios
10.2.4 Gross Profit Margin (GPM) – Definition, Calculation, Interpretation & Evaluation
1. What the GPM Measures
- Definition: The gross profit margin shows the proportion of sales revenue that remains after the cost of sales (COGS) has been deducted. It reflects how efficiently a business turns turnover into gross profit before any operating expenses, interest or tax are considered.
- Syllabus link: This ratio belongs to the *Finance & Accounting* unit (10.2) of the Cambridge International Business (9609) syllabus and is a core requirement for both AS‑level and A‑level examinations.
2. Formula
Gross Profit Margin (%) = \(\displaystyle\frac{\text{Gross Profit}}{\text{Sales Revenue}}\times100\)
- Gross Profit = Sales Revenue – Cost of Sales
- Sales Revenue = total turnover from the sale of goods or services (often labelled “Revenue” or “Turnover” on the income statement).
3. Step‑by‑Step Calculation
- Locate Sales Revenue and Cost of Sales in the income statement.
- Calculate Gross Profit:
Gross Profit = Sales Revenue – Cost of Sales.
- Divide Gross Profit by Sales Revenue.
- Multiply the result by 100 to express the margin as a percentage.
4. Worked Example
XYZ Ltd – Income‑statement extract (year ended 31 Dec 2024)
| Item |
Amount (£'000) |
| Sales Revenue |
1,200 |
| Cost of Sales |
720 |
Calculations
\[
\text{Gross Profit}=1,200-720=480\ \text{£'000}
\]
\[
\text{GPM}= \frac{480}{1,200}\times100 = 40\%
\]
5. Graphical Interpretation (exam‑friendly)
- When asked to illustrate, draw a simple bar chart:
- Vertical axis – “Gross Profit Margin (%)”.
- Horizontal axis – entities to be compared (e.g., XYZ Ltd, Industry average, Key competitor).
- Label each bar with the exact percentage.
6. Interpretation – What a 40 % GPM Tells You
- Higher GPM (e.g., 40 %) usually indicates:
- Strong pricing power or a premium product.
- Effective control of direct production costs (materials, labour, overheads directly tied to output).
- Lower GPM** (e.g., < 30 %) may suggest:
- Intense competition forcing lower selling prices.
- Rising raw‑material costs or inefficient production processes.
- Use the GPM as a starting point for deeper analysis:
- Compare with the industry average to judge relative efficiency.
- Compare with previous years to spot trends (improvement or deterioration).
- Contrast with a key competitor to assess competitive positioning.
- Investigate the impact of any recent changes in raw‑material prices, product mix, or inventory policy.
7. Limitations of the GPM
- Ignores all expenses incurred after the cost of sales (e.g., admin costs, marketing, interest, tax). A high GPM does not guarantee overall profitability.
- Cost of Sales is affected by the inventory valuation method used (FIFO, LIFO, weighted‑average). Different methods can distort comparisons between firms.
- Seasonal businesses may experience large swings in GPM; always compare like‑for‑like periods.
- For multi‑product companies a single GPM can mask wide variations between product lines – segmental analysis may be required.
8. Exam‑style Evaluation Checklist
- State the formula before inserting numbers – examiners award marks for method.
- Show all intermediate calculations (gross profit, division, multiplication).
- When interpreting, link the figure to business decisions (pricing strategy, cost‑control measures, product‑mix changes, inventory policy).
- Always evaluate the significance:
- “Is a 40 % GPM good for XYZ Ltd’s industry?”
- “What could improve it? What could erode it?”
- If a comparison is required, present a concise table or bar chart summarising the company’s GPM, a competitor’s GPM and the industry average, then comment on relative performance.
- Use the exact terminology required by the syllabus – “gross profit”, “cost of sales”, “margin”.
9. Quick Revision Checklist
- Know the formula and the meaning of each component.
- Identify Sales Revenue and Cost of Sales on an income statement.
- Convert the ratio to a percentage confidently.
- Remember key interpretation points (pricing power, cost control) and limitations (inventory methods, seasonality, segmental issues).
- Practice writing a short evaluation paragraph in exam answers.
- Be able to produce a simple bar chart or table for comparison questions.
10.2.5 Net Profit Margin (NPM) – Definition, Calculation & Interpretation (for context)
Definition
The net profit margin measures the proportion of sales that remains as profit after **all** expenses (cost of sales, operating expenses, interest and tax) have been deducted.
Formula
\[
\text{Net Profit Margin (\%)} = \frac{\text{Net Profit}}{\text{Sales Revenue}}\times100
\]
Worked Example (using the same XYZ Ltd figures)
| Item |
Amount (£'000) |
| Sales Revenue |
1,200 |
| Cost of Sales |
720 |
| Operating Expenses |
300 |
| Interest & Tax |
60 |
Net Profit = 1,200 – 720 – 300 – 60 = 120 £'000
\[
\text{NPM}= \frac{120}{1,200}\times100 = 10\%
\]
Interpretation & Limitations (brief)
- Shows overall profitability after every cost has been accounted for.
- Highly sensitive to changes in operating expenses, interest rates and tax regimes.
- Cross‑company comparison must consider differences in financing structure and tax jurisdiction.
Exam Tip
After calculating, evaluate whether the margin is typical for the industry and suggest ways to improve it (e.g., reducing overheads, increasing sales price, improving operational efficiency).
10.2.6 Return on Capital Employed (ROCE) – Definition, Calculation & Interpretation (for context)
Definition
ROCE measures the efficiency with which a company generates profit from the total capital that is employed (both equity and long‑term debt).
Formula
\[
\text{ROCE (\%)} = \frac{\text{Operating Profit}}{\text{Capital Employed}}\times100
\]
- Operating Profit = Gross Profit – Operating Expenses.
- Capital Employed = Total Assets – Current Liabilities (or Equity + Long‑term Debt).
Worked Example (illustrative)
| Item |
Amount (£'000) |
| Operating Profit |
180 |
| Total Assets |
1,500 |
| Current Liabilities |
300 |
Capital Employed = 1,500 – 300 = 1,200 £'000
\[
\text{ROCE}= \frac{180}{1,200}\times100 = 15\%
\]
Interpretation & Limitations
- A higher ROCE indicates more efficient use of capital.
- Can be distorted by unusually high or low asset bases (e.g., recent acquisitions).
- Does not reflect cash‑flow timing; combine with liquidity analysis for a fuller picture.
Exam Tip
When evaluating ROCE, discuss both the level (is 15 % good for the sector?) and the quality of the capital base (productive assets vs. idle assets).
10.2.7 Gross Profit Ratio – Terminology Note
The gross profit ratio is mathematically identical to the gross profit margin; the only difference is that the ratio is often expressed as a **decimal** rather than a percentage. In Cambridge examinations the term “gross profit margin” is preferred, but you may encounter the ratio form in case‑study data. Convert by multiplying by 100.
Link to the Rest of the Syllabus
After analysing profitability (GPM, NPM, ROCE) the syllabus proceeds to liquidity ratios (current ratio, acid‑test ratio) and then to broader strategic topics such as PESTLE, SWOT and marketing mix analysis. Remember that a firm can be highly profitable yet face short‑term cash‑flow problems – always be prepared to discuss both profitability and liquidity in case‑study questions.
Summary Table – Key Profitability Ratios
| Ratio |
Formula |
What it Measures |
Typical Exam Use |
| Gross Profit Margin (GPM) |
\(\displaystyle\frac{\text{Gross Profit}}{\text{Sales Revenue}}\times100\) |
Efficiency of production & pricing before overheads |
Calculate, interpret, compare (industry, competitor, trend) and evaluate pricing/cost strategies. |
| Net Profit Margin (NPM) |
\(\displaystyle\frac{\text{Net Profit}}{\text{Sales Revenue}}\times100\) |
Overall profitability after all expenses |
Show impact of operating costs, interest & tax; evaluate overall health. |
| Return on Capital Employed (ROCE) |
\(\displaystyle\frac{\text{Operating Profit}}{\text{Capital Employed}}\times100\) |
Efficiency of using total capital to generate profit |
Assess long‑term performance; discuss asset utilisation and financing structure. |
| Gross Profit Ratio |
\(\displaystyle\frac{\text{Gross Profit}}{\text{Sales Revenue}}\) |
Same as GPM, expressed as a decimal |
Recognise alternative terminology; convert to % when required. |
Final Exam Checklist for Profitability Ratios
- Write the correct formula using syllabus terminology.
- Extract the required figures accurately from the income statement (and balance sheet for ROCE).
- Show every intermediate calculation; keep work legible and label results.
- Interpret the result in the context of the industry, market conditions and internal business decisions.
- Evaluate the significance – discuss strengths, weaknesses and possible actions.
- If comparison is required, present a clear table or bar chart and comment on relative performance.