profit margin: calculation and interpretation

Analysis of Published Accounts – Ratio Analysis (Cambridge IGCSE / A‑Level Business 9609)

1. Why Use Ratio Analysis?

• Provides a quick, comparable snapshot of a company’s financial health.
• Helps managers, investors and creditors assess performance, efficiency, risk and the impact of strategic decisions.
• Exam focus – you will be asked to define, calculate and interpret a range of ratios from published accounts.

2. Ratio Families Required for the Syllabus (10.2)

Ratio family	Typical ratios
Liquidity	Current ratio, Acid‑test (quick) ratio
Profitability	Gross profit margin, Operating profit margin, Net profit margin, Return on Capital Employed (ROCE)
Financial efficiency	Inventory turnover, Receivables turnover, Payables turnover
Gearing (solvency)	Debt‑to‑equity ratio, Debt‑to‑capital ratio
Investment (share‑holder) ratios	Dividend yield, Dividend cover, Price‑earnings (P/E) ratio

3. Liquidity Ratios

3.1 Current Ratio

Definition: Measures the ability to meet short‑term obligations using *all* current assets.

Formula: Current Ratio = Current Assets ÷ Current Liabilities

Interpretation:

• Ratio > 1 – more current assets than current liabilities; generally satisfactory.
• Typical acceptable range for most industries: 1.5 – 2.0. Very high values may indicate excess cash or inventory that is not being used profitably.

3.2 Acid‑test (Quick) Ratio

Definition: A stricter liquidity test that excludes inventory because inventory may not be quickly converted to cash.

Formula: Acid‑test Ratio = (Current Assets – Inventory) ÷ Current Liabilities

Interpretation:

• Ratio > 1 shows the firm can meet short‑term debts without relying on inventory sales.
• Useful when inventory is slow‑moving or highly seasonal.

Worked Example (Liquidity)

Item	£'000
Current assets	540
Inventory	180
Current liabilities	300

Current Ratio = 540 ÷ 300 = 1.8

Acid‑test Ratio = (540 – 180) ÷ 300 = 360 ÷ 300 = 1.2

4. Profitability Ratios

4.1 Gross Profit Margin

Definition: Shows the proportion of revenue left after covering the cost of goods sold (COGS). It reflects core production efficiency.

Formula: Gross Profit Margin (%) = (Gross Profit ÷ Revenue) × 100

Where: Gross Profit = Revenue – Cost of Sales.

4.2 Operating Profit Margin

Definition: Indicates how much profit is generated from the company’s ordinary operations before interest and tax.

Formula: Operating Profit Margin (%) = (Operating Profit ÷ Revenue) × 100

Where: Operating Profit = Gross Profit – Operating Expenses (EBIT).

4.3 Net Profit Margin (the “profit margin”)

Definition: The final profitability indicator – the proportion of revenue that remains after all expenses, interest and tax.

Formula: Net Profit Margin (%) = (Net Profit ÷ Revenue) × 100

Note on tax: Because tax rates differ between companies and countries, the net margin can be distorted for cross‑industry comparison. In such cases, the operating margin is often preferred.

4.4 Return on Capital Employed (ROCE)

Definition: Measures the efficiency with which a company generates profit from the total capital it controls.

Formula: ROCE (%) = (Operating Profit ÷ Capital Employed) × 100

Capital Employed = Total assets – Current liabilities  =  Fixed assets + Net working capital.

Comparative Table of Profitability Ratios

Ratio	Profit figure used	When to use
Gross Profit Margin	Gross profit (Revenue – Cost of Sales)	Assess core production efficiency.
Operating Profit Margin	Operating profit (EBIT)	Evaluate performance after operating expenses but before interest & tax.
Net Profit Margin	Net profit (after tax)	Overall profitability – most relevant to shareholders.
ROCE	Operating profit (EBIT)	Compare returns on the total capital used; useful for investment decisions.

Worked Example (Profitability)

Item	£'000
Revenue (Sales)	1,200
Cost of Sales	720
Gross Profit	480
Operating Expenses	180
Operating Profit (EBIT)	300
Tax Expense	90
Net Profit	210

• Gross Profit Margin = 480 ÷ 1,200 × 100 = 40 %

• Operating Profit Margin = 300 ÷ 1,200 × 100 = 25 %

• Net Profit Margin = 210 ÷ 1,200 × 100 = 17.5 %

Assume the balance‑sheet extracts below:

Item	£'000
Fixed assets (net)	800
Current assets	540
Current liabilities	300
Long‑term debt	400

Capital Employed = (800 + 540) – 300 = 1,040 £'000

ROCE = 300 ÷ 1,040 × 100 = 28.8 %

5. Financial‑Efficiency Ratios

5.1 Inventory Turnover

Definition: Shows how many times inventory is sold and replaced during the period.

Formula: Inventory Turnover = Cost of Sales ÷ Average Inventory

Average Inventory: (Opening inventory + Closing inventory) ÷ 2.

Higher values indicate efficient stock management and lower holding costs.

5.2 Receivables Turnover

Definition: Measures how quickly a firm collects money owed by customers.

Formula: Receivables Turnover = Revenue ÷ Average Trade Receivables

Average receivables are calculated the same way as average inventory.

5.3 Payables Turnover

Definition: Indicates the speed with which a company pays its suppliers.

Formula: Payables Turnover = Cost of Sales ÷ Average Trade Payables

Lower turnover may suggest the firm is using supplier credit as a source of short‑term finance.

Worked Example (Efficiency)

Item	£'000
Cost of Sales	720
Opening inventory	150
Closing inventory	180
Average inventory	(150 + 180) ÷ 2 = 165

Inventory Turnover = 720 ÷ 165 ≈ 4.36 times per year

6. Gearing (Solvency) Ratios

6.1 Debt‑to‑Equity Ratio

Formula: Debt‑to‑Equity = Total Debt ÷ Equity

Shows the proportion of financing that comes from creditors versus shareholders.

6.2 Debt‑to‑Capital Ratio

Formula: Debt‑to‑Capital = Total Debt ÷ (Total Debt + Equity)

Values close to 1 indicate high financial risk; values below 0.5 are usually considered low‑risk.

Worked Example (Gearing)

Item	£'000
Total debt (long‑term + current)	500
Equity (share capital + retained earnings)	540

Debt‑to‑Equity = 500 ÷ 540 ≈ 0.93

Debt‑to‑Capital = 500 ÷ (500 + 540) = 500 ÷ 1,040 ≈ 0.48 (48 %)

7. Investment (Share‑holder) Ratios

7.1 Dividend Yield

Formula: Dividend Yield (%) = (Dividend per Share ÷ Market Price per Share) × 100

7.2 Dividend Cover

Formula: Dividend Cover = Profit after Tax ÷ Total Dividends Paid

Cover > 2 suggests the company can comfortably maintain its current dividend policy.

7.3 Price‑Earnings (P/E) Ratio

Formula: P/E Ratio = Market Price per Share ÷ Earnings per Share (EPS)

Worked Example (Investment)

Item	£
Dividend per share	0.45
Market price per share	9.00
Profit after tax (net profit)	210,000
Total dividends paid	45,000
Shares outstanding	30,000

Dividend Yield = 0.45 ÷ 9.00 × 100 = 5 %

Dividend Cover = 210,000 ÷ 45,000 = 4.7 times

EPS = 210,000 ÷ 30,000 = 7.00

P/E Ratio = 9.00 ÷ 7.00 ≈ 1.29

8. Interpretation & Limitations (All Ratios)

• Comparative analysis: Always compare a ratio with (a) the company’s own historic data, (b) industry averages, and (c) key competitors.
• Accounting policies: Different depreciation methods, inventory valuation (FIFO, LIFO, weighted‑average) and revenue recognition can distort ratios.
• One‑off items: Restructuring costs, asset disposals or extraordinary gains should be noted as they may temporarily inflate or depress ratios.
• Tax effects: Net profit margin is influenced by tax rates; for cross‑industry comparison a pre‑tax (operating) margin is often more appropriate.
• Size & growth stage: Start‑ups may show low profitability but high ROCE; mature firms may have high margins but limited growth potential.
• Seasonality: Use average balances for turnover ratios to smooth seasonal fluctuations.

9. Using Ratios for Strategic Decision‑Making (link to 10.4)

• Pricing strategy: A low gross profit margin may signal the need to raise prices or reduce production costs.
• Cost control: A falling operating profit margin highlights inefficiencies in overheads or variable costs.
• Investment appraisal: ROCE above the company’s cost of capital justifies expansion projects.
• Financing decisions: High gearing (debt‑to‑equity) may force the firm to raise equity or refinance debt before undertaking new projects.
• Dividend policy: Dividend cover informs whether the current payout is sustainable or if earnings should be retained for growth.
• Working‑capital management: Inventory, receivables and payables turnover ratios help identify cash‑flow bottlenecks.

10. Common Pitfalls (Across Ratios)

• Mixing up *gross*, *operating* and *net* profit figures.
• Including non‑operating income (e.g., asset sales) in the revenue base for profit‑margin calculations.
• Using closing‑period balances for turnover ratios instead of the required average balances.
• Failing to adjust for seasonal fluctuations when comparing year‑to‑year figures.
• Relying on a single ratio; always consider a balanced set of ratios to get a full picture.

11. Exam Tips (10.2 & 10.4)

1. Read the question carefully – note which profit figure or balance‑sheet item is required.
2. Write the relevant formula first; this earns marks for method.
3. Show every intermediate calculation (including averages for turnover ratios).
4. When interpreting, link the ratio to at least two possible causes (e.g., cost control, pricing power) and, where possible, compare with an industry benchmark.
5. State any assumptions you make (e.g., “average inventory = (opening + closing) ÷ 2”).
6. For multi‑part questions, answer each part in a separate paragraph and label the ratio you are discussing.
7. Remember the limits of each ratio – mention one or two key limitations in your interpretation.

12. Suggested Diagrams for the Exam

• Bar chart: Company’s profit margins (gross, operating, net) versus industry averages.
• Trend line graph: Net profit margin over the last three years to illustrate improvement or decline.
• Ratio matrix: A 2 × 2 table showing liquidity, profitability, efficiency and gearing ratios side‑by‑side for quick comparison.
• Scatter plot: ROCE against industry average ROCE to visualise relative efficiency.