the meaning and importance of profitability

Resources → Subject Notes → Business → Lesson Plan

10.2 Analysis of Published Accounts – Profitability Ratios

Objective

To understand the meaning and importance of profitability ratios when analysing a company’s published accounts and to be able to apply them confidently in Cambridge IGCSE/A‑Level examinations.

1. What is Profitability?

Profitability measures a company’s ability to generate earnings from the resources it controls – sales, assets or shareholders’ equity. It shows how efficiently a business converts inputs (raw materials, labour, capital) into profit.

2. Why is Profitability Important?

  • Provides investors with a clear view of the return on their investment.
  • Helps managers evaluate performance and make strategic decisions (pricing, cost control, investment, dividend policy).
  • Gives creditors insight into the firm’s capacity to meet interest and principal repayments.
  • Enables comparison with competitors and industry benchmarks.
  • Indicates the sustainability of growth and the ability to fund future projects.

Link to Managerial Decisions

Ratio Low Result – What It Suggests High Result – What It Suggests Possible Managerial Action
Gross Profit Margin (GPM) Cost of goods sold is high relative to sales. Strong control of production costs; pricing power. Renegotiate supplier contracts, improve production efficiency, or review pricing.
Operating Profit Margin (OPM) (optional/extension – not required for AS) Operating expenses are excessive. Efficient overhead management; effective cost‑control. Control overheads, streamline processes, or consider outsourcing.
Net Profit Margin (NPM) Overall cost structure, interest or tax burden is high. Very profitable after all expenses; possibly strong pricing or low financing costs. Review financing structure, tax planning, or cost‑reduction programmes.
Return on Capital Employed (ROCE) Capital is not being used efficiently. Capital is generating a high return; good asset utilisation. Re‑allocate capital to higher‑return projects, improve asset utilisation.
Return on Equity (ROE) Shareholders are receiving a poor return. Shareholders are receiving an excellent return; may indicate strong profitability or high financial leverage. Consider dividend policy, share buy‑backs, or strategies to boost net profit.

3. Key Profitability Ratios – Definitions, Formulas & Interpretation

Ratio Definition (meaning) Formula Interpretation
Gross Profit Margin (GPM) Proportion of sales remaining after the cost of goods sold (COGS) has been deducted. \[ \text{GPM}= \frac{\text{Gross Profit}}{\text{Sales}}\times 100 \] Higher GPM = better control of production/purchasing costs or stronger pricing power.
Operating Profit Margin (OPM) (optional) Profitability after all operating expenses but before interest and tax. \[ \text{OPM}= \frac{\text{Operating Profit}}{\text{Sales}}\times 100 \] Shows how well the core business (excluding financing) generates profit.
Net Profit Margin (NPM) Overall profitability after all expenses, interest and tax. \[ \text{NPM}= \frac{\text{Net Profit}}{\text{Sales}}\times 100 \] Higher NPM = more profit retained from each £ of sales.
Return on Capital Employed (ROCE) Efficiency of capital utilisation – how much operating profit is generated per £ of capital employed. \[ \text{ROCE}= \frac{\text{Operating Profit}}{\text{Capital Employed}}\times 100 \] Higher ROCE = better use of long‑term financing and assets.
Return on Equity (ROE) Return generated for shareholders’ investment. \[ \text{ROE}= \frac{\text{Net Profit}}{\text{Shareholders’ Equity}}\times 100 \] Higher ROE = more profit per £ of equity; a key indicator for investors.

Capital Employed – Two Accepted Definitions (Cambridge Syllabus)

  • Definition 1: Total Assets – Current Liabilities
  • Definition 2: Fixed Assets + Working Capital (where Working Capital = Current Assets – Current Liabilities)

4. How to Interpret Ratios

  1. Trend analysis: Compare the ratio with previous periods to spot improvement or deterioration.
  2. Benchmarking: Compare with industry averages or key competitors.
  3. Business context: Consider capital intensity, seasonality, stage of growth, and any one‑off items.
  4. Holistic view: Analyse profitability alongside liquidity and efficiency ratios for a complete picture.

5. Limitations of Profitability Ratios

  • Based on accounting figures that may be affected by different accounting policies.
  • Do not reflect cash flow – a company can be profitable but cash‑poor.
  • Seasonal businesses may show distorted margins if figures are not seasonally adjusted.
  • Ignore qualitative factors such as brand strength, market position and management quality.

6. Worked Example – Manufacturing Company (High GPM, Moderate ROCE)

Income statement (in £ ‘000)

ItemAmount
Sales1,200
Cost of Goods Sold720
Gross Profit480
Operating Expenses180
Operating Profit300
Interest Expense30
Tax70
Net Profit200

Balance‑sheet data

  • Total assets = £1,500,000
  • Current liabilities = £300,000
  • Shareholders’ equity = £800,000

Capital Employed calculations

  • Definition 1: £1,500,000 – £300,000 = £1,200,000
  • Definition 2 (illustrative): Fixed assets (£900,000) + Working capital (£300,000) = £1,200,000

Profitability ratios

  • GPM = (480 ÷ 1,200) × 100 = 40 %
  • OPM = (300 ÷ 1,200) × 100 = 25 % (optional)
  • NPM = (200 ÷ 1,200) × 100 = 16.7 %
  • ROCE = (300 ÷ 1,200) × 100 = 25 %
  • ROE = (200 ÷ 800) × 100 = 25 %

Interpretation

  • GPM of 40 % indicates strong control of production costs or pricing power.
  • ROCE of 25 % shows the capital employed is generating a respectable return, but there may be scope to improve asset utilisation.
  • ROE matches ROCE because the firm has relatively low financial leverage.

7. Contrasting Example – Capital‑Intensive Firm (Low ROCE, High GPM)

Income statement (in £ ‘000)

ItemAmount
Sales2,000
Cost of Goods Sold1,200
Gross Profit800
Operating Expenses500
Operating Profit300
Interest Expense20
Tax80
Net Profit200

Balance‑sheet data

  • Total assets = £5,000,000
  • Current liabilities = £500,000
  • Shareholders’ equity = £3,000,000

Capital Employed

  • Definition 1: £5,000,000 – £500,000 = £4,500,000

Profitability ratios

  • GPM = (800 ÷ 2,000) × 100 = 40 % (same as the first example)
  • OPM = (300 ÷ 2,000) × 100 = 15 %
  • NPM = (200 ÷ 2,000) × 100 = 10 %
  • ROCE = (300 ÷ 4,500) × 100 = 6.7 % (low – heavy asset base)
  • ROE = (200 ÷ 3,000) × 100 = 6.7 %

Interpretation

  • GPM remains strong at 40 % – the firm controls production costs well.
  • ROCE of 6.7 % is low, highlighting that the large asset base is not being used efficiently; the business may need to improve asset utilisation or consider divesting under‑used equipment.
  • ROE mirrors ROCE because the firm relies little on debt.

8. Using Profitability Ratios in Examinations

  1. Read the question carefully – identify which ratio(s) are required.
  2. Write the relevant formula clearly (LaTeX or plain‑text is acceptable).
  3. Extract the necessary figures from the published accounts.
  4. Show every step of the calculation; give the final answer as a percentage (to one decimal place unless otherwise specified).
  5. Interpret the result:
    • State what the figure tells you about the company’s performance.
    • Where possible, compare with industry averages or previous years.
    • Link the interpretation to a managerial decision (e.g., “A profit margin of 8 % is below the industry average of 12 %, suggesting the firm should review its pricing strategy”).
Suggested diagram: A flowchart showing the relationship between Sales → Cost of Goods Sold → Gross Profit → Operating Expenses → Operating Profit → Interest & Tax → Net Profit, with each stage feeding into the relevant profitability ratio.

Create an account or Login to take a Quiz

25 views
0 improvement suggestions

Log in to suggest improvements to this note.