The owners of a business are likely to be very interested in how much money their company is making. “Profit” is the amount of profit generated in pounds. “Profitability” looks at how this profit in pounds compares to some other value in the accounts. The higher the profitability ratios the better.
Margins on sales
Margins compare the profit in £’s to the sales revenue generated on the P&L. Since “margin” is short for “margin on sales” they are literally calculated as the profit figure divided by the sales revenue, showing the result as a percentage. There are two margins that you can calculate depending upon which profit figure is used:
– Gross profit margin is calculated as gross profit/sales revenue x 100. This shows the profitability of the business after taking account of cost of sales.
– Net profit margin is calculated as net profit/sales revenue x 100. This shows the profitability of the business after taking account of all operating costs. The net profit figure is also known as “profit from operations”, “operating profit” or “profit before interest and tax”.
Returns on investments
Running a business to generate profit will normally involve some investment by the owners in assets (shops, machinery, vehicles etc). We can calculate ratios to compare the profit in £’s to a value of the assets from the balance sheet. There are two measures we can use depending upon which asset value is used:
– Return on capital employed (ROCE) is calculated as net profit/TALCL x 100. In this case TALCL stands for Total Assets Less Current Liabilities.
– Return on net assets (RONA) is calculated as net profit/net assets x 100. Net assets will be Total Assets Less Total Liabilities (a slightly different way of valuing the balance sheet to TALCL).
As well as looking at the profits currently being made, the owners of the business are likely to be keen to ensure that the business is likely to continue making these profits in the future. The liquidity ratios focus on the ability of the business to generate cashflow.
– Current ratio and quick ratio
The current ratio examines whether the value of liquid (or current) assets covers the value of short-term (or current) liabilities. It is calculated as current assets/current liabilities. A figure greater than 1 implies that the business should be able to cover short-term liabilities.
The quick ratio does a similar job but ignores the value of inventory. This is because inventory could potentially take quite a long time to convert into cash. The quick ratio is calculated as (current assets – inventory)/current liabilities.
– Period calculations
Another way to examine liquidity is to look at the length of time that each element of working capital exists for ie how long does it take to collect money from credit customers, how long do we hold inventory for, and how long do we take to pay credit suppliers:
– Receivables collection period in days = trade receivables/credit sales x 365
– Inventory holding period in days = inventory/cost of sales x 365
– Payables payment period in days = trade payables/credit purchases (or COS) x 365
Gearing examines the way in which the business is financed. The two sources of finance considered are equity (funds raised from shareholders through issuing ordinary shares) and debt (amounts borrowed from banks and other financial institutions).
There are two ways of calculating the gearing of a business although they are both ways of comparing the levels of equity and debt.
– Total Debt/Total Equity or D/E.
– Total Debt/Total Debt plus Total Equity or D/(D + E).
If a business has very high levels of gearing it means it has a lot of borrowing which can cause problems with covering interest payments.
Why don’t you have a go at this example. When you have finished, follow the link to see me talk through my solution: