This module explores profitability ratios. These are key metrics that show how effectively profit-driven organizations generate returns on invested capital.

Learning objective

By the end of this module, you should be able to:

Calculate key accounting ratios related to: Profitability
Calculate and interpret the relationship between the elements of the financial statements regarding profitability, liquidity, efficient use of resources, and financial position
Draw valid conclusions from the information contained within the financial statements and present these to the appropriate user of the financial statements

Definitions

Profitability ratios: These are a group of ratios that evaluate the financial performance of a profit-driven organization and measure the profit generated on the invested capital.

Thus, these ratios may not apply to non-profit-making forms of entities. The elements in computing these ratios are either the revenue or profit from the statement of financial performance and capital employed from the statement of financial position.

These are the specific ratios:

Profit margin
Return on capital employed (ROCE)
Return on equity (RoE)
Asset turnover ratio

Profit margin

This ratio measures profit as a percentage of revenue. It tells you how much profit is made from each amount of sales, and it reflects both pricing decisions and cost control.

Profit margin ratios are named based on the profit figure used in the calculation:

Gross profit margin
Operating profit margin
Net profit margin

Interpreting the profit margin ratios: A higher profit margin may indicate that the entity is efficient in controlling costs.

When interpreting profit margins, it’s useful to look at both revenue growth and cost movements. If the profit margin is decreasing while revenue is growing, you may want to check whether any of the following (among others) are contributing factors:

Introduction of new products
Reduction in prices to increase market share
Inability to pass on inflationary price increases

Definitions

Gross profit margin: This ratio measures how well costs of production have been controlled. An increase in gross profit margin indicates that the direct costs of operations (e.g., variable costs, raw materials, labor, etc.) are not rising as quickly as selling prices, whilst a decrease will indicate the opposite. The ratio shows whether the entity is efficient in controlling its costs of production. Formula:

$Gross profit margin = \frac{Gross Profit}{Revenue} \times 100$

Operating profit margin: This ratio builds on the gross profit margin by considering the effect of the operation expenses, such as selling, general, and administrative expenses, and depreciation (where applicable). Thus, it measures the efficiency with which operating costs have been controlled in the generation of profit from sales. Formula:

$Operating profit margin = \frac{Profit Before Interest and Tax (PBIT)}{Revenue} \times 100$

Net profit margin: This ratio further builds on the operating profit margin by considering the effect of interest and tax expenses. Formula:

$Net profit margin = \frac{Profit after Tax}{Revenue} \times 100$

Note: Sometimes, net profit margin can also be used for operating profit margin. Be sure of what you are asked, whether it is profit after tax or operating profit (i.e., PBIT) that is required to be used. For example, you may be asked to compute net profit margin (PBIT). In this case, though it is net profit margin, there is a hint to use PBIT, hence, operating profit margin.

Asset turnover ratio

This is an overall measure of how efficiently an entity uses its assets (capital employed) to generate revenue. Formula:

$Asset Turnover Ratio = \frac{Revenue}{Capital employed}$

Note: Other materials may give the formula as revenue divided by total sales. However, note that for this exam, except otherwise stated in the question, the formula is revenue divided by capital employed.

Interpretation: A higher ratio indicates more efficient use of assets to generate revenue. It may suggest that a relatively small investment in assets is generating a relatively large amount of revenue. A lower ratio suggests less efficiency. However, it may also indicate that a company is replacing heavily depreciated assets with new equipment in the short term.

Return on capital employed (ROCE)

Also known as Return on Investment (ROI). It measures how much profit a company generates for each amount of capital invested. This helps you assess operational efficiency and long-term profitability, especially in capital-intensive industries.

ROCE compares the profit earned to the funds (capital) used to generate that profit. Formula:

$ROCE = \frac{Profit Before Interest and Tax (PBIT/EBIT)}{Capital Employed} \times 100$

*Capital employed is typically total assets minus current liabilities or the sum of shareholders’ equity and long-term debt. Usually, where enough information is available, the average capital employed is used in the computation.

$Average Capital Employed = \frac{Opening Capital employed + Closing capital employed}{2}$

Note: With a change of subject,

$ROCE = Operating profit margin \times Asset turnover$

$ROCE = \frac{PBIT}{Revenue} \times \frac{Revenue}{Capital employed} = \frac{PBIT}{Capital Employed}$

Based on this, you may be given operating profit margin and asset turnover and be asked to calculate the ROCE.

Interpretation: A higher ROCE suggests more effective capital utilization, while a lower ROCE may indicate inefficient capital use. Industry comparisons and historical trends are essential for meaningful interpretation.

Return on equity (RoE)

It measures the return on the equity invested by the shareholders in the business. This ratio normally uses the values of the shareholders’ investment as shown in the statement of financial position (rather than the market values of the shares).

ROE indicates how efficiently management uses equity capital to grow the business and create shareholder value. Formula:

$ROE = \frac{Profit after Tax - Preference Dividend}{Equity Capital} \times 100$

Interpretation: A higher ROE suggests effective reinvestment of earnings and strong profitability, while a declining ROE may signal poor capital utilization. The higher the ROE as compared to returns when invested elsewhere, the better.

Illustration: Financial statement analysis

Sokoto Company Limited is a manufacturing company that has been operating for several years. The company’s financial controller has prepared the financial statements for the year ended 31 December 2024. As a financial analyst, you have been asked to evaluate the company’s profitability performance for the period.

The following financial statements have been provided for your analysis:

Statement of profit or loss and other comprehensive income

	$
Sales revenue	935,200.00
Cost of Sales	(442,300.00)
Gross Profit	492,900.00
Distribution cost	(151,000.00)
Administrative expenses	(213,192.00)
Profit before interest and tax	128,708.00
Finance expense	(16,000.00)
Profit before Tax	112,708.00
Income tax for the year	(51,600.00)
Profit after tax	61,108.00
Other Comprehensive Income
Revaluation Surplus	50,000.00
Total comprehensive income	111,108.00

Statement of financial position as at 31 December 2024

	$	$
Non-current Asset:
Property, Plant and Equipment		522,800.00
Current Asset:
Inventories	94,200.00
Accounts receivables	119,808.00
Prepaid expenses	5,800.00
Cash at bank	45,200.00
Total Current Assets		265,008.00
Total Asset		787,808.00

EQUITY AND LIABILITIES
Equity:
Ordinary share capital (50,000 shares)	200,000.00
Retained earnings	189,508.00
Revaluation Surplus	50,000.00
Total Equity		439,508.00
Non-current Liabilities:
8% Debenture		200,000.00
Current Liabilities:
Account Payables	83,300.00
Accrued expenses	16,400.00
Income tax payable	48,600.00
Total Current Liabilities		148,300.00
Total Equity and Liabilities		787,808.00

Industry average ratios (manufacturing sector - 2024)

Ratio	Industry average
Gross profit margin	48.5%
Operating profit margin	15.2%
Net profit margin	8.5%
Return on capital employed (ROCE)	18.0%
Return on equity (ROE)	14.5%
Asset turnover	1.2 times

Required: Calculate the following profitability ratios for Sokoto Company Limited for the year ended 31 December 2024:

a) Gross profit margin

b) Operating profit margin (Profit before interest and tax margin)

c) Net profit margin

d) Asset turnover

e) Return on Capital Employed (ROCE)

f) Return on Equity (ROE)

g) Compare each of your calculated ratios with the industry average provided above and comment on Sokoto Company Limited’s performance relative to the industry.

Suggested Solution:

Make sure you try calculating and making the comparisons by yourself before reviewing the suggested solution below.

a) What is the gross profit margin?

(spoiler)

$Gross profit margin = \frac{Gross Profit}{Revenue} \times 100$

All the elements in the formula are in the statement of profit or loss. So check from that statement for the revenue and gross profit amounts.

$Gross profit margin = \frac{$492 , 900}{$935 , 200} \times 100 = 52.70%$

Analysis: Compared to the industry average of 48.5%, Sokoto Company Limited demonstrates strong gross profitability, indicating effective cost management in production and favorable pricing strategies.

b) What is the operating profit margin?

(spoiler)

$Operating profit margin = \frac{Profit Before Interest and Tax (PBIT)}{Revenue} \times 100$

All the elements in the formula are in the statement of profit or loss. So check from that statement for the revenue and gross profit amounts.

$Operating profit margin = \frac{$128 , 708}{$935 , 200} \times 100 = 13.76%$

Analysis: Operating profit margin of 13.76% falls below the industry benchmark of 15.2%, suggesting that distribution costs and administrative expenses are relatively high and may require cost optimization.

c. What is the net profit margin?

(spoiler)

$Net profit margin = \frac{Profit after Tax}{Revenue} \times 100$

All the elements in the formula are in the statement of profit or loss. So check from that statement for the revenue and gross profit amounts.

$Net profit margin = \frac{$61 , 108}{$935 , 200} \times 100 = 6.53%$

Analysis: Net profit margin of 6.53% is significantly below the industry average of 8.5%, indicating that the company faces higher finance costs and/or tax burden compared to competitors. This can be improved if finance costs are reduced. However, reducing finance cost would mean the long-term debts would have to be reduced or maintained, but at relatively lower interest rates. Reducing long-term debts, however, would affect the gearing ratios.

d. What is the asset turnover?

(spoiler)

$Asset Turnover Ratio = \frac{Revenue}{Capital employed}$

The capital employed and revenue could be found on the statement of financial position and statement of profit or loss, respectively.

Where:

Capital Employed = Total Equity + Non-current Liabilities

$Capital Employed = $439, 508 + $200, 000 = $639, 508$

OR Capital Employed = Total Assets - Current Liabilities

$Capital Employed = $787, 808 - $148, 300 = $639, 508$

$Asset turnover ratio = \frac{$935 , 200}{$639 , 508} = 1.46 times$

Analysis: The asset turnover ratio is above the industry average of 1.2 times.

e. What is the ROCE?

(spoiler)

$ROCE = \frac{Profit Before Interest and Tax (PBIT/EBIT)}{Capital Employed} \times 100$

Where:

Capital Employed = Total Equity + Non-current Liabilities

$Capital Employed = $439, 508 + $200, 000 = $639, 508$

OR Capital Employed = Total Assets - Current Liabilities

$Capital Employed = $787, 808 - $148, 300 = $639, 508$

$ROCE = \frac{$128 , 708}{$639 , 508} \times 100 = 20.12%$

Option 2: Having calculated the asset turnover ratio and operating profit margin, one can compute it as:

$ROCE = 1.46 times \times 13.76% = 20.09% (approximately the answer)$

Analysis: The company’s ROCE of 20.12% exceeds the industry average of 18.0%, showing efficient utilization of capital resources. However, the performance is mainly driven by the asset turnover since the operating profit margin was below the industry average.

f. What is the return on equity?

(spoiler)

$ROE = \frac{Profit after Tax - Preference Dividend}{Equity Capital} \times 100$

The equity capital and profit could be found on the statement of financial position and statement of profit or loss, respectively.

$ROE = \frac{$61 , 108}{$200 , 000} \times 100 = 13.90%$

Analysis: ROE (13.90%) is marginally below the industry average (14.5%), suggesting slightly lower returns for equity shareholders. From the earlier computations, you noted that both the operating profit and net profit margins were below the industry averages. This may suggest that the low performance of the ROE is driven mainly by the higher operating expenses as well as finance costs. Any attempt to control operating expenses would directly improve the ROE, since there are no preference shareholders, per the question.

Summary table of the analysis

Ratio	Sokoto Company Limited	Industry average	Variance	Performance analysis
Gross profit margin	52.70%	48.5%	+4.20%	Above industry average - Superior cost control and pricing strategy
Operating profit margin	13.76%	15.2%	-1.44%	Below industry average - Higher operating expenses relative to competitors
Net profit margin	6.53%	8.5%	-1.97%	Below industry average - Lower profitability after all expenses and tax
ROCE	20.12%	18.0%	+2.12%	Above industry average - Efficient use of capital employed
ROE	13.90%	14.5%	-0.60%	Slightly below industry average - Marginally lower returns to shareholders

Overall Assessment: Sokoto Company Limited shows mixed profitability performance. While the company excels in gross margin and capital efficiency, there are opportunities to improve operational efficiency and reduce overhead costs to bring operating and net profit margins in line with industry standards.

Note: This question only performed an industry-level comparison. However, you may be given information for the same company for two (2) different years for a similar comparison. All you need is knowing the formulas and being able to interpret the results in terms of whether it is a good or bad performance, and factors that may have contributed to such results, as well as what could be done to improve the results.

Profitability ratios measure profit generated on invested capital using revenue and capital employed figures
Profit margins progress from gross to operating to net, each adding more expense categories
Asset turnover ratio measures revenue generation efficiency using revenue divided by capital employed
ROCE equals operating profit margin multiplied by asset turnover ratio, showing their interconnection
Higher ratios generally indicate better performance, but industry comparisons are essential for meaningful interpretation
ROE measures returns to shareholders, while ROCE measures returns on total capital employed including debt

Next | 9.3 Liquidity ratios

Profitability ratios

This module explores profitability ratios. These are key metrics that show how effectively profit-driven organizations generate returns on invested capital.

Learning objective

By the end of this module, you should be able to:

Calculate key accounting ratios related to: Profitability
Calculate and interpret the relationship between the elements of the financial statements regarding profitability, liquidity, efficient use of resources, and financial position
Draw valid conclusions from the information contained within the financial statements and present these to the appropriate user of the financial statements

Definitions

Profitability ratios: These are a group of ratios that evaluate the financial performance of a profit-driven organization and measure the profit generated on the invested capital.

These are the specific ratios:

Profit margin
Return on capital employed (ROCE)
Return on equity (RoE)
Asset turnover ratio

Profit margin

This ratio measures profit as a percentage of revenue. It tells you how much profit is made from each amount of sales, and it reflects both pricing decisions and cost control.

Profit margin ratios are named based on the profit figure used in the calculation:

Gross profit margin
Operating profit margin
Net profit margin

Interpreting the profit margin ratios: A higher profit margin may indicate that the entity is efficient in controlling costs.

Introduction of new products
Reduction in prices to increase market share
Inability to pass on inflationary price increases

Definitions

Gross profit margin: This ratio measures how well costs of production have been controlled. An increase in gross profit margin indicates that the direct costs of operations (e.g., variable costs, raw materials, labor, etc.) are not rising as quickly as selling prices, whilst a decrease will indicate the opposite. The ratio shows whether the entity is efficient in controlling its costs of production. Formula:

$Gross profit margin = \frac{Gross Profit}{Revenue} \times 100$

Operating profit margin: This ratio builds on the gross profit margin by considering the effect of the operation expenses, such as selling, general, and administrative expenses, and depreciation (where applicable). Thus, it measures the efficiency with which operating costs have been controlled in the generation of profit from sales. Formula:

$Operating profit margin = \frac{Profit Before Interest and Tax (PBIT)}{Revenue} \times 100$

Net profit margin: This ratio further builds on the operating profit margin by considering the effect of interest and tax expenses. Formula:

$Net profit margin = \frac{Profit after Tax}{Revenue} \times 100$

Asset turnover ratio

This is an overall measure of how efficiently an entity uses its assets (capital employed) to generate revenue. Formula:

$Asset Turnover Ratio = \frac{Revenue}{Capital employed}$

Return on capital employed (ROCE)

ROCE compares the profit earned to the funds (capital) used to generate that profit. Formula:

$ROCE = \frac{Profit Before Interest and Tax (PBIT/EBIT)}{Capital Employed} \times 100$

$Average Capital Employed = \frac{Opening Capital employed + Closing capital employed}{2}$

Note: With a change of subject,

$ROCE = Operating profit margin \times Asset turnover$

$ROCE = \frac{PBIT}{Revenue} \times \frac{Revenue}{Capital employed} = \frac{PBIT}{Capital Employed}$

Based on this, you may be given operating profit margin and asset turnover and be asked to calculate the ROCE.

Return on equity (RoE)

ROE indicates how efficiently management uses equity capital to grow the business and create shareholder value. Formula:

$ROE = \frac{Profit after Tax - Preference Dividend}{Equity Capital} \times 100$

Illustration: Financial statement analysis

The following financial statements have been provided for your analysis:

Statement of profit or loss and other comprehensive income

	$
Sales revenue	935,200.00
Cost of Sales	(442,300.00)
Gross Profit	492,900.00
Distribution cost	(151,000.00)
Administrative expenses	(213,192.00)
Profit before interest and tax	128,708.00
Finance expense	(16,000.00)
Profit before Tax	112,708.00
Income tax for the year	(51,600.00)
Profit after tax	61,108.00
Other Comprehensive Income
Revaluation Surplus	50,000.00
Total comprehensive income	111,108.00

Statement of financial position as at 31 December 2024

	$	$
Non-current Asset:
Property, Plant and Equipment		522,800.00
Current Asset:
Inventories	94,200.00
Accounts receivables	119,808.00
Prepaid expenses	5,800.00
Cash at bank	45,200.00
Total Current Assets		265,008.00
Total Asset		787,808.00

EQUITY AND LIABILITIES
Equity:
Ordinary share capital (50,000 shares)	200,000.00
Retained earnings	189,508.00
Revaluation Surplus	50,000.00
Total Equity		439,508.00
Non-current Liabilities:
8% Debenture		200,000.00
Current Liabilities:
Account Payables	83,300.00
Accrued expenses	16,400.00
Income tax payable	48,600.00
Total Current Liabilities		148,300.00
Total Equity and Liabilities		787,808.00

Industry average ratios (manufacturing sector - 2024)

Ratio	Industry average
Gross profit margin	48.5%
Operating profit margin	15.2%
Net profit margin	8.5%
Return on capital employed (ROCE)	18.0%
Return on equity (ROE)	14.5%
Asset turnover	1.2 times

Required: Calculate the following profitability ratios for Sokoto Company Limited for the year ended 31 December 2024:

a) Gross profit margin

b) Operating profit margin (Profit before interest and tax margin)

c) Net profit margin

d) Asset turnover

e) Return on Capital Employed (ROCE)

f) Return on Equity (ROE)

g) Compare each of your calculated ratios with the industry average provided above and comment on Sokoto Company Limited’s performance relative to the industry.

Suggested Solution:

Make sure you try calculating and making the comparisons by yourself before reviewing the suggested solution below.

a) What is the gross profit margin?

(spoiler)

$Gross profit margin = \frac{Gross Profit}{Revenue} \times 100$

All the elements in the formula are in the statement of profit or loss. So check from that statement for the revenue and gross profit amounts.

$Gross profit margin = \frac{$492 , 900}{$935 , 200} \times 100 = 52.70%$

Analysis: Compared to the industry average of 48.5%, Sokoto Company Limited demonstrates strong gross profitability, indicating effective cost management in production and favorable pricing strategies.

b) What is the operating profit margin?

(spoiler)

$Operating profit margin = \frac{Profit Before Interest and Tax (PBIT)}{Revenue} \times 100$

All the elements in the formula are in the statement of profit or loss. So check from that statement for the revenue and gross profit amounts.

$Operating profit margin = \frac{$128 , 708}{$935 , 200} \times 100 = 13.76%$

Analysis: Operating profit margin of 13.76% falls below the industry benchmark of 15.2%, suggesting that distribution costs and administrative expenses are relatively high and may require cost optimization.

c. What is the net profit margin?

(spoiler)

$Net profit margin = \frac{Profit after Tax}{Revenue} \times 100$

All the elements in the formula are in the statement of profit or loss. So check from that statement for the revenue and gross profit amounts.

$Net profit margin = \frac{$61 , 108}{$935 , 200} \times 100 = 6.53%$

Analysis: Net profit margin of 6.53% is significantly below the industry average of 8.5%, indicating that the company faces higher finance costs and/or tax burden compared to competitors. This can be improved if finance costs are reduced. However, reducing finance cost would mean the long-term debts would have to be reduced or maintained, but at relatively lower interest rates. Reducing long-term debts, however, would affect the gearing ratios.

d. What is the asset turnover?

(spoiler)

$Asset Turnover Ratio = \frac{Revenue}{Capital employed}$

The capital employed and revenue could be found on the statement of financial position and statement of profit or loss, respectively.

Where:

Capital Employed = Total Equity + Non-current Liabilities

$Capital Employed = $439, 508 + $200, 000 = $639, 508$

OR Capital Employed = Total Assets - Current Liabilities

$Capital Employed = $787, 808 - $148, 300 = $639, 508$

$Asset turnover ratio = \frac{$935 , 200}{$639 , 508} = 1.46 times$

Analysis: The asset turnover ratio is above the industry average of 1.2 times.

e. What is the ROCE?

(spoiler)

$ROCE = \frac{Profit Before Interest and Tax (PBIT/EBIT)}{Capital Employed} \times 100$

Where:

Capital Employed = Total Equity + Non-current Liabilities

$Capital Employed = $439, 508 + $200, 000 = $639, 508$

OR Capital Employed = Total Assets - Current Liabilities

$Capital Employed = $787, 808 - $148, 300 = $639, 508$

$ROCE = \frac{$128 , 708}{$639 , 508} \times 100 = 20.12%$

Option 2: Having calculated the asset turnover ratio and operating profit margin, one can compute it as:

$ROCE = 1.46 times \times 13.76% = 20.09% (approximately the answer)$

Analysis: The company’s ROCE of 20.12% exceeds the industry average of 18.0%, showing efficient utilization of capital resources. However, the performance is mainly driven by the asset turnover since the operating profit margin was below the industry average.

f. What is the return on equity?

(spoiler)

$ROE = \frac{Profit after Tax - Preference Dividend}{Equity Capital} \times 100$

The equity capital and profit could be found on the statement of financial position and statement of profit or loss, respectively.

$ROE = \frac{$61 , 108}{$200 , 000} \times 100 = 13.90%$

Analysis: ROE (13.90%) is marginally below the industry average (14.5%), suggesting slightly lower returns for equity shareholders. From the earlier computations, you noted that both the operating profit and net profit margins were below the industry averages. This may suggest that the low performance of the ROE is driven mainly by the higher operating expenses as well as finance costs. Any attempt to control operating expenses would directly improve the ROE, since there are no preference shareholders, per the question.

Summary table of the analysis

Ratio	Sokoto Company Limited	Industry average	Variance	Performance analysis
Gross profit margin	52.70%	48.5%	+4.20%	Above industry average - Superior cost control and pricing strategy
Operating profit margin	13.76%	15.2%	-1.44%	Below industry average - Higher operating expenses relative to competitors
Net profit margin	6.53%	8.5%	-1.97%	Below industry average - Lower profitability after all expenses and tax
ROCE	20.12%	18.0%	+2.12%	Above industry average - Efficient use of capital employed
ROE	13.90%	14.5%	-0.60%	Slightly below industry average - Marginally lower returns to shareholders

Achievable ACCA Financial Accounting

9. Interpretation of financial statements

Our ACCA course is currently in development and is a work-in-progress.