Profitability ratios

This module explores profitability ratios. These are key metrics that show how effectively profit-driven organisations 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 organisation 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 profit or loss 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, labour, 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:

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

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:

$$\text{Operating profit margin}=\frac{\text{Profit before interest and tax (PBIT)}}{\text{Revenue}}\times 100$$

Net profit margin

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

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

Note: Some questions use “net profit margin” to mean PBIT ÷ revenue. Use whichever profit figure the question specifies.

Asset turnover ratio

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

$$\text{Asset turnover ratio}=\frac{\text{Revenue}}{\text{Capital employed}}$$

Note: Other materials may give the formula as revenue divided by total assets. 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:

$$\text{ROCE}=\frac{\text{Profit before interest and tax (PBIT/EBIT)}}{\text{Capital employed}}\times 100$$

Under IFRS 18, PBIT corresponds to profit before financing and income taxes (equal to operating profit here, since there is no investing income).

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.

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

Note: ROCE can be split into two components:

$$\text{ROCE}=\text{Operating profit margin}\times \text{Asset turnover}$$

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

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 utilisation, 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:

$$\text{ROE}=\frac{\text{Profit after tax}-\text{Preference dividend}}{\text{Total equity (share capital + reserves)}}\times 100$$

Interpretation: A higher ROE suggests effective reinvestment of earnings and strong profitability, while a declining ROE may signal poor capital utilisation. 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)
Operating profit	128,708.00
Profit before financing and income taxes	128,708.00
Finance expense	(16,000.00)
Profit before income taxes	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
Trade 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:
Trade 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:

1. Gross profit margin

2. Operating profit margin (profit before interest and tax margin)

3. Net profit margin

4. Asset turnover

5. Return on capital employed (ROCE)

6. Return on equity (ROE)

7. 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.

1. What is the gross profit margin?

2. What is the operating profit margin?

3. What is the net profit margin?

4. What is the asset turnover?

5. What is the ROCE?

6. What is the return on equity?

Summary table of the analysis

Ratio	Sokoto Company Limited	Industry average	Variance	Performance analysis
Gross profit margin	52.70%	48.5%	+4.20pp	Above industry average - superior cost control and pricing strategy
Operating profit margin	13.76%	15.2%	-1.44pp	Below industry average - higher operating expenses relative to competitors
Net profit margin	6.53%	8.5%	-1.97pp	Below industry average - lower profitability after all expenses and tax
Asset turnover	1.46 times	1.2 times	+0.26 times	Above industry average - assets generate more revenue per $ invested
ROCE	20.13%	18.0%	+2.13pp	Above industry average - efficient use of capital, driven mainly by asset turnover rather than margin
ROE	13.90%	14.5%	-0.60pp	Slightly below industry average - marginally lower returns, driven by higher operating expenses and finance costs

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. The next few modules cover liquidity, efficiency, and gearing ratios, which complete the picture of financial statement analysis.