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2 - Profitability Ratios
Accounting (Royal Holloway, University of London)
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1: Profitability Ratios
 Businesses generally exist with the primary purpose of creating wealth for
their owners
 Profitability ratios provide insights relating to the degree of success and
achieving this purpose
 They express the profit made in relations to other key figures in the financial
statement or to some business resource
o Gross profit margin
o Operating profit margin
o Return on capital employed
o Return on ordinary shareholders’ fund
Gross Profit Margin
 It related the gross profit of the business relative to the sales revenue generated
in the same period
 Expressed as %
 It is a measure of profitability in buying (or producing) and selling goods or
services before any other expenses are taken into account

Example
o The decline in this ration means that gross profit was lower relative to
sales revenue in 20X2 than it had been in 20X1
o Note: if gross margin in 22.1% then cost of sales is 77.9% of sales
(cost of sales plus gross margin = sales)
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Operating profit margin
 It relates the operating profit for the period to the sales revenue
 Expressed as a %
 The most appropriate measures of operational performance

Example
o A very weak performance in 20X2 compared with that of 20X1
Return on Capital Employed (ROCE)
 It is fundamental measure of business performance
 It expresses the relationship between the operating profit generated during a
period and the average long-term capital invested in the business
 Expressed as %
 Note: when the beginning of the year figure is unavailable to calculate an
average, then use the year-end figure only
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
Example
o A poor performance in 20X2, with the return on the assets being less
than the rate that the business has to pay for most of its borrowed funds
Return on Ordinary Shareholder’s Fund (ROSF)
 It compares the amount of profit for the period available to the owners’
average stake in the business during the same period
 Expressed as %
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
Example
o Businesses seek to generate as high a value as possible for ROSF ratio
o This provide that its not achieved at the expense of potential future
returns by, taking on more risky activities
The
Relationship between Profitability and Efficiency
 Operating profit / sales revenue X sales revenue / long-term capital employed
= return on capital employed
 Example
o The overall return on funds employed within the business (ROCE) will
be determined both by the profitability of sales (OPM) and by
efficiency in the use of capital (SR to CE)
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