Profitability Analysis

Profitability analysis is aimed at understanding the performance of a business over time with regard to specific performance measurement criteria.

Gross profit margin

On a unit basis the gross profit represents the difference between the unit sales price and the direct cost per unit. The margin works this out on an average basis across all sales for the year.

Gross profit margin is calculated as follows:

Gross profit / sales revenue x 100

Changes in this ratio may be attributable to:

• selling prices
• product mix
• purchase costs
• production costs
• inventory valuations

Comparing gross profit margin over time

If gross profit has not increased in line with sales revenue, you need to establish why not. Is the discrepancy due to:

• increased 'purchase' costs: if so, are the costs under the company's control (i.e. does the company manufacture the goods sold)?
• inventory write-offs (likely where the company operates in a volatile marketplace, such as fashion retail)? or
• other costs being allocated to cost of sales – for example, research and development (R&D) expenditure?

Inter-company comparison of gross profit margin

Inter-company comparison of margins can be very useful but it is especially important to look at businesses within the same sector. For example, food retailing is able to support low margins because of the high volume of sales. Jewellers would usually need higher margins to offset lower sales volumes.

Low margins usually suggest poor performance but may be due to expansion costs (launching a new product) or trying to increase market share. Lower margins than usual suggest scope for improvement.

Above-average margins are usually a sign of good management although unusually high margins may make the competition keen to join in and enjoy the 'rich pickings'.

Operating profit margin (net profit)

The operating profit margin or net profit margin is calculated as:

Profit before interest and tax / sales revenue x 100

The operating margin is an expansion of the gross margin and includes all of the items that come after gross profit but before finance charges and taxation, such as selling and distribution costs and administration costs.

If the gross margin is a measure of how profitably a company can produce and sell its products and services the operating margin also measures how effectively the business manages/administers that process.

Therefore, if the gross margin has remained static but the operating margin has changed consider the following possibilities (these represent suggestions; it is not a comprehensive list):

• changes in employment patterns (recruitment, redundancy etc)
• changes to depreciation due to large acquisitions or disposals
• significant write-offs of irrecoverable debt
• changes in rental agreements
• significant investments in advertising
• rapidly changing fuel costs.

The operating margin is affected by more factors than the gross profit margin but it is equally useful to users and if the company does not disclose cost of sales it may be used on its own in lieu of the gross profit percentage.

One of the many factors affecting the trading profit margin is depreciation, which is open to considerable subjective judgement. Inter-company comparisons should be made after suitable adjustments to align accounting policies.

By the time you have reached operating (net) profit, there are many more factors to consider. If you are provided with a breakdown of expenses you can use this for further line-by-line comparisons. Bear in mind that:

• some costs are fixed or semi-fixed (e.g. property costs) and therefore not expected to change in line with revenue
• other costs are variable (e.g. packing and distribution, and commission).

Return on Capital Employed

ROCE is an important analysis tool as it allows users to assess how much profit the business generates from the capital invested in it. Profit margins of different companies are not necessarily comparable due to different sizes and business structures. You could have one company that makes large profits but based on huge levels of investment. Shareholders may decide they can make similar returns in different companies without such a high initial investment required.

In simple terms ROCE measures how much operating profit is generated for every $1 capital invested in the business. It is calculated as follws:

Profit before interest and tax / capital employed x 100

Capital employed is measured as equity, plus interest-bearing finance, i.e. non-current loans plus share capital and reserves.

Once calculated, ROCE should be compared with:

• previous years' figures – provided there have been no changes in accounting policies, or suitable adjustments have been made to facilitate comparison (note, however that the effect of not replacing non-current assets is that their value will decrease and ROCE will increase)
• the company's target ROCE – where the company's management has determined a target return as part of its budget procedure, consistent failure by a part of the business to meet the target may make it a target for disposal
• other companies in same industry – care is required in interpretation, because of the possibility, noted above, of different accounting policies, ages of plant, etc.

The ratio also shows how efficiently a business is using its resources. If the return is very low, the business may be better off realising its assets and investing the proceeds in a high interest bank account! (This may sound extreme, but should be considered particularly for a small, unprofitable business with valuable assets such as property.) Furthermore, a low return can easily become a loss if the business suffers a downturn.

Net asset turnover

This is calculated as:

Sales revenue / capital employed = times p.a.  

It measures management's efficiency in generating revenue from the net assets at its disposal. This is similar to ROCE but in this case we measure the amount of sales revenue generated for every $1 capital invested in the business. Generally speaking, the higher the ratio the more efficient the business is. 

Be aware that both ROCE and asset turnover can be significantly affected by a change in the business structure. For example; imagine that a manufacturing company buys a significant amount of property and plant in a year with the aim to increasing production and therefore sales. The short term affect is that ROCE and asset turnover will initially fall but this does not mean the business is actually performing any worse. It may even be an indication of future gains.

The reason is that the capital balance (net assets) will increase in comparison to the steady sales figures of the business. It cannot be expected that a business can buy new assets and simply grow immediately. It would take a number of years for a business to grow into their new assets and increase production until they operated at 100% capacity. Even if they could instantly use 100% of the new facilities it is unlikely that they will simply be able to sell all the new goods they produce instantly. They will have to find new customers, perhaps in new markets to sell them to. Of course, this does not take into account competitor responses!

In summary; the increase in capital would be both significant and instant. The consequent improvement in performance would take longer to achieve and would most likely be spread over a number of years. Both ROCE and asset turnover would fall instantly and then start to improve each year as revenues start to grow.

Relationship between ratios

ROCE can be subdivided into operating profit margin and asset turnover.

Operating margin x asset turnover = ROCE

 Profit margin is often seen as an indication of the quality of products or services supplied (top-of-range products usually have higher margins).

Asset turnover is often seen as a measure of how intensively the assets are worked or how efficiently they are used to generate revenue.

A trade-off often exists between margin and asset turnover that means different businesses can actually achieve the same ROCE:

• Low-margin businesses (e.g. food retailers) often have intensive asset usage (i.e. they produce a high volume of goods to sell but sell them at low prices).
• Higher margin businesses (e.g. luxury jewellery items) produce less goods but sell them at a high price. Many of these businesses still use very labour intensive, rather than machine intensive, methods of production. Such crafts are highly valued and consumers are willing to pay a premium for them.

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