G1 Profitability Ratios
Profitability ratios provide a useful metric to help measure and analyse a business’s performance. They can illustrate its ability to generate profits, enhance efficiency and achieve financial stability. Managers can use ratios to identify areas in need of improvement.
Profitability ratios can be used to identify trends in performance over time or to make comparisons with competitors. Investors may use profitability ratios to support judgements on the viability of an investment.
| 2023 | 2022 | 2021 | 2020 | 2019 | |
|---|---|---|---|---|---|
| Revenue | 700,000 | 650,000 | 600,000 | 550,000 | 500,000 |
| Cost of sales | 385,000 | 227,500 | 240,000 | 220,000 | 225,000 |
| Gross profit | 315,000 | 422,500 | 360,000 | 330,000 | 275,000 |
| Expenses | 259,000 | 344,500 | 312,000 | 264,000 | 225,000 |
| Net profit | 56,000 | 78,000 | 48,000 | 66,000 | 50,000 |
| Capital employed | 787,500 | 780,000 | 960,000 | 732,000 | 700,000 |
The Gross Profit Margin
The gross profit margin calculates how much sales revenue becomes gross profit. It can be used to analyse how effectively a firm manages its cost of sales. It is calculated using this formula
Gross profit margin = (gross profit/revenue) × 100
For The Coffee Hub in 2023, gross profit margin = (315,000/700,000) x 100 = 45%. This means 45% of its revenue became gross profit with 55% being spent on cost of sales.
Higher gross profit margins indicate that a firm is more efficient in its cost of sales. This could mean that they have increased revenue without increasing their cost of sales, perhaps through price increases. It could also mean they have reduced their raw material costs, perhaps through less waste or negotiating more preferable prices with their suppliers.
It is important to consider the context when using the gross profit margin to measure performance. Businesses involved in services such as solicitors require few raw materials whereas coffee shops would have much higher cost of sales due to their raw material requirements. It is therefore essential to factor in the type of industry when comparing businesses using gross profit margin as a metric. A gross profit margin above 50% is typically seen as good but in service sectors, it is not uncommon for gross profit margins to be above 90%.
The Mark-Up Ratio
The mark-up ratio calculates the difference between the cost of sales and the selling price. It is stated as a percentage added onto the cost of sales and is calculated using this formula
Mark-up ratio = (gross profit/cost of sales) × 100
For The Coffee Hub in 2023, markup ratio = (315,000/385,000) x 100 = 82%. This means that it's price is 82% higher than it's cost of sales.
The markup ratio is an important tool for managers to use when setting prices and managing inventory. It is important to compare markup ratios to market prices to ensure production costs are covered while remaining competitive and profitable. On products with low markup ratios, it is important for firms to ensure that they can generate large amounts of sales to make it viable. The right markup for a product depends on the cost to produce and the type of industry it operates in.
| Industry | Average Markup % |
|---|---|
| Clothing | 100% - 300% |
| Jewelry | 50% |
| Electronics | 10% |
| Name-brand Groceries | 44% - 100% |
| Pre-prepared Foods | 40% - 60% |
| Restaurant Food | 60% |
| Beverages (Restaurants) | Up to 500% |
| Convenience Store Items | 72% - 132% |
| Pharmaceuticals | Often >100% |
| Luxury Goods | 40% - 100% |
| Software (SaaS) | Often >70% |
Typical markup ratios vary from industry to industry. For example:
Grocery stores typically have markup ratios of under 15% as their products tend to be fast moving consumer goods. This means that they need to sell them in large quantities to remain profitable.
Restaurants can have markup ratios of between 30 - 60% on food and up to 500% on drinks. This is due to their high overheads such as staffing requirements.
Luxury goods typically have very high markups as these tend to sell less often and in lower quantities. The high markups also add to their brand perception of luxury.
Seasonal goods have higher markups when they are in season compared to then they are out of season. This is to encourage sales when demand is typically low. For example, winter coats are cheaper in the summer.
The Net Profit Margin
The net profit margin calculates how much of the sales revenue ends up as net profit. It can be used to measure how effective a firm is in managing all of their costs including expenses. The net profit margin can be compared to the gross profit margin to establish if issues are with cost of sales or with expenses. It is calculated using this formula
Net profit margin = (net profit/revenue) × 100
For The Coffee Hub in 2023, net profit margin = (56,000 / 700,000) x 100 = 8%. This means that 8% of its revenue became net profit with 92% being spent on cost of sales and expenses.
| Year | The Coffee Hub | Brewed Awakening | The Daily Grind | Java Junction | Steamy Sips |
|---|---|---|---|---|---|
| 2019 | 10% | 10% | 15% | 8% | 11% |
| 2020 | 12% | 9% | 16% | 7% | 13% |
| 2021 | 8% | 11% | 17% | 10% | 12% |
| 2022 | 12% | 10% | 19% | 9% | 14% |
| 2023 | 8% | 12% | 21% | 11% | 15% |
High net profit margins indicate that a business is in good financial health through efficient management of their costs compared to revenue. This could be the result of effective pricing strategies which would increase revenue or reduce costs through more efficient operations, relocation or negotiation with suppliers. Costs could be either cost of sales and expenses and both contribute to net profit.
Managers can use net profit margins over time to establish trends. If it is declining, this could indicate issues that need to be addressed such as unpopular pricing strategies or increasing expenses such as rent. Managers may also compare their net profit margins to those of competitors within the same industry to identify where improvements can be made to gain competitive advantage.
Return on Capital Employed (ROCE)
The return on capital employed (ROCE) ratio calculates how much profit a firm makes in comparison to the investment made in the business. The investment is recorded as capital employed on the statement of financial position. ROCE is calculated using this formula
ROCE = (profit/capital employed) × 100
For The Coffee Hub in 2023, ROCE = (56,000 / 787,500) x 100 = 7%. This means that in 2023, The Coffee Hub generated £0.07 in profit for every £1 invested.
The ROCE gives insight into how effectively a business is using its capital to generate profits. This is because capital employed refers to the money that has been invested into assets. For example, the coffee machine in a coffee shop is an asset. The ROCE can help managers assess the impact of the investment into the coffee machine and other assets on the profits of the business.
Managers can use ROCE to identify trends in performance and find areas where they can improve efficiency. They can also compare their company's ROCE with competitors. If rival firms are achieving a higher ROCE, managers may look into their operations to learn what changes could be beneficial. Additionally, potential investors are interested in ROCE before making investment decisions, as they want to compare possible returns with other investment options.