Profitability Ratios

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Return on Capital Employed (ROCE)

A business buys assets such as trucks, computers, etc to help makes its operations more efficient, cut down on costs and make bigger profits.

ROCE shows how well a business has generated profit from its long-term financing.

It is expressed in the form of a percentage, and the higher the percentage, the better.

ROCE is calculated:

ACCA FA H2ai/b How to calculate ROCE

How can firms increase the ROCE ratio?

Movements in return on capital employed are best interpreted by examining profit margins and asset turnover (in more detail below) as ROCE is made up of these component parts.

Firms can increase their ROCE ratio by:

  1. Cutting costs so as to increase the profit margin ratio

  2. Increasing the revenue made from their assets, i.e. more efficient use of assets

Limitations of using ROCE ratio

  • Be careful when using the ROCE ratio because it does not always yield the correct percentage.

    For instance, a company may simply run down its old assets. 

    This means the denominator “Total Assets – - Current Liabilities” (value of assets is lower) will be lower and so give a higher ROCE percentage.

    In this case, there has been no improvement in operations of the company, in fact the firm is cutting down on potentially profitable capital investments.

  • Always compare a company’s ROCE to the interest rate it is charged.

    The ROCE needs to be higher.

    Similarly if a company pays off a 5% loan, while its current ROCE is 10%, then this is illogical. It should use the money to get 10% not pay off a loan which only costs 5%.

Asset Turnover

Asset turnover shows how efficiently management have utilised assets to generate revenue.

It is calculated as:

ACCA FA H2ai/b Asset Turnover

When looking at the components of the ratio, a change will be linked to either a movement in revenue, a movement in net assets, or both.

An increase in asset turnover can result from:

  1. a significant increase in sales revenue

  2. the business entering into a sale and operating lease agreement, then the asset base would become smaller, thus improving the result.

Return on Equity (ROE)

The ROE ratio reveals how much profit has been made in comparison to shareholder equity.

A business that has a high return on equity is more likely to be one that is capable of generating cash internally.

Gross Profit Margin

The gross profit margin looks at the performance of the business at the direct trading level.

ACCA FA H2ai/b Gross profit margin

Variations in the Gross Profit Margin are as a result of:

  1. changes in the selling price/sales volume

  2. changes in cost of sales

For example, cost of sales may include inventory write downs that may have occurred during the period due to damage or obsolescence, exchange rate fluctuations or import duties.

Net Profit Margin

The net profit margin is generally calculated by comparing the profit before interest and tax of a business to revenue.

However, the examiner may specifically request the calculation to include profit before tax.

Analysing the net profit margin enables you to determine how well the business has managed to control its indirect costs during the period. In the exam, when interpreting operating profit margin, it is advisable to link the result back to the gross profit margin.

For example, if gross profit margin deteriorated in the year then it would be expected that the net profit margin would also fall. 

However, if this is not the case, or the fall is not so severe, it may be due to good indirect cost control or perhaps there could be a one-off profit on disposal distorting the operating profit figure.

It is important to note that the profit margin and asset turnover together explain the ROCE.

ACCA FA H2ai/b Net profit sales
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