CAT / FIA FMA Syllabus F. Performance Measurement - Measuring Profitability - Notes ^{2 / 15}

Return on Capital Employed / Return on investment

The main ratio to measure profitability in an organisation is return on capital employed (ROCE) / return on investment (ROI).

• Capital employed is defined as total assets less current liabilities or share capital and reserves plus long term capital. 

  It is important to exclude all assets of a non-operational nature, 

  e.g. trade investments and intangible assets such as goodwill.

• ROCE/ROI represents the percentage of profit being earned on the total capital employed; and relates profit to capital invested in the business. 

  Capital invested in a corporate entity is only available at a cost – corporate bonds or loan stock finance generate interest payments and finance from shareholders requires either immediate payment of dividends or the expectation of higher dividends in the future.

The primary ratio measuring overall return is analysed in more detail by using secondary ratios

1. Asset turnover

2. Net Profit margin – net profit before interest and tax as a percentage of sales

Net Profit Margin

The profit margin indicates how much of the total revenue remains to provide for taxation and to pay the providers of capital, both interest and dividends.

Gross Profit Margin

The trading activities of a business can be analysed using the gross profit margin.

When particular areas of weakness are found, subsidiary ratios are worked out: -

• Production cost of sales / sales

• Distribution and marketing costs / sales

• Administrative costs / sales

Asset Turnover

The asset turnover indicates how well the assets of a business are being used to generate sales or how effectively management have utilised the total investment in generating income.

Illustration

Sales revenue $10,000
Gross profit $2,000
Operating profit (PBIT) $1,000
Capital employed $4,000

What is the ROCE?

1,000/4,000 * 100% = 25%

What is the G.P. Margin?

2,000/10,000 * 100% = 20%

What is the O.P Margin?

1,000/10,000 * 100% = 10%

What is the asset turnover?

10,000/4,000 = 2.5 times