CIMA BA2 Syllabus C. PLANNING AND CONTROL - Financial Performance Measures - Notes ^{4 / 7}

Gross Profit Margin

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

• It shows how efficient the organisation is at using their cost of sales (direct materials / labour / expenses).

Net Profit Margin

This shows how good the organisation is at using all of its costs, including the non production costs.

Return on Capital Employed.

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

• 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 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.

Asset Turnover

1. 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.

   This is measured in number of times, not as a %.

Illustration

Sales revenue $10,000
Gross profit $2,000
Operating profit (PBIT) (Net profit) $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 Net Profit Margin?

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

What is the asset turnover?

10,000/4,000 = 2.5 times

Another way to find ROCE

ROCE can also be found using this:

Net profit margin x Asset Turnover

How?

Net profit margin = Net profit / Sales 

Asset turnover = Sales / Capital employed

So,

Net profit / Sales x Sales / Capital employed = Net profit / Capital employed = ROCE 

Let us see if this works with the illustration above

Net profit Margin  = 10%
Asset Turnover = 2.5 times

ROCE = 10% x 2.5 = 25% same as above

Residual Income

This is similar to capital employed, as we take our capital employed and we decide what % return we want (this is also known as a notional interest charge). 

It is calculated like this:

Profit - (Capital employed x Notional interest charge)

Therefore,

If our capital employed is $1,000
Notional interest charge 10%
Actual profit

Residual Income = 150 - (1,000 x10%) = 50