Profitability Ratios 1 / 5

Return on Capital Employed

ROCE

This is a measure of management’s overall efficiency in using the finance/assets. 

Additionally, it is most correct to use average total capital employed during the year, as the profit has been earned throughput the year. However, if you are not given the average capital employed, then simply use the capital employed at the end of the year.

  • ROCE will increase if less PPE is in the accounts

    So old PPE will give a higher than usual ROCE

    ROCE will decrease if more PPE is in the accounts

    So, Revaluations upwards will give a lower than usual ROCE

  • ROCE will increase if less expenses (except interest and tax) are in the accounts

  • ROCE will decrease if more loans / share issues are made that year - especially near the year end

ROCE can be broken down (explained by) 2 more ratios:

Operating Margin
Asset Turnover

So if Operating Margin is up and ROCE is down - Net Asset Turnover must be down a lot

(The assets aren't producing the amount of sales they used to)

Operating Margin

= Operating Profit (PBIT) / Sales

Asset Turnover

= Sales / Capital Employed

Gross Margin

Gross Margin is affected by..

An increase in the sales PRICE or decrease in COS PRICE

An increase in gross profit as a whole doesn't necessarily mean an increase in the margin - as it could be due to more volume and nothing to do with the price

  • Inventory measured in different ways (as this affects "price")

  • Inventory write downs due to damage/obsolescence (You've reduced its 'price')

  • A change in the Sales Mix - different items sell at different prices

  • New (different margin) products - have different prices and hence margins

  • New suppliers with different prices

  • Discounts offered - reducing the sales price

  • More or less Import duties - changing COS price

  • Exchange rate fluctuations

  • Change in cost classification: 

    eg. Some costs included as operating expenses now in cost of sales

Gross Profit Mark up

This ratio is an alternative measure of profitability. 

It is calculated like this:

Gross Profit / Cost of sales x 100