Financial Analysis

Profitability Ratios

Summary of formulas

Capital employed = non-current liabilities + capital (or equity for a limited company)

Gross profit margin

Expresses gross profit as a % of revenue. For every £1 of sales, Xp is gross profit.

To improve:

• Increase unit selling price — but risks reducing sales volume
• Reduce unit cost of sales — e.g. change supplier or buy in bulk (risk: lower quality; higher holding costs)

Mark-up

Expresses gross profit as a % of cost of sales. For every £1 of cost, Xp is added to reach the selling price.

Margin vs mark-up:

A margin of 25% ≠ a mark-up of 25% — the denominator is different.

Profit in relation to revenue

Expresses net profit as a % of revenue. For every £1 of sales, Xp is profit after all expenses.

To improve: increase gross profit margin and/or reduce expenses relative to revenue.

Expenses in relation to revenue

Expresses total expenses as a % of revenue. For every £1 of revenue, Xp is spent on expenses.

To improve (examples):

• Rent: relocate to cheaper premises (risk: less favourable location, reduced capacity)
• Light and heat: switch supplier or reduce consumption
• Wages: reduce staffing (risk: lower quality of service; harder to reduce than variable costs)

Return on capital employed (ROCE)

Expresses profit as a % of long-term capital invested. For every £1 of capital, Xp is profit.

To improve:

• Increase profit for the year (see GPM and expenses strategies above)
• Reduce capital employed (reduce non-current liabilities or capital/equity)

Worked example (Geraint Roglic, year ended 31 August 2019)

For every £1 of sales: 73p is cost of sales, 17p is expenses, 10p is profit.