Business Management 3.5 – PROFITABILITY AND LIQUIDITY RATIOS
PROFITABILITY RATIOS
Gross profit margin: indicate how effectively managers have added value to the costs of sales.
Money done per each dollar on sales.
gross profit
Gross profit margin ( % )= x 100
sales revenue
Net profit margin: low because of high overheads compared to sales. Assess profitability and
performance as well as managers’ effectiveness at converting revenue into net profits
net profit
Net profit margin ( % )= x 100
sales revenue
STRATEGY Example Evaluation
+ gross and net profit margin Cheaper materials Quality perception and
- Direct costs Cut labour costs by impact on reputation
relocation or automation Quality risks
Reduce workers’ pay New machines (+ gross
profit but – net profit)
Lower motivation levels (-
productivity and quality)
+ gross and net profit margin Increase prices (higher Customers might stop
+ prices than costs) buying
Consumers may
considered to be
profiteering decision and
long-term image may
damage
+ net profit Cheapest office location Image damages
- Overhead costs - promotion costs With low promotional
Delayering the costs sales could fall
organisation Fewer wages impact
business efficiency
Return on Capital Employed (ROCE): higher value is higher return on each dollar invested.
net profit
ROCE ( % )= x 100
capital employed
capital employed=non current assets−current assets−current liabilities
capital employed=non−current liabilities + shareholders´ equity
Strategies to increase ROCE Limitations
+ Net profit = capital employed Price elastic demand
Higher prices Long-term strategy
Innovative products to set higher prices Quality impact
- overheads Not effective in short-term
+ capital invested to increase net Finance needed and increase net profits
profits further than capital employed may be less than increase in capital
- Capital employed. Sell assets to reduce debts employed
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PROFITABILITY RATIOS
Gross profit margin: indicate how effectively managers have added value to the costs of sales.
Money done per each dollar on sales.
gross profit
Gross profit margin ( % )= x 100
sales revenue
Net profit margin: low because of high overheads compared to sales. Assess profitability and
performance as well as managers’ effectiveness at converting revenue into net profits
net profit
Net profit margin ( % )= x 100
sales revenue
STRATEGY Example Evaluation
+ gross and net profit margin Cheaper materials Quality perception and
- Direct costs Cut labour costs by impact on reputation
relocation or automation Quality risks
Reduce workers’ pay New machines (+ gross
profit but – net profit)
Lower motivation levels (-
productivity and quality)
+ gross and net profit margin Increase prices (higher Customers might stop
+ prices than costs) buying
Consumers may
considered to be
profiteering decision and
long-term image may
damage
+ net profit Cheapest office location Image damages
- Overhead costs - promotion costs With low promotional
Delayering the costs sales could fall
organisation Fewer wages impact
business efficiency
Return on Capital Employed (ROCE): higher value is higher return on each dollar invested.
net profit
ROCE ( % )= x 100
capital employed
capital employed=non current assets−current assets−current liabilities
capital employed=non−current liabilities + shareholders´ equity
Strategies to increase ROCE Limitations
+ Net profit = capital employed Price elastic demand
Higher prices Long-term strategy
Innovative products to set higher prices Quality impact
- overheads Not effective in short-term
+ capital invested to increase net Finance needed and increase net profits
profits further than capital employed may be less than increase in capital
- Capital employed. Sell assets to reduce debts employed
1
