Profitability Ratios

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PROFITABILITY RATIOS
One of the most important measures of a company’s success is its profitability. However, individual figures shown in the income statement/profit and loss account for gross profit and net profit mean very little by themselves. When these profit figures are expressed as a percentage of sales, they are more useful. This percentage can then be compared with those of previous years, or with the percentages of other similar companies. Changes in the gross profit percentage ratio can be caused by a number of factors. For example, a decrease may indicate greater competition in the market and therefore lower selling prices and a lower gross profit or, alternatively, an increase in the cost of purchases. An increase in the gross profit percentage may indicate that the company is in a position to exploit the market and charge higher prices for its products or that it is able to source its purchases at a lower cost. The relationship between the gross and the net profit percentage gives an indication of how well a company is managing its business expenses. If the net profit percentage has decreased over time while the gross profit percentage has remained the same, this might indicate a lack of internal control over expenses. The return on capital employed (ROCE) ratio is another important profitability ratio. It measures how efficiently and effectively management has deployed the resources available to it, irrespective of how those resources have been financed. Various formulae can be found in textbooks for calculating ROCE. The most common uses operating profit (defined as profit before interest and taxation) and the closing values for capital employed (although using averages for the year is more accurate). This ratio is useful when comparing the performance of two or more companies, or when reviewing a company’s performance over a number of years.
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