Profitability is the relationship between profit and sales and helps managers to determine how well each dollar of sales generates profits The level of profitability depends on:
1. The volume of sales
2. The percentage mark-tup applied
3. The level of expenses incurred
There are three ratios to measure profitability:
Gross Profit Ration (GPR)
Is derived from the income statement
It shows how well the company is maintaining and adequate margin between sales and purchases
The GPR calculates how much GP is made (for every $1 of sales) after COGS has been paid For example:
A result of 70% means that for every $1 of sales revenue, $0.70 has been made in GP In order to analyse:
The GP margin reflects the ‘mark up’ between the firm’s purchasing costs and its selling prices A low or declining GP margin suggests high supply costs and/or products are priced too low A high GP margin suggests low supply costs/and or products priced to high Alternative suppliers may need to be sourced if supply costs are too high Some authors feel that 40% for retail businesses is good
The higher the GPR the better
Net profit Ratio (NPR)
Is derived from the Income Statement
It shows the amount of sales revenue that results in net profit. Businesses should aim for a high net profit ratio.
The NPR calculates how much NP is made (for every $1 of sales) after expenses have been paid. For example
A result of 25% means that for every $1 of sales revenue, $0.25 has been made in NP. In order to analyse:
The NP margin reflects the expenses of a business.
A low or declining NP margin (especially when the GP is relatively high) suggests excessive costs. A high NP margin suggests low costs/expenses and sound financial management. A low or declining NP margin suggests that expenses should be examined to see whether reductions can be made (e.g. staffing costs) Some authors feel a 10-12% NPR is ‘good’
The higher the NPR the better
Return on Owners equity
Is derived from the Income Statement and the Balance Sheet
It shows how effective their funds have been in generating a return for the owners (how much the owners will earn per dollar of investment)
A result of 12.5% means that every $1 contributed by the owners generates 12.5 cents return for the owners. In order to analyse:
Some authors feel that a 20% return is good, but it should be compared with other returns possible (e.g. what could someone get if they invested in a term deposit or another business instead) To improve this, a business should reduce its expenses and improve efficiency – change sale price, promotion and marketing strategies to improve revenue. They should exit areas of poor return and reinvest the money.
Efficiency is a business improves its efficiency when it can achieve greater output from the given inputs. Greater efficiency contributes to a competitive advantage. These ratios show how well the business is keeping expenses under control and how long it takes for the business to receive money from their debtors. There are 2 efficiency ratios:
1. Expense ratio
2. Accounts receivable turnover ratio
The expense ratio:
It indicates how much of each $ of sales is taken up in expenses. Managers should determine why expense ratios have increased or decreased (e.g. if the selling expense ratio has increased, it may indicate that advertising costs have not generated the expected increase in sales) Expenses should be compared with budgeted amounts in order to find reasons for the differences. This analysis should take into account the fact that some expenses are fixed whilst others are variable. For example:
A result of 34% means that the business had expenses of 34 cents to earn every $1 of sales. The lower the percentage the better.
The accounts receivable turnover ratio
This ratio measures the efficiency of a firm’s credit policy and collection of its debts. Corrective action can be taken...
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