Fundamentals of Management Accounting · Ch 3 — Ratio Analysis
Profitability Ratios
Profitability Ratios
Profitability Ratios measure a firm's overall earning capacity — both as a margin on sales and as a return on the capital invested to earn those sales.
Gross Profit Ratio = (Gross Profit ÷ Revenue from Operations) × 100
Shows the margin left after covering the direct cost of goods sold, before operating expenses.
Net Profit Ratio = (Net Profit after Tax ÷ Revenue from Operations) × 100
Shows the final margin retained after every expense, interest, and tax — the most complete profitability-to-sales measure.
Return on Investment (Return on Shareholders' Funds) = (Net Profit after Tax ÷ Shareholders' Funds) × 100
Shows the return earned for the owners on the funds they have invested in the business.
Return on Capital Employed (ROCE) = (Net Profit before Interest and Tax ÷ Capital Employed) × 100, where Capital Employed = Shareholders' Funds + Long-term Debt
Shows the overall return earned on all long-term funds (both owners' and borrowed), regardless of how the business is financed. It uses the pre-interest, pre-tax profit because that profit is the return available to reward both sources of long-term capital.
Return on Investment and Return on Capital Employed are listed separately in the syllabus because they answer different questions: ROI measures return to the owners (numerator: profit after tax; denominator: shareholders' funds only), while ROCE measures return on the entire long-term capital base (numerator: profit before interest and tax; denominator: shareholders' funds plus long-term debt).
Worked illustration (using the data of Section 1). …
Gross Profit as a percentage of Revenue from Operations; the margin left after the direct co …
Net Profit after Tax as a percentage of Revenue from Operations; the final margin after all expenses, …
Net Profit after Tax as a percentage of Shareholders' Funds; the return earned for the owners on the …
Net Profit before Interest and Tax as a percentage of Capital Employed (Shareholders' Funds plus Long-term Debt); the return on all l …