5.5.1 Profitability and Profitability Ratios

The concept and importance of profitability 

As we saw in Income statements, profit is a crucial business objective. 

Profitability takes this one step further. It measures how efficiently a business is making a profit. The magic tools that allow us to measure profitability are ratios.

Firstly, what are ratios? Ratios aren’t just used in analysis of accounts but throughout everyday life, as a means of measuring performance.

Let’s take the example of football’s greatest rivalry Messi vs Ronaldo. Who has the best scoring ratio?

Ronaldo scores 440 goals in 487 league games. Messi scores 408 goals in 313 league games.  As Ronaldo has played more games how can we compare who is the more efficient goal scorer?

If we use the ratios goals per game we can compare like with like. If we divide total goals by the total number of games we find Ronaldo scores 0.8 goals per game and Messi scores 0.8 goals per game.

We use  the same principle when using ratios to compare the financial performance of different companies.

Let’s look at these examples from Apple and Google.

Both make $15 billion a year gross profit, but from a different level of revenue. So how do we figure out which one is more profitable?

To calculate the profitability we need to find out how much gross profit Apple and Google make for every dollar of revenue. How efficiently do they convert revenue from sales into profit?

So we divide gross profit by revenue. Then we multiply by 100 to make it a percentage.

We find out Apple has a ratio of 50% while Google has a ratio of 75%. This is also called the gross profit margin. 

That means for gross profit Google, is 25% more profitable than Apple. So for every 100 dollars of revenue, Google earns 25 dollars more gross profit than Apple.

But what about profit,  is Google more profitable than Apple? We repeat the same process but input the profit results rather than gross profit. So we divide profit by revenue and multiply by 100 to make it a percentage.

We find out Apple has a ratio of 33.3% while Google has a ratio of 25%. This is also called the profit margin.

That means for profit Apple, is 8.3  % more profitable than Google. So for every 100 dollars of revenue, Apple earns 8.3 dollars more profit than Google.

The next step is to interpret the results, why does Apple have a lower gross profit margin but a higher profit margin?

To do this we need to return to the income statement to see how gross profit is calculated: 

Gross Profit = Revenue – Cost of Sales

This means Google has been more effective at controlling it’s cost of sales. Cost of sales are the materials used to make its products or services, for example, components used to make a smartphone.

However, Apple has a higher profit margin.

Profit = Revenue – Total costs

So Apple has been more effective than Google in controlling its expenses like advertising, rent or management salaries.

The final step is suggesting how profitability ratios could be improved.

There are two ways of improving gross profit margin:

• Increase price. This means that the business will make more gross profit for every $ of sales revenue.

Evaluation: If the price increase leads to significantly lower sales this will have a negative impact on business profits. There is an important link here to price elasticity. 

• Decrease in cost of sales 

If the business can reduce the cost of materials but keep their selling price the same they will earn more gross profit for every $ of revenue.

Evaluation: if a business reduces their cost of materials this may impact the quality of their products and lead to a decrease in sales.

To improve profit margin we can use the same methods  that we use to improve gross profit margin: increasing price and decreasing cost of sales. But as we also include expenses when calculating profit this gives us another way of increasing the profit margin.

• Decrease expenses  If the business can reduce the expenses they will earn more profit for every $ of revenue

Evaluation: if a business decreases expenses this may reduce sales. For example, if the advertising budget is reduced this could lead to less people finding out about the product and reducing sales as a result.

Return on Capital Employed (ROCE)

Return on capital employed does not appear as often as the other ratios in exam questions at IGCSE. It’s primarily used by investors, so people can see if they buy shares in a business how much profit they will get in return. It’s also used to see how profitably managers are running a business. 

However, if you are asked a question about profitability on paper 2 and capital employed is given you will be expected to calculate ROCE, so let’s find out how it’s done.

Instead of comparing Apple and Google let’s compare Apple’s results between 2019 and 2020.

Extract from Apple’s Accounts

This means that in 2020 Apple is making 2.5% less profit for every $ invested than in 2020 compared to 2019.

There are two ways of increasing ROCE. Increasing profit or reducing capital employed.

In this example, Apple may have increased capital employed to get a higher profit in the long term. For example, if Apple has invested in a new, more efficient factory that is currently being built, it will take a number of years for this to make an impact on the ROCE. In the short term it will reduce ROCE as the investment will reduce profits. However,  in the long term it will have a positive effect on return on capital employed, as when the factory become operational costs will decrease and profits will increase.