5.5.1 Concept of Importance of Profitability
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?
| Who is the more efficient goals scorer? (Goals per game ratio) | |
| Cristiano Ronaldo 440 goals in 487 games 440 goals ÷ 487 games = 0.8 goals per game | Lionel Messi 408 goals in 313 games 408 goals ÷ 313 games = 1.18 goals per game |
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.
| Apple | ||
| Revenue ($billion) | 30 | 20 |
| Gross profit | 15 | 15 |
| Profit | 10 | 5 |
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.
| Gross Profit Margin = Gross Profit ÷ Revenue x 100 Calculates how much profit is made for every $1 of revenue. |
| Gross Profit Margin (gross profit per $1 revenue) | |
| Apple 15 gross profit ÷ 30 revenue x100 = 50% | Google 15 gross profit ÷ 20 revenue x100 = 75% |
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.
| Profit Margin = Profit ÷ Revenue x 100 Calculates how much profit is made for every $1 of revenue. |
| Profit Margin (profit per $1 revenue) | |
| Apple 10 Profit ÷ 30 Revenue x100 = 33.3% | Google 5 Profit ÷ 20 revenue x100 = 25% |
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.
| ⭐⭐⭐Top Tip ⭐⭐⭐ Review how gross profit and profit are calculated (5.3 Income Statements) before learning how profit margin results can be improved. |
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.
| Capital Employed = Profit ÷ Capital Employed x 100 Measures how efficiently a business makes profit compared to the capital invested in the business. |
| ⭐⭐⭐Top Tip ⭐⭐⭐ Ratios can be used to compare a business’s performance with a competitor, or the financial performance of a business in one year compared with another year. |
Instead of comparing Apple and Google let’s compare Apple’s results between 2019 and 2020.
Extract from Apple’s Accounts
| 2019 | 2020 | |
| Profit (billions $) | 8 | 10 |
| Capital Employed (billion $) | 64 | 100 |
| Return on Capital Employed (measures return on investment) | |
| Apple 2019 8 ÷ 64 x 100 = 12.5% | Apple 2020 10 ÷ 100 x 100 = 10% |
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.
5.5.3 Liquidity Ratios
The Concept and Importance of Liquidity
While profitability is linked to income statements, liquidity is all about measuring cash flow and how efficiently a firm is managing the cash in its business.
Liquidity is the ability of a business to pay its short term debts. Cash flow is crucial to a business’s survival. If a business doesn’t have enough cash, it can’t pay it’s short term debts and it will become illiquid, insolvent and stop operating.
However, if a business has too much cash it means there is an opportunity cost. If that cash is not needed to pay short term debts it means that it could be used more effectively elsewhere and re-invested in the business.
Current Ratio
The current ratio guides businesses to find the most suitable level of cash so there is enough cash to pay short term debts, but not too much cash which could be used more effectively elsewhere in the business.
| Current Ratio = Current Assets ÷ Current Liabilities Acid Test Ratio = Current Assets – Inventory ÷ Current Liabilities |
| ⚠⚠ DANGER! ⚠⚠ Unlike the profitability ratios, liquidity ratios are not converted into a percentage, so don’t multiply by 100. |
| Extract from B. Eilish Hoodies Statement of Financial Position | ||
| 2019 | 2020 | |
| Current Assets $m | 350 | 450 |
| Current Liabilities $m | 250 | 300 |
| Non-current Liabilities $m | 480 | 520 |
| Inventory | 200 | 250 |
To calculate the current ratio in 2019 we divide current assets by current liabilities. So it is 350 divided by 250, giving a result of 1.4.
For 2020 we follow the same process. So it is 450 divided by 300, giving a result of 1.5.
| Current Ratio Calculation for B. Eilish Hoodies | |
| 2019 350 ÷ 250 = 1.4 | 2020 450 ÷ 300 = 1.5 |
But what do these results mean for B. Eilish Hoodies liquidity?
Generally the best current ratio result is somewhere between 1.5 and 2.0. Below 1.5 there is a danger that the business will not have enough cash to be able to pay its short term debts.
From 2019 to 2020 the current ratio has improved from 1.4 to 1.5, so the business is now in a better position in terms of liquidity.
| Current Ratio Value | Explanation | |
| Above 2.0 | !!! | Too high, cash could be used more effectively elsewhere in the business |
| 1.5 to 2.0 | + | Correct level, enough cash to pay short term debts. |
| 1.0 to 1.5 | X | Too low, business may not be able to pay short term debts |
| Below 1.0 | X X | Danger! More current liabilities than current assets. |
Acid Test Ratio
To calculate the acid test ratio in 2019 we subtract inventory from current assets, then divide by current liabilities. So it 350 minus 200 divided by 250 giving a result of 0.6.
For 2020 we follow the same process, so we subtract inventory from current assets, then divide by current liabilities. So it is 450 minus 300 divided by 300 giving a result of 0.5.
| Acid Test Ratio Calculation for B. Eilish Hoodies | |
| 2019 (350- 200) ÷ 250 = 0.6 | 2020 (450-300) ÷ 300 = 0.5 |
But what do these results mean? The optimum figure for Acid Test Ratio is 1.0, so B.Eilish is well below that in 2019 and in 2020 the situation is even worse. This means that B.Eilish may have difficulty paying short term debts and is at risk of not having enough cash flow for the business to continue operating.
| Acid Test Ratio Value | Explanation | |
| Above 1.0 | + | Enough cash to pay short term debts. |
| Below 1.0 | X | Too low, business may not be able to pay short term debts |
The reason we subtract inventory from current assets to calculate the acid test ratio is that inventory is the most difficult current asset to convert to cash. If there is an electricity bill that needs to be paid B.Eilish can’t offer to pay with her inventory of hoodies!
However, the optimum level of cash and inventory held by a business also varies from industry to industry. Some businesses will quickly sell their inventory, like fresh food markets. Others like jewellery shops will take much longer to sell off their inventory.
You have now completed all the calculations required in Unit 5. But who actually wants to look at all this financial information anyway? In the next section we’ll find out.
5.5.4 Why and how accounts are used
Needs of different users of accounts and ratio analysis
How users of accounts and ratio results might use information to help make decisions
You need to know which stakeholders are interested in financial accounts, what they want to know, and why.
| ⭐⭐⭐Top Tip ⭐⭐⭐ Just like questions about stakeholders, it’s helpful to put yourself in the shoes of each user of financial information. Why do they interested in a business’s accounts? How will they be impacted by the financial performance of a business? How will the results influence their decisions? |
Managers and Leaders have a responsibility to ensure the financial success of a business.
They are interested in the income statement and profitability ratios, so they can see how the performance of the company compares against previous years and against competitors. They also use financial information to make decisions for the business going forward.
For example, if the income statement shows a particular market or product has a higher profit margin, this could be the focus for their marketing strategy in the future.
It’s worth noting managers success (and bonuses) will often be measured against the profitability of the business.
Managers will also be interested in liquidity ratios, so they can analyse the businesses ability to pay its short term debts. If working capital is low they can look at ways of improving cash flow to ensure the business can continue to operate.
Investors will keenly look at the income statement and profitability ratios. If the business is improving it’s profitability it will mean more dividends for shareholders. If profit margins are low investors may decide to move their money elsewhere.
Investors will also look at the statement of financial position, as it shows the total value of a business. If the net worth of the business is increasing year on year, it means the value of the investors shares is likely to increase.
Banks and creditors are more interested in the statement of financial position as they need to make sure a business can pay its debts.
If a business has a high level of debt banks may be unwilling to loan capital as there is a risk the business will not be able to repay.
If a business has low liquidity a supplier may decide not to sell on credit, as they may not receive payment from the business.
Competitors will compare their profitability to companies in the same industry to assess their performance. Toyota may compare its results with Ford, Tesla and other car manufacturers.Finally, the government is interested in financial accounts because of tax. If a business is profitable it will pay more tax so the government will want it’s share.
