The meaning of profitability ratios

Profitability ratios express key business data as percentages, showing what happens to each pound spent by a customer. They help assess how effectively a business turns sales into profit by considering different types of costs.

Types of profitability ratios

• Gross profit margin - Measures the percentage of sales revenue that remains after subtracting the direct costs of producing goods or services. It ignores indirect costs.
• Net profit margin - Measures the percentage of sales revenue that remains after subtracting all costs, including both direct and indirect expenses, as well as items like loan interest.

Higher profitability ratios generally indicate better performance.

Calculating gross profit margin

Gross profit margin shows the fraction of every pound in sales revenue that is not spent on the direct costs of making a product or providing a service.

$\text{Gross profit margin}=\frac{\text{gross profit}}{\text{sales revenue}}\times 100$

Where:

• Gross profit = Sales revenue minus cost of sales (£)
• Sales revenue = Total income from sales (£)

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Worked example - Calculating gross profit margin

A restaurant has a gross profit of £90,000 and sales revenue of £160,000. Calculate the gross profit margin.

Step 1: Identify the values

• Gross profit = £90,000
• Sales revenue = £160,000

Step 2: Apply the formula

$\text{Gross profit margin}=\frac{\pounds \mathrm{90,000}}{\pounds \mathrm{160,000}}\times 100$

Step 3: Perform the calculation

$\text{Gross profit margin}=56.3\%\text{ (to 1 d.p.)}$

Step 4: Interpretation

This means that for every £1 spent by customers, about 56p remains after direct costs, available to cover other expenses.

Factors affecting gross profit margin

What counts as a good gross profit margin varies by business type. Higher percentages are generally better.

Ways to improve gross profit margin

• Increasing prices - Raising the selling price can boost the margin.
• Reducing direct costs - Lowering costs like raw materials or labour directly involved in production improves the margin.

Business models and gross profit margin

• Businesses with low gross profit margins, such as discount retailers, often rely on high sales volumes to compensate.
• These businesses must maintain competitive prices to survive.

Calculating net profit margin

Net profit margin shows the fraction of every pound in sales revenue that the business keeps after all costs have been deducted.

$\text{Net profit margin}=\frac{\text{net profit}}{\text{sales revenue}}\times 100$

Where:

• Net profit = Gross profit minus all other expenses (£)
• Sales revenue = Total income from sales (£)

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Worked example - Calculating net profit margin

A café has a gross profit of £110,000, sales revenue of £180,000, operating expenses of £70,000, and loan interest of £5,000. Calculate the net profit and net profit margin.

Step 1: Identify the values

• Gross profit = £110,000
• Operating expenses = £70,000
• Loan interest = £5,000
• Sales revenue = £180,000

Step 2: Calculate net profit

Net profit = £110,000 - £70,000 - £5,000 = £35,000

Step 3: Apply the formula

$\text{Net profit margin}=\frac{\pounds \mathrm{35,000}}{\pounds \mathrm{180,000}}\times 100$

Step 4: Perform the calculation

$\text{Net profit margin}=19.4\%\text{ (to 1 d.p.)}$

This means that for every £1 spent by customers, the café keeps about 19p as net profit after all costs.

Comparing gross and net profit margins

Gross profit margin should always be higher than net profit margin, as it excludes indirect costs.

Factors influencing net profit margin

• Business growth - As businesses expand, indirect costs often increase, which can reduce net profit margin.
• New businesses - Smaller or newer companies typically have higher net profit margins because they have fewer indirect costs.