1. Evaluating Earning Power
Profitability ratios measure a business’s ability to generate earnings relative to its sales revenue, asset base, or shareholder investment. They show how efficiently management controls expenses to generate returns.
2. Core Profitability Formulas
- Gross Profit Margin: Measures trading and production efficiency before accounting for overheads.
Gross Profit Margin (%)=Gross ProfitRevenue×100
- Net Profit Margin: Measures overall operational efficiency by showing the percentage of each dollar earned that remains after all expenses are deducted.
Net Profit Margin (%)=Net ProfitRevenue×100
- Return on Capital Employed (ROCE): The primary metric for measuring investment efficiency. It shows how effectively a business uses its total long-term funding base to generate operating profits.
ROCE (%)=Operating Profit (EBIT)Total Capital Employed×100
*Note: Capital Employed = Equity + Non-Current Liabilities (or Total Assets – Current Liabilities).
*Note: Capital Employed = Equity + Non-Current Liabilities (or Total Assets – Current Liabilities).
3. Strategic Analysis Interpretation
A business can increase its ROCE by either expanding its net profit margin (increasing prices or cutting overheads) or accelerating its asset turnover (generating more sales volume from the same asset base).