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  Profitability

Introduction to Profitability

The following ratios might be employed to calculate the profitability of the business:

  • return on ordinary funds of shareholders
  • return on capital employed
  • operating profit margin
  • gross profit margin.

All are described as follow:

Return on ordinary funds of shareholders (ROSF)

The return on ordinary funds of shareholders ratio compares the amount of profit for the period offered to the owners with the average stake of owners in the business throughout that similar period. The ratio (which is generally expressed in percentage terms) is as follows:

ROSF = (Profit for the years less any preferance dividend/Ordinary share capitals + Reserves) x 100

The profit for the year (less preference dividend (if any)) is employed in calculating the ratio, like this figure presents the amount of profit that is attributable to the owners.

Return on capital employed (ROCE)

The return on capital employed (ROCE) ratio is a basic measure of business performance. This ratio expresses the relationship among the operating profit produced throughout a period and the average long-term capital invested in the business.

The ratio is described in percentage terms and is defined as follows:

ROCE = [(Operating Profit)/ (Share capital + Reserves + Non-current liabilities)] x 100

Note: that the profit figure used is the operating profit (i.e. the profit before interest and taxation) since the ratio attempts to measure the returns to all suppliers of long-term finance before any deductions for interest payable on borrowings, or payments of dividends to shareholders, are made.

Operating profit margin

The operating profit margin ratio relates the operating profit for the period to the sales revenue.

The ratio is described as follows:

Operating profit margin = (operating profit/Sales revenue) x 100

The operating profit (i.e. profit before interest and taxation) is employed in this ratio like it presents the profit from trading operations before the interest payable expense is taken into account. This is frequently considered like the most suitable measure of operational performance, while employed as a basis of comparison, because variations arising from the way where the business is financed will not affect the measure.

Gross profit margin

The gross profit margin ratio relates the gross profit of the business to the sales revenue produced for similar period. Gross profit presents the variation between sales revenue and the cost of sales. So the ratio is a measure of profitability in buying (or producing) and selling goods or services before any other expenses are taken into account. Like cost of sales presents a main expense for several businesses, an alteration in this ratio can have a important effect on the 'bottom line' (i.e. the profit for the year).

The gross profit margin ratio is computed as follows:

Gross profit margin = (Gross profit/Sales revenue) x 100

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