F1 7.02 Profitability Ratios: Profit and Expenses Percentages

In this session on Profitability Ratios we shall look at the following:

• The Gross Profit Percentage
• The Operating Profit Percentage
• The Specified Expense/Revenue Percentage

Profitability Ratios

Profitability ratios tell us about a company’s performance; its ability to turn sales revenue into profit, the relative amount spent on different types of costs, and the return that the company generates from the money it uses to fund its activities.

All of the profitability ratios that we shall look at on this course should be presented as percentages. Exam questions typically specify the number of decimal places should be used but if this is not the case, one or two decimal places will usually provide sufficient accuracy.

Gross profit percentage

The Gross Profit Percentage (also known as the Gross Profit Margin) measures the percentage of sales revenue left after the costs incurred in making the products sold, or delivering the services provided, are deducted. It is a measure of how efficiently the business converts sales into gross profit.

Alternatively, we can think of it as the percentage of sales revenue that will go towards paying the running costs of the business and in providing a return for the company’s providers of finance (i.e. its lenders and shareholders).

The Gross Profit Percentage formula is shown below.

Operating profit percentage

The Operating Profit Percentage (also known as the Operating Profit Margin) measures the percentage of sales revenue left after the costs incurred in making the products sold, or delivering the services provided and the running costs of the company are deducted. It is a measure of how efficiently the business converts sales into operating profit.

Alternatively, we can think of it as the percentage of sales revenue that will provide a return to the company’s providers of finance (i.e. its lenders and shareholders).

The Operating Profit Percentage formula is shown below.

Illustrations of calculations

A company’s Statement of Profit or Loss and Statement of Financial Position are shown below.

The calculations of Gross Profit Percentage and Operating Profit Percentage are shown below. The numbers used in their calculation can all be found in the Statement of Profit or Loss.

Gross Profit Percentage: 6,420/15,030 x 100 = 42.71%

Operating Profit Percentage: 1,750/15,030 x 100 = 11.64%

Evaluating profit percentages

Different types of businesses and different types of products have different profit percentages. How then, do we determine whether the profit percentage we have calculated represents good or poor performance?

We will compare the ratio calculated against one or more types of comparator. For example, the ratio for a previous period, a competitor or a target.

It is usually good if a business’ profit percentage is higher than its comparator. For example, we might say that a company’s operating profit percentage of 20% is better than that of its competitor whose operating profit percentage is 16%. Similarly, if a company’s gross profit percentage was 55% in the previous year and 42% in the current we would say that the ratio has worsened.

Note: When commenting on ratios you should try to avoid terms such as “gone up” or “gone down”, “risen” or “fallen”, “higher” or “lower” as these do not tell the reader whether the company’s position or performance is good or bad. Instead, you should try to use qualitative terms such as “better” or “worse” or “improved” or “deteriorated” as these provide more information to the reader and does not assume that they understand the ratio being discussed.

Reasons why profit percentages change

Students often lose easy marks in exams when they are asked to provide possible reasons for a change in gross or operating profit percentages. Let’s illustrate this issue with the following example:

We can see that the above business’ gross profit percentage has improved from 30% to 33% but if students are asked to provide a possible reason for this improvement many will say it has happened because the company’s sales have increased over the same period. Whilst this answer could be true, it is not sufficiently detailed to gain marks.

If, in our above example, the Cost of Sales consists of variable costs, a change in the company’s Sales should not result in a change in the gross profit percentage (since Costs of Sales would then change proportionately as Sales change). Something else, must therefore be going on.

Gross profit percentage: reasons for change

• Changes to selling prices will result in a change in the gross profit percentage
• Changes to the portion of total sales that qualify for bulk or trade discounts will also result in a change in the gross profit percentage
• Changes to the costs of goods sold per unit will also result in a change in the gross profit percentage. These changes could be caused by:
  • Changes to materials prices (perhaps due to changes to the availability of discounts)
  • Changes to labour prices (including that caused by the use of more or less overtime)
  • Changes in fixed costs or, changes to the number of units that the fixed costs are spread over

So, for our above example, the gross profit percentage may have risen because the company was able to increase its selling prices, or perhaps it was able to obtain greater discounts on its materials or the its Cost of Sales include many fixed costs which remained the same as Sales increased (thus spreading their cost over a larger number of sales).

Operating profit percentage: reasons for change

• Any changes that affect the gross profit percentage will also affect the company’s operating profit percentage
• Changes to the amounts spent on administrative overheads, or selling and distribution costs will also affect the operating profit percentage
  • As many expenses falling into these categories tend to be fixed in nature, an increase in sales typically results in an improvement in the operating profit percentage whilst a decrease in sales typically results in a worsening of the ratio

Specified Expense/Revenue Percentage

A Specified Expense/Revenue Percentage ratio takes whichever expense is of interest to the user and expresses it as a percentage of sales revenue. It therefore looks at the portion of sales that the company spends on that particular expense.

The Specified Expense/Revenue formula is shown below.

Illustration

A company’s statements are shown below. The user of the statements wishes to calculate the Selling Costs/Revenue Percentage and the Administration Costs/Revenue Percentage.

Selling Costs/Revenue Percentage: 1,880/15,030 x 100 = 12.51%

Administrative Costs/Revenue Percentage: 2,790/15,030 x 100 = 18.56%

Evaluating Specified Expense/Revenue Percentages

It is usually good if a business’ Specified Expense/Revenue Percentage is lower than its comparator (e.g. lower than the previous year or a competitor) and bad if it is higher. Sometimes, however, a lower ratio may indicate that there is a potential problem for the business.

For example, let’s say that a business’ Advertising Expense/Revenue Percentage has fallen from 10% last year to 4% this year. This change could mean that the business is spending too little on advertising and this might damage the business’ sales in the future.

In order to judge performance we should therefore try to find out the reason for changes in overheads in order to ensure that they will not damage the business in the longer term.

Question 1

A company’s statement of profit or loss and statement of financial position for the latest and previous years are shown below.

Question 2

A company’s statement of profit or loss and statement of financial position for the latest and previous years are shown below.