In a previous post we discussed the importance and limitation of financial ratios. In this post we will consider some of the most important ratios to measure the profitability of a business.
Return on ordinary shareholders funds
Comparison between the the amount of profit available to the owners with the owners’ average stake in the business during the same period. Normally expressed in percentage, we can calculate this ratio as follows:
ROSF = [Profit for the year (net profit) – preference dividends (if any) / Ordinary shares capital + Reserves] x 100
When calculating this ratio, the average of the figures for ordinary shareholders’s funds as at the beginning and at the end of the year should be used.
Broadly, the higher the value of this ratio is the better for the business, as long as profit is not achieved at the expenses of potential future returns.
Return on capital employed (ROCE)
Relationship between the operating profit generated during a period and the average long-term capital invested in the business:
ROCE = [Operating profit / (Share capital + Reserves + Non-current liabilities)] x 100
In this case the profit before any interest and taxation is considered. ROCE is a primary measure of profitability as it compares input (capital invested) to output (operating profit) of the business activity.
Operating profit margin
Relationship between the operating profit for the period and the sales revenue:
OPM = (Operating profit / Sales Revenue) x 100
Operating profit (before interests and tax deductions) is used because it is the result of the trading activity. This can be considerent the most relevant measure of profitability especially if used for comparison, because differences arising from the way in which the business is financed do not affect the measure.
Gross profit margin
Gross profit is related to the sales revenue. Measure the profitability in buying/producing and selling goods/services:
Gross profit margin = (Gross profit / Sales revenue) x 100
Changes in the cost of sales can significantly influence this ratio