# Profitability Ratios February 2023

Teresa Clarke explains a subject that will be tested in the new AAT syllabus.

The new Q2022 AAT Level 3 ‘Financial Accounting: Preparing Financial Statements’ includes this topic. You will need to calculate the following ratios and be able to interpret them.

## Gross profit margin

Use the words in the description of the ratio to remember how to calculate it. Gross profit as a margin of sales. Remember that gross profit is calculated by taking the sales figure and deducting the cost of sales.

Sales £120,000
Cost of sales £90,000
Gross profit £30,000
Gross profit divided by sales or gross profit
/ sales, multiplied by 100 to turn it into a
percentage.
£30,000 / £120,000 = 0.25
0.25 x 100 = 25%

Take a minute to think about what this tells us.

This means that 25% of the total sales or revenue is gross profit. If the percentage was to increase next year, it would mean that we are making a higher gross profit, more money, than the previous year. If the percentage were to decrease next year, it would mean that we are making a lower gross profit, less money, than the previous year.

## Net profit margin

Again, use the words in the description to remember how to calculate it. Net profit as a percentage of sales. Remember that net profit is calculated by taking the gross profit and deducting all the expenses.

Gross profit £30,000
Total expenses £6,000
Net profit £24,000
Net profit divided by sales or net profit / sales,
multiplied by 100 to turn it into a percentage.
£24,000 / £120,000 = 0.20
0.20 x 100 = 20%

Take a minute to think about what this tells us.

This means that 20% of the total sales or revenue is net profit. If the percentage was to increase next year, it would mean that we are making a higher net profit, more money, than the previous year. If the percentage was to increase, it would mean that we are making a lower net profit, less money, than the previous year.

## Expense over revenue percentage

Using the words in the description again to remember how to calculate this. The expense over revenue percentage is a particular expense, such as motor expenses, over revenue or sales.

Sales

£120,000

Cost of sales

£90,000

Gross profit

£30,000

Expenses:

£1,000

Motor expenses

£1,500

Finance expenses

£500

Rent expense

£2,000

Insurance expense

£1,000

Total expenses

£6,000

Net profit

£24,000

Expense over revenue as a percentage
Motor expense divided by revenue x 100
£1,500 / £120,000 = 0.0125
0.0125 x 100 = 1.25%

Take a minute to think about what this tells us. This means that 1.25% of the total sales or revenue is spent on motor expenses. If the percentage was to increase next year this would mean that more of the revenue is used to pay the motor expenses, meaning the profit would be lower. If the percentage is lower, it would mean that less of the revenue has been used to pay motor expenses, giving a higher net profit.

## Return on capital employed

This one can be tricky to remember. Return simply means how much we have earned from the business activities in the year – namely, the net profit.

The capital employed is the amount of money we have used during the year to earn that net profit.

Remember that assets minus liabilities equal capital.

But capital might not be all we had to use in the year. If we had a long-term liability, such as a loan, we also had this money to use to earn the money. We add back any long-term or noncurrent liabilities as we also used this money.

Capital employed is capital plus any non-current liabilities.

Total current and non-current assets

£200,000

Current liabilities

£120,000

Non-current liabilities

£20,000

Assets £200,000 – all liabilities £140,000 = Capital £60,000
Capital £60,000 plus non-current liabilities £20,000 = £80,000
Return on capital employed = net profit / capital employed £24,000 / £80,000 = 0.30
0.30 x 100 = 30%

Take a minute to think about what this tells us. This means that for every £100 of capital employed, we have made £30 profit, 30%. If the percentage was to increase next year it would mean that we made more profit from the money used. If the percentage was to decrease, it would mean that we have made less profit from the money used.

Remember that there are limitations to the usefulness of ratios, but hopefully this has helped you to understand the figures more clearly.

If you enjoy my way of explaining things, you might like my workbooks, which are all available from Amazon in both paperback and as eBooks.

The links to all my workbooks can be found here. https://www.teresaclarke.co.uk/books/

• Teresa Clarke is an AAT tutor