F7考試：PERFORMANCE APPRAISAL ---- PROFITABILITY

PROFITABILITY

Return on capital employed (ROCE)

Profit before interest and tax
　　Shareholders' equity + debt

This ratio is generally considered to be the primary profitability ratio as it shows how well a business has generated profit from its long?term financing. An increase in ROCE is generally considered to be an improvement.

Movements in return on capital employed are best interpreted by examining profit margins and asset turnover in more detail (often referred to as the secondary ratios) as ROCE is made up of these component parts. For example, an improvement in ROCE could be due to an improvement in margins or more efficient use of assets.

Asset turnover

Revenue
　　Total assets - current liabilities

Asset turnover shows how efficiently management have utilised assets to generate revenue. When looking at the components of the ratio a change will be linked to either a movement in revenue, a movement in net assets, or both.

There are many factors that could both improve and deteriorate asset turnover. For example, a significant increase in sales revenue would contribute to an increase in asset turnover or, if the business enters into a sale and operating lease agreement, then the asset base would become smaller, thus improving the result.

Profit margins

Gross or Operating profit
　　Revenue

The gross profit margin looks at the performance of the business at the direct trading level. Typically variations in this ratio are as a result of changes in the selling price/sales volume or changes in cost of sales. For example, cost of sales may include inventory write downs that may have occurred during the period due to damage or obsolescence, exchange rate fluctuations or import duties.

The operating profit margin (or net profit margin) is generally calculated by comparing the profit before interest and tax of a business to revenue, but, beware in the exam as sometimes the examiner specifically requests the calculation to include profit before tax.

Analysing the operating profit margin enables you to determine how well the business has managed to control its indirect costs during the period. In the exam when interpreting operating profit margin it is advisable to link the result back to the gross profit margin. For example, if gross profit margin deteriorated in the year then it would be expected that operating margin would also fall.

However, if this is not the case, or the fall is not so severe, it may be due to good indirect cost control or perhaps there could be a one-off profit on disposal distorting the operating profit figure.