Profitability Ratios

Profitability ratios measure the organization’s ability to deliver profits. Three ratios are commonly used.

     1. Return on capital employed (ROCE) / Return on investment (ROI):

Operating profit ÷ (Non-current liabilities + Total equity) %

  • ROCE/ROI measures the return that is being earned on the capital invested in the business.
  • Operating profit represents the profit available to pay interest to debt investors and dividends to shareholders.
  • If we wished to calculate return on equity shareholder’s funds we would use profit after interest and tax divided by total equity
  • The higher the ROCE figure, the better it is for investors

 

2. Return on sales (ROS) or Operating Margin:

Operating profit ÷ Revenue %

  • Return on sales looks at operating profit earned as a percentage of revenue.

 

3. Gross margin:

Gross profit ÷ Revenue %

  • Gross margin on the other hand focuses on the organization’s trading activities.

 

The ROCE and ROS ratios are often considered in conjunction with the asset turnover ratio. They are considered at the same time because:

ROCE                               = ROS                              x                 asset turnover

operating profit                 = operating profit              x                 revenue
capital employed                 revenue                                            capital employed

 

This relationship can be useful in exam calculations. For example, if you are told that a business has a return on sales of 5% and an asset turnover of 2, then its ROCE will be 10% (5% x 2). This is more than a mathematical trick. It means that any change in ROCE can be explained by either a change in ROS, or a change in asset turnover, or both.

 

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