PROFITABILITY RATIOS
Profitability ratios are a class of financial tools that are used to assess the business’ability to generate earnings compared to its expenses and other relevant costs incurred during a specific period of time. Some examples of profitability ratios are profit margin (both net and gross) and ROCE (return on capital employed). These are really helpful tools that can be used to improve the business’s strategies. ​
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Profit Margin Ratios
Gross Profit Margin and Net Profit Margin ratios are used ot assess how successful the management of a business has bee at converting sales revenue in converting both gross profit and net profit . They are used to measure the performance of a company and its management team. Tantum decided to use this useful tools before making the decision to go global in case we needed to change our management strategies before an important change like open branches in new countries. The difference between Net Profit Margin and Gross Profit Marigin rapresents the overheads costs.
Net Profit Margin
Net Profit Margin (%) =
Net Profit
Sales Revenue
x 100
Tantum's Net Profit Margin (%) =
$ 152,200
$ 600,000
x 100 = 25.4 %
The Net Profit Margin could be more useful if compared with results of previous years, so that the company would know weather the performance and profitability of a company is increased or not.
The Net Profit Margin is a good indicator of management effectiveness at converting revenue into profits.
This result means that Tantum is making 25 cents net profit on each $1 of sales.
Gross Profit Margin
Gross Profit Margin (%) =
Gross Profit
Sales Revenue
x 100
Tantum's Gross Profit Margin (%) =
$ 220,000
x 100 = 36.6 %
$ 600,000
The Gross Profit Margin is a good inficator of hoe effectively managers have added value to the cost of sales .
Tantum is making 36 cents gross profit on each $1 of sales.
How to increase Profit Margins
ROCE
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Return on Capital Employed (ROCE)
Return on capital employes (ROCE) measures a company’s profitability and the efficiency with which its capital is employed.
Capital employed is the sum of shareholders equity and debt liabilities, it can also be semlified at (total assests - current liabilities).
A higher ROCE indicates more efficient use of capital.
Net Profit
Return on Capital Employed (%) =
Capital Employed
x 100
Tantum's Return on Capital Employed (%) =
$ 152,200
$ 450,100
x 100 = 33.8 %
How to increase ROCE
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Inventory Turnover Ratio
EFFICIENCY RATIOS
There are several efficiency ratios that can be used to assess how efficiently the working capital of a business is being managed and how significant borrowed capital is to the financing of the business. These ratios are meaningful when compared to peers in the same industry and can identify businesses that are better managed relative to others. Also, efficiency ratios are important because an improvement in the ratios usually translate to improved profitability.​
The inventory turnover ratio shows how effectively inventory is managed by comparing cost of goods sold with average inventory for a period. It measures how many times a company sold its total average inventory during the year.
So the higher the result, the more efficient managers are in selling inventory rapidly.
However, Tantum can’t benefit from this ratio because as a consuting company, we offer services so we don’t have stock.
Inventory Turnover Ratio =
Cost of goods sold
Inventory level
How to increase Inventory Turnover Ratio
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Debtor days Ratio
This ratio measures the average length of time it takes the business to recover payment from customers who have bought goods on credit (the debtors). The shorter this time of period is, the bette the management is at managing debtors and controlling its working capital. This value varies from business to business and from industry to industry.
Tantum’s debtor days ratio is high, for this reason we decided to adopt new strategies to reduce it.
Debtors (accounts receivable)
Debtor days Ratio =
Revenue
x 365
Tantum's debtor days Ratio =
$ 75,000
$ 600,000
x 365 =45.6 days
How to increase Debtor days Ratio
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Creditor days Ratio
Creditor days Ratio =
Trade creditors
Credit purchases
x 365
This ratio measures the number of days a company takes to pay its suppliers. If the firm is paying its suppliers very quickly, the number will be low; if instead the number is higher it means the business is taking longer to pay its traders.
Tantum's creditor days ratio is high, this means we need to improve our efficency in paying back our suppliers.
Tantum's creditor days Ratio =
x 365 =45.6 days
$ 200,000
$ 25,000
How to increase Creditor days Ratio
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Gearing Ratio
The grearing ratio measures the degree to which the capital of the business is financed from long-term loans, it shows the extent to which the company’s assets are financed from external long-term borrowing.
A high gearing ratio represents a high portion of debt to equity and a great deal of leverage, while a low grearing ratio represents a low proporion of debt to equity.
Tantum's high gearing ratio means that we are borrowing from external long-terms loans. We do os because we decided to investt in and to expand the business internationally.
Long-term loans
Gearing Ratio =
Capital employed
x 100
Or
Gearing Ratio =
Shareholders' equity + non-current liabilities
Non-current liabilities
x 100
Tantum's Gearing Ratio =
x 100 = 49.3%
$ 405,100
$ 200,000