7. Profitability Ratios
• Gross profit ratio
• Net profit ratio
• Ratio of expenses to sales
8. Gross Profit Ratio
Indicates the ability of a
trading enterprise to
generate gross profit
from sales.
Gross Profit
x100
Compare result to Net Sales
industry benchmarks to
determine suitability of
business performance
9. Result indicates:
• for every $ of sales – number
of cents retained as gross
profit
• how effective business is in
passing on increases in COGS
to customers
10. High result may indicate:
• ability of business to cover all
costs
• capacity to earn acceptable
net profit and return to owner
Low result may indicate inability
to:
• meet further costs
• return satisfactory net profit
• return satisfactory rate to
owner
11. Recommendations
Improve sales
• Ascertain:
– stock levels - should be high enough to
meet demand
– appropriateness of stock to appeal to
market
– demand for stock held
– Appropriateness of selling price
• Conduct market research/analysis
to assist with the above.
12. Institute policy to minimise COGS
• Investigate alternative suppliers
selling similar quality products for
less
• Take advantage of discounts
offered to lower costs
13. Net Profit Ratio
•Indicates the ability of
a trading enterprise to
generate a return on the
owner’s investment.
Net Profit
•Compare result to x100
industry benchmarks to Net Sales
determine suitability of
business performance
14. • Result indicates:
• for every $ of sales – number
of cents retained as net profit
• how effective business is in
minimising expenses
• poor GP ratio will impact on
NP ratio
15. High result may indicate:
• High operating revenue
• Low operating expenses
Low result may indicate inability to:
• inappropriate pricing policy
• inadequate stock
• inappropriate stock
• expenses too high
16. Recommendations
Improve sales
• as per Gross Profit
recommendations
Minimise expenses
• Set budgets for departments
• Investigate alternative suppliers to
lower costs
• As per Gross Profit
recommendations
17. Rate of Return on Equity
Ratio
Indicates the return to
the owner on the
amount invested in the
business
Net Profit
x100
Aim for a return of, Average Owner' s Equity
around, 14% which
allows funding for future
growth and a return on
investment.
( OE beg + OE end) /2 = Avg OE
18. High result may indicate:
• efficient operation
• business may be under-
capitalised (owner has not
contributed equity to the
optimum level)
– Under-capitalisation can be
identified when NP ratio is close to
or under industry benchmark yet
ROE is well above industry
benchmark
19. Low result may indicate:
• owner’s money may perform better
invested elsewhere
• business may be over-capitalised (if owner
has invested over the optimum sum into
the business)
– Can be identified when NP ratio is close to
industry benchmark yet the ROE result is well
below industry benchmark
• management may take little risk therefore
business is cautiously run
• inefficient management making poor
decisions, lack of foresight.
20. Recommendations
Improve net profit result using previous
recommendations.
Check level of capitalisation to ensure
appropriateness for industry.
– If under-capitalised owner should consider
investing further funds into the business.
– If over-capitalised owner should consider
investing excess funds into alternative
investments.