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Sunday, 18 April 2010

Measure Profitability

Measure Profitability

The business with the largest profit is not necessarily the best performer.  Profit should be measured in relation to the size of the investment required to achieve that level of profit.  Therefore, the best measure of profitability is 'return on investment'.



MEASURING 'RETURN'

Gross profit margin % =  Gross Profit / Revenue

This measures the margin made on top of direct costs.  A relatively high sales margin demonstrates the ability of a business either to charge a premium price or to control input costs.  It is useful when benchmarking against similar businesses in the same industry.

Net profit margin % = Operating profit / Revenue

This is similar to gross margin but takes account of operating expenses.  Net profit margin measures the ability to control costs.  Operating profit is preferred to other profit totals, as it exclude finance and taxation costs, which can vary between businesses and years.


MEASURING 'INVESTMENT'

The most common definition of 'investment' is capital employed, which is equity plus non-current liabilities (alternatively, total assets less current liabilities).  Capital employed is effectively the amount invested in a business by both shareholders and debt holders.

Asset turnover (times)  = Annual revenue / Capital employed

This shows how well the finance invested in a business, subsequently invested in assets, has been utilised to generate sales.  It measures the amount of revenue earned from each $1 invested.  Asset turnover demonstrates the number of times assets generate their value in terms of revenue each year.  It is sometimes referred to as a measure of activity.  A relatively high asset turnover could indicate efficient use of assets, although the measure is sensitive to the valuation of assets.


MEASURING RETURN ON INVESTMENT/CAPITAL EMPLOYED

'Return on Investment' (ROI) has many permutations, the most common of which are

  • return on capital employed (ROCE); 
  • return on net assets (RONA); 
  • return on total asset (ROTA); 
  • return on equity (ROE); and 
  • accounting rate of return (ARR).  
They are all essentially measuring the same thing - profit as a percentage of the investment required to achieve that profit.  ROI is also used in internal investment appraisal.

ROCE = Net profit margin x Asset turnover

ROCE = Operating profit / Revenue) x (Revenue / Capital employed)

Analysing the net profit margin or asset turnover will help to explain a high or low ROCE.

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