Profitability Ratios: Gross Margin and Profit Margin
Profitability ratios measure how well a business generates profit relative to sales or capital employed. Two important profitability ratios are gross margin and profit margin.
Gross margin shows the percentage of sales revenue remaining after deducting the cost of goods sold (COGS). It indicates how efficiently a business produces or purchases its goods.
Profit margin reflects the percentage of sales revenue left after all expenses, including operating costs and taxes, have been deducted. It shows overall profitability from trading activities.
- Gross Margin (%) = (Gross Profit ÷ Sales Revenue) × 100
- Profit Margin (%) = (Net Profit ÷ Sales Revenue) × 100
Example Calculations for Profitability Ratios
Suppose a company has sales revenue of £200,000, cost of goods sold of £120,000, and net profit of £30,000.
Gross profit = Sales revenue − COGS = £200,000 − £120,000 = £80,000
Gross margin = (£80,000 ÷ £200,000) × 100 = 40% meaning 40p of every £1 of sales is gross profit before other expenses are deducted. This suggests good control over production or purchasing costs if compared favourably to industry averages or previous periods.
- Profit margin = (£30,000 ÷ £200,000) × 100 = 15% meaning 15p of every £1 of sales remains as net profit after all expenses. A higher profit margin indicates better overall profitability.
Return on Capital Employed (ROCE)
ROCE measures how efficiently a business uses its capital to generate profits. It compares operating profit to the capital invested in the business.
Capital employed is usually total assets minus current liabilities or the sum of equity and non-current liabilities.
ROCE is expressed as a percentage and helps investors assess the return generated on their investment.
- ROCE (%) = (Operating Profit ÷ Capital Employed) × 100
Example Calculation for ROCE
If operating profit is £50,000 and capital employed is £250,000:
ROCE = (£50,000 ÷ £250,000) × 100 = 20% meaning the business generates a 20% return on the capital invested. A higher ROCE indicates more efficient use of capital.
Comparing ROCE over time or against competitors helps evaluate management effectiveness.
Liquidity Ratios: Current Ratio and Liquid (Acid Test) Ratio
Liquidity ratios assess a company's ability to meet short-term obligations.
The current ratio compares current assets to current liabilities, showing if the business has enough assets to cover debts due within one year.
The liquid ratio is more stringent, excluding inventory from current assets because inventory may not be quickly converted to cash. It measures immediate liquidity.
- Current Ratio = Current Assets ÷ Current Liabilities
- Liquid Ratio = (Current Assets − Inventory) ÷ Current Liabilities
Example Calculations for Liquidity Ratios
A company has current assets of £80,000, inventory of £30,000, and current liabilities of £50,000.
Current ratio = £80,000 ÷ £50,000 = 1.6:1 meaning the company has £1.60 in current assets for every £1 of current liabilities, indicating reasonable short-term financial health.
Liquid ratio = (£80,000 − £30,000) ÷ £50,000 = £50,000 ÷ £50,000 = 1.0:1 meaning the company can cover current liabilities exactly with liquid assets excluding inventory.
- A current ratio below 1 suggests liquidity problems, while a very high ratio may indicate inefficient asset use.
- A liquid ratio below 1 may signal difficulty in paying immediate debts without selling inventory.
At-a-glance summary
Comparison table
| Ratio | Purpose | Formula | Example Calculation (Units) |
|---|---|---|---|
| Gross Margin | Measures production/purchasing efficiency | (Gross Profit ÷ Sales) × 100 | (£80,000 ÷ £200,000) × 100 = 40% |
| Profit Margin | Measures overall profitability | (Net Profit ÷ Sales) × 100 | (£30,000 ÷ £200,000) × 100 = 15% |
| ROCE | Measures return on capital invested | (Operating Profit ÷ Capital Employed) × 100 | (£50,000 ÷ £250,000) × 100 = 20% |
| Current Ratio | Assesses ability to pay short-term debts | Current Assets ÷ Current Liabilities | £80,000 ÷ £50,000 = 1.6:1 |
| Liquid Ratio | Assesses immediate liquidity excluding inventory | (Current Assets − Inventory) ÷ Current Liabilities | (£80,000 − £30,000) ÷ £50,000 = 1.0:1 |
| Inventory Turnover Rate | Shows how often inventory is sold and replaced | Cost of Goods Sold ÷ Average Inventory | £120,000 ÷ £30,000 = 4 times |
| Trade Receivables Turnover (Days) | Average days to collect customer payments | (Trade Receivables ÷ Credit Sales) × 365 | (£40,000 ÷ £150,000) × 365 ≈ 97 days |
| Trade Payables Turnover (Days) | Average days to pay suppliers | (Trade Payables ÷ Credit Purchases) × 365 | (£25,000 ÷ £100,000) × 365 ≈ 91 days |
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Quick check
1. How do you calculate gross margin percentage?
Gross margin (%) = (Gross profit ÷ Sales revenue) × 100.
2. What does a profit margin of 10% indicate?
It means the business keeps 10p as net profit from every £1 of sales after all expenses.
3. Why is the liquid ratio more stringent than the current ratio?
Because it excludes inventory, focusing on assets quickly convertible to cash to pay liabilities.
4. If trade receivables turnover is 60 days, what does this mean?
On average, the business takes 60 days to collect payments from customers.