Financial performance (profitability)

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Gross profit margin

Gross margin (%)

An increase in gross profit margin indicates that variable costs, raw materials, labour, power etc are not rising as quickly as selling prices, whilst a decrease will indicate the opposite.

Changes in the gross profit margin over time should be analysed further to identify the cause: has the company introduced new products? Is it cutting prices to increase market share? Was it unable to pass on inflationary price increases?

Operating profit margin

Operating profit margin (%)

This will differ from the gross profit margin in that operating expenses, e.g. wages/salaries and depreciation are deducted. An analysis of the causes of changes in this percentage might reveal that the company's other costs are increasing/decreasing at a greater rate than sales.

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Return on capital employed

Return on capital employed (%)

This measures the level of returns a business has made using the capital it has within it. It allows for comparison of overall performance year on year as well as allowing comparison to an entity in a similar industry of different size measuring the business’s efficiency.

Take the profit figure from the right line. Return on capital employed uses profit before financing and income taxes, as the layout above shows, and the operating profit margin uses operating profit — profit before income taxes is neither, and using it also makes the two years incomparable if borrowings have changed. Where a requirement itself states the formula for a ratio, that is the formula to use, however you learned it.

Net asset turnover

Asset turnover (# times)

* Capital employed = shareholders’ funds + interest bearing debt.

This measures the efficiency of a business in generating revenue from its capital employed. The minimum investment in capital employed to generate revenue is another indicator of efficiency.

Some factors to consider:

Timing of Sales
Asset efficiency vs profitability
Asset valuation policies

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ROCE

The following extracts are from Hassan’s financial statements:

	$
Profit before financing and income taxes	10,200
Interest expense on borrowings and lease liabilities	(1,600)
Income taxes	(3,300)
Profit	5,300

Share capital	20,000
Reserves	15,600
	35,600
Loan liability	6,900
	42,500

What is Hassan’s return on capital employed?

A	15%
B	29%
C	24%
D	12%

ROCE = PBIT / Net debt + equity x 100%

ROCE = 10,200 / 35,600 + 6,900 x 100% = 24%

Answer B

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Financial performance (1)

Archer Co is a retailer and trades through its stores on the high street, selling high quality goods. The company has recently been suffering from rising costs, that it has been unable to pass on to its customers. In response to the number of people shopping via the Internet, Archer Co has implemented a cost cutting strategy in the prior year, and in the current year asked shareholders for funds to help reduce it debt burden. The following financial information for the current year is available:

Statement of profit and loss for the year ended 31 May 2019
	*2019* *$’000s*	*2018* *$’000s*
Revenue	42,000	45,000
Cost of sales	(19,000)	(17,000)
Gross profit	23,000	28,000
Operating expenses	(10,000)	(17,000)
Operating profit	13,000	11,000
Interest on borrowings and lease liabilities	(700)	(1,000)
Profit before income taxes	12,600	10,000
Income tax expense	(3,150)	(2,500)
Profit	9,450	7,500

Calculate the following ratios for the years ending 31 May 2019 and 31 May 2018:

Gross margin

Operating margin

Using the information provided and the ratios calculated above, comment on the comparative performance for the two years ended 31 May 2019 and 2018.

(a)

	2019	2018
Gross margin	54.8% (=23,000/42,000)	62.2% (=28,000/45,000)
Operating margin	31.0% (=13,000/42,000)	24.4% (=11,000/45,000)

(b) The revenue has fallen by 6.7% due to more customers shopping using the Internet. If the company does not do more to address the decline then it will run the risk of continued falling sales in future periods.It might be a future strategy to sell its goods via the Internet as well as from its high street stores.

Gross margin has fallen due to rising costs of production that have been unable to be passed on directly to its customers. This will have been done in order to maintain competitiveness with the online market, but if margins are to improve then Archer Co will need to either increase the selling prices or look to source the same products at more competitive prices.

Operating margin has increased because Archer Co has implemented a cost cutting exercise that will have reduced staff numbers, and/or closed down stores that were under-performing. This will have resulted in large costs of redundancy in the prior year that are not present in the current year costs, and lower wages/rent in the current year.

Finance costs have reduced as the funds received from the shareholders has been used to reduce the borrowing and lower the interest costs.

Financial performance (2)

A Co and B Co both operate in the retail sector selling children’s clothes.

Extracts from the draft financial statements for the companies for the year ended 31 December 20X0 are as follows:

	*A Co* *$000*	*B Co* *$000*
Revenue	180,000	150,000
Cost of sales	(136,000)	(105,000)
Gross profit	44,000	45,000
Operating expenses	(20,000)	(18,000)
PBFIT	24,000	27,000
Interest on borrowings and lease liabilities	(4,000)	(2,000)
Profit before income taxes	20,000	25,000

The following information is also relevant:

A Co manufactures and retails premium branded children’s clothes, which it sells online and in its own international chain of branded stores.
B Co sells mid-market children’s clothes in department stores. It sources its goods directly from the manufacturer and does not make international sales. B Co is looking to expand its operations to include the international market in the future.
Following an impairment review A Co suffered an impairment in the year of $10 million. The impairment expense is included within operating expenses.

Using the financial statement extracts provided, calculate the following ratios for both A Co and B Co:

(i) Gross profit margin

(ii) Operating profit margin

(iii) Interest cover

Comment on the performance of both companies for the year ended 31 December 20X0.

(a)

	Co A	Co B
Gross profit margin	= 24.4% (44,000/180,000)	= 30% (45,000/150,000)
Operating profit margin	=13.3% (24,000/180,000)	=18% (27,000/150,000)
Operating profit margin (excl. impairment)	= 18.9% (24,000 + 10,000)/180,000
Interest cover	= 6 times (24,000/4,000)	= 13.5 times (27,000/2,000)
Interest cover (excl. impairment)	= 8.5 times (24,000 + 10,000)/4,000

(b) A Co has a higher revenue than B Co and is the larger of the two companies, highlighting the appeal of the premium branded clothes.

It is common for companies selling premium branded products to have higher margins than those selling cheaper products, but Co B’s gross profit margin is higher than that of A Co on a lower revenue. This is because it sources its clothes directly from the manufacturer therefore saving on manufacturing costs.

Another reason for Co B’s higher margin could be that Co A has had to discount the selling prices of its premium brands due to competition.

The operating profit margin of each company is in line with expectations as Co B’s continues to be higher than that of Co A’s. However, when we remove the non-recurring impairment charge, Co A’s margin is higher than that of Co Bs. This is because Co A operates online, and its overheads will not be as large as those of Co B who sells via department stores.

The interest cover of Co B is higher than that of Co A, however Co A’s is high enough to cover any future interest payments provided that profits remain consistent. Co B’s interest cover gives confidence in its ability to issue further debt as it pursues it international expansion.

Overall, Co B looks the more profitable operation but when we remove Co A’s impairment charge, Co A becomes more profitable. Co B has the capacity to expand internationally and can use this to boost its profitability in future years.

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