Profitability Ratios

As we stated in Session 1, profitability ratios give an indication of the efficiency of the operation of the business. This reflects on management and from the banker’s point of view the better the management the better the prospects for repayment of our loans. While profit is not necessarily cash, the level of profit being earned can be the first indication of cash flow to follow.

Typically, we might calculate Gross Profit Margin, Operating Profit Margin and Net Profit Margin. In each case, we express the relevant profit figure as a percentage of Sales.

Each ratio may give us valuable additional information about the business or, more likely, prompt us to investigate further. We will consider each of them briefly in turn.

Next shows some of the main points to consider about the Gross Profit Margin.

Gross profit margin:

- Comparisons between accounting periods useful

- Varies from business to business

- Several explanations for a drop in the margin.

In normal circumstances it is assumed that this ratio figure should be reasonably constant over time if pricing policy and command over the market is both consistent and proactive. Significant changes between accounting periods should be investigated.