Ratio analysis: profitability and return on capital employed

Profit margins

• Gross profit margin = gross profit / revenue x 100. Shows how much of each $1 of sales is left after the direct cost of sales. Improve by raising prices or cutting cost of sales (cheaper suppliers, less waste).
• Operating profit margin = operating profit / revenue x 100 (in Appendix 9).
• Profit for the year margin = profit for the year / revenue x 100. Also reflects overheads and interest; improve by controlling overheads and reducing debt.

For the company in the last lesson: GPM = 2,800 / 8,000 x 100 = 35%; operating margin = 15%; profit for the year margin = 1,000 / 8,000 x 100 = 12.5%. A big gap between the gross and profit for the year margins points to high overheads or interest.

Return on capital employed (ROCE)

ROCE = operating profit / capital employed x 100, where capital employed = non-current liabilities + total equity.

It measures the return generated on all the long-term finance invested. Compare it with the interest rate on savings (the return owners could get with no risk), with previous years and with competitors. Higher is better.

Example: 1,200 / 9,600 x 100 = 12.5%.

A real example

In the January 2020 WBS13 paper, Question 1(a) gave a luxury fashion company's gross profit of GBP1,897.4m and revenue of GBP2,732.8m. GPM = 1,897.4 / 2,732.8 x 100 = 69.43%. The mark scheme gave 1 mark for the formula, 2 for using the right figures and 1 for the answer; an answer of 69.43 without the % sign and without working scored 3 out of 4. Such a high margin reflects the premium prices a strong luxury brand can charge.

Interpreting

• Always compare: with the same firm in previous years (trend), with competitors and the industry average, and with targets.
• Explain causes: a falling GPM may come from rising material costs or price cuts to win market share; a falling profit for the year margin with a stable GPM points to overheads or interest.
• Suggest decisions: change prices, switch suppliers, cut overheads, reduce debt, sell under-used assets to raise ROCE.

Worked example

A company has revenue $2.4m, gross profit $0.9m, operating profit $0.36m and capital employed $3m. Calculate GPM, operating profit margin and ROCE.

1. GPM = 0.9 / 2.4 x 100 = 37.50%.
2. Operating margin = 0.36 / 2.4 x 100 = 15.00%.
3. ROCE = 0.36 / 3 x 100 = 12.00%.
4. ROCE should be compared with interest rates and competitors before judging it.

Answer: GPM 37.50%, operating margin 15.00%, ROCE 12.00%.

Check yourself

1. Revenue is $500,000 and gross profit is $185,000. Calculate the gross profit margin.
   Show answer

   37.00 %. 185,000 / 500,000 x 100 = 37.00%.

2. January 2020 WBS13: gross profit GBP1,897.4m, revenue GBP2,732.8m. Calculate the gross profit margin to 2 decimal places.
   Show answer

   69.43 %. 1,897.4 / 2,732.8 x 100 = 69.43%.

3. Revenue is $1,250,000 and profit for the year is $95,000. Calculate the profit for the year margin.
   Show answer

   7.60 %. 95,000 / 1,250,000 x 100 = 7.60%.

4. Operating profit is $1,200,000 and capital employed is $9,600,000. Calculate ROCE.
   Show answer

   12.50 %. 1,200,000 / 9,600,000 x 100 = 12.50%.

5. Operating profit is $84,000. Non-current liabilities are $200,000 and total equity is $500,000. Calculate ROCE.
   Show answer

   12.00 %. Capital employed = 200,000 + 500,000 = 700,000. ROCE = 84,000 / 700,000 x 100 = 12.00%.

6. A firm's gross profit margin is stable but its profit for the year margin has fallen sharply. The most likely cause is
   • a rise in the cost of raw materials
   • a cut in selling prices
   • a rise in overheads or interest costs
   • a fall in the cost of sales
   Show answer

   a rise in overheads or interest costs. Cost of sales and prices affect the GPM; overheads and interest come below gross profit.

7. Why would an investor compare a company's ROCE with the interest rate on savings accounts?
   • To see whether the risk of investing in the business is rewarded by a higher return
   • Because ROCE must always equal the interest rate
   • To calculate the company's gearing
   • To find the gross profit
   Show answer

   To see whether the risk of investing in the business is rewarded by a higher return. Savings are almost risk-free; the business should earn more.

8. Explain one way a business could improve its gross profit margin.
   Show answer

   It could negotiate lower prices from suppliers or reduce waste to cut the cost of sales, so more of each $1 of revenue is left as gross profit.. Name an action on price or cost of sales and link to the margin.

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Sources

• Pearson Edexcel International Advanced Subsidiary/Advanced Level in Business specification (XBS11/YBS11, 2018), Unit 3 Business decisions and strategy and Appendices 6, 7 and 9
• Pearson Edexcel IAL Business WBS13/01 mark scheme, January 2020

Last updated 8 November 2026. Spotted a mistake? Tell us.