NET PROFIT MARGIN AND RETURN ON CAPITAL

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1 NET PROFIT MARGIN AND RETURN ON CAPITAL TABLE OF CONTENTS Measuring profit: net profit margin Measuring profit: return on capital invested How can profits be increased? What is the difference between cash flow and profit? Self Check Questions

2 Measuring profit: net profit margin Net profit is sales revenue minus all costs (fixed and variable). Net profit margin is net profit expressed as a percentage of sales revenue. The formula for net profit margin = NET PROFIT / SALES REVENUE X 100. a simplified income statement Sales revenue for year 1000 Variable costs 500 (000) (000) GROSS PROFIT 500 Overheads 200 NET PROFIT 300 Using the simple figures in the income statement above, net profit margin = 300/1000 x 100 = 30%. Calculating net profit margin provides a useful way of comparing the performance of a business across several years. It is also a way of comparing the performance of one business with that of another. Before reading further, look at the table below. Which company do you think is doing best? company a b c (m) (m) (m) Turnover Net profit Capital value

3 You might think that all three companies are doing equally well, but that ignores the net profit margin. Calculate the net profit margin for each business and it can be seen that Company A has a much higher profit margin than the other two companies, on a smaller sales revenue. The net profit margins for each business are as follows: Company A = 40% Company B = 11% Company C = 25% This might be because A has lower costs than the others, it may be because it is able to set a higher price or it may be a combination of the two. If we suppose that each company sells its products at 1, here is net profit per product: Company A = 40p Company B = 11p Company C = 25p Higher profit margins are preferable to lower ones. An improved profit margin will usually lead to higher overall profits. It might be tempting to think that if a business reduces price that will lead to increased sales and higher overall profits. But this is not necessarily the case. Unless the firm can justify a lower price by reducing unit costs, net profit margin will fall. Without cost savings, reducing prices will only improve total profit if the increase in demand caused by the price cut is big enough to outweigh lost profit margin. Many businesses sell a range of products at different prices and with different costs. Net profit margin can also be used to compare the profitability of different products. Measuring profit: return on capital invested A different way of measuring profit is to calculate net profit as a percentage of capital invested. This is called return on capital. As with net profit margin, business owners generally seek to increase the return on capital. 3

4 The formula for return on capital invested is Net profit / Capital invested x 100 To illustrate return on capital, look again at the figures for Company A above. Using the formula above shows that return on capital is 1/10 x 100 = 10%. What is meant by capital invested? This is equal to the value of fixed assets actually owned by the business. This may include things such as buildings, land, machinery and vehicles. To make a profit, money has to be tied up in these essential assets rather than being used for other purposes. As discussed earlier, the starting point for assessing whether return on capital is acceptable is current bank interest rates. Bank interest is guaranteed and profit from a business is not. So business owners will normally be looking for a return on capital well above interest rates. On the other hand, a low return on capital may be acceptable in the short term if business investors believe that net profits and return on capital will rise significantly in the future. For instance, a low percentage figure for return on capital is to be expected in the first few years of a new business as consumer awareness increases and sales gradually rise. The more risk there is involved in what a business does, the higher return on capital investors will want. Risk here does not refer to physical danger (although that may be an issue). It refers to the likelihood that a business or a new product will not succeed. For example, in 2010 even mobile phone manufacturing giant Nokia was making modest profits. Mobile telephony is a competitive and fast moving industry. A new product may generate very good levels of profit. Or it may be completely superseded by a new product from a rival manufacturer in a very short time and lose money. Any business putting capital into this industry will expect a good return on capital to compensate for the high level of risk. How can profits be increased? There are four ways in which a firm can seek to increase its profits. Some practical examples are given. Of course, achieving an increase in profits is unlikely to be straightforward. 4

5 Increase sales without reducing net profit margin. Sales can be increased by improving existing products or launching new products. For example, the aircraft manufcturer Boeing hopes to increase sales and profits by launching innovative new aircraft such as the 787 Dreamliner long-haul jet. It may be possible to increase sales by selling an existing product in a wider range of markets. For example, construction machinery manufacturer JCB has seen a big growth in sales by expanding into a range of developing markets such as China and India as well as selling in traditional markets in the US and Europe. Another way to increase sales may be through more effective promotion. Increase net profit margin by reducing variable cost per unit If variable costs are reduced by simply using cheaper materials or components, this could have the obvious drawback of reducing the quality of the product and its reputation. On the other hand, it may be possible to reduce variable labour costs without affecting quality. One way of doing this is by increasing automation, especially in manufacturing. The BMW Mini, for example, is made in one of the most highly automated car factories anywhere. In some service industries, such as retailing, reducing the amount of labour required may be difficult. In other service industries, such as banking, big increases in the use of information technology have reduced the need for labour in routine activities. Increase net profit margin by reducing fixed costs Fixed costs can be reduced by selling online instead of through retail premises. This is one way of drastically reducing fixed costs such as rent. Increasing the energy efficiency of a building through better insulation can be a way of reducing the cost of heating. Management costs, which are generally treated as a fixed cost, can be reduced by outsourcing some work or restructuring the organisation to reduce the number of managers. The obvious danger with this last example is that in the long run, the firm may be managed less efficiently. Finally, if sales are down over a long period, it may be neccessary to reduce the scale at which a business operates. This reduces fixed costs and improves net profit margin. Increase net profit margin by increasing price The less competition there is for a business in its market, the more opportunity there is to increase price. But whenever price is increased, there is a danger that customers switch to other firms or 5

6 products. Raising prices is only a good option if the business is confident that any reduction in demand this causes will be more than offset by an improved net profit margin. What is the difference between cash flow and profit? Suppose, appearing on its actual cash flow statement, a business has a large positive cash balance. Does this mean the business is in profit? The answer is no, not necessarily. Cash flow and profit are two quite different things. Cash flow is about the timing of money flowing in and out. Profit is about the difference between total income and total costs over a period of time. It is possible for a business to have a positive bank balance at a particular point in time but still be a loss making business. To illustrate this, suppose that Gurdeep, a florist, purchases fresh flowers from a grower for The grower gives him 30 days credit. After two days, the flowers have sold badly and are starting to die. Gurdeep is forced to heavily discount the price to move the flowers quickly. After four days, he ends up making a loss of 500, as the total revenue from the sale of all these flowers only amounts to From a cash flow point of view, however, Gurdeep has not had the cash outflow of 2000 so his cash flow figures after four days will be positive. On the other hand, it is quite possible for a business to have made a profit but still have cash flow problems. For example, suppose Jane, a second-hand car dealer, has bought cars at auction for 100,000 cash. She decides to offer her customers 60 days interest free credit. Most customers take advantage of this deal. Over the next month she sells the vehicles for a total of 130,000, and is pleased with her profit of 30,000. The only problem is that she knows she will be overdrawn at the bank for a while (a negative cash balance) as most customers will not provide cash inflows for some weeks to come. 6

7 Self Check Questions 1. What is meant by net profit? 2. How is net profit margin calculated? 3. How is return on capital calculated? 4. State four ways of increasing profit. 5. What might be a disadvantage of seeking to increase profit by raising prices? 7

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