# Calculating profitability indicators - profitability

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1 Calculating profitability indicators - profitability Introduction When a business is deciding whether to grant credit to a potential customer, or whether to continue to grant credit terms to an existing customer, it can analyse the customer s current and past financial statements. This analysis should calculate key performance indicators for three key areas: liquidity profitability cash flow and financial position. In this worksheet we will focus on calculating and interpreting profitability performance indicators. Similar worksheets have also been prepared for liquidity indicators and cash flow and financial position indicators. You may also want to try the two worksheets: Calculating liquidity indicators and Calculating financial position indicators. Profitability indicators measure the business s ability to generate profit. In the Credit management and control unit we focus on the ability of a customer to pay its suppliers when the invoices fall due. In the short term the cash flow and liquidity of a business is particularly relevant to its ability to pay its debts. Over the longer term the business must be profitable to enable it to pay its debts when they fall due. As part of the decision to grant credit to a customer, a business should obtain copies of the customer s recent financial statements; ideally for the past three years; and calculate profitability indicators from these figures. These performance indicators can then be compared with the same measures for previous years; acceptable industry standards; or used as part of a credit scoring system. On the next screen we will look at the formulae for calculating the key performance indicators used to assess the profitability of a business. We will then calculate these performance indictors to assess the profitability of a potential customer. Key profitability performance indicators The four key performance indicators normally calculated to assess profitability are as follows. Gross profit margin gross profit x 100 Profit for the period margin (net profit margin) operating profit x 100 Interest cover operating profit

5 How is the formula stated? Click to display/hide the solution. Return on capital employed (ROCE) = operating profit x 100 capital employed the ROCE for 2010 already calculated. You should now complete the figures for 2011 and 2012 and calculate the ROCE for each of these years. Your calculations should be rounded to the nearest whole percentage. Operating profit 1,200 1,650 1,500 Equity 3,900 3,300 2,400 Non-current liabilities 2,000 2,000 2,000 Capital employed 5,900 5,300 4,400 Return on capital employed 20% 31% 34% What do the above calculations tell us about the profitability of Delrex Limited over the three year period? Write your answer down, and then click to reveal our suggested analysis. Explanation Although the ROCE for Delrex Limited has dropped slightly from 2010 to 2011, at over 30% this still indicates that the business is providing a good return on the shareholders investment. However, there is a significant drop in the 2012 figure, to just over 20%. At this level the ROCE still represents a healthy return on investment, however before agreeing to grant credit to Delrex Limited we should investigate whether this downward trend is set to continue or whether there is a specific reason for the fall in profitability of the business. Assessment of profitability of Delrex Limited Gross profit margin 29% 44% 44% Profit for the period margin 13% 22% 22% Interest cover Return on capital employed 20% 31% 34%

6 In this worksheet we have looked at performance indicators to assess the profitability of Delrex Limited. All of the profitability performance indicators have stayed fairly consistent for 2010 and 2011, with good gross profit and profit for the period margins. However, in 2012 the profit margins have dropped significantly and the interest cover has reduced by a third from 6 to 4. The ROCE in 2010 and 2011 is very healthy, with a return on investment of over 30%. However, in 2012 the profit for the year has decreased and the shareholders equity has increased, which means the ROCE for 2012 has decreased significantly to just over 20%. The deterioration in these profitability indicators in 2012 may suggest a problem at Delrex Limited, which will need to be investigated before granting credit terms.

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