Profitability ratios

Profitability is a measure of how efficiently a business turns its revenue or capital into profit (1), usually expressed as a percentage such as a margin or ROCE (1) — distinct from the absolute amount of profit.

ROCE measures the profit from operations earned as a percentage of the long-term capital employed in the business (share capital + reserves + non-current liabilities). In other words, it shows how much operating profit the firm generates for every dollar of long-term capital invested, so it indicates how efficiently the business uses its capital. A higher ROCE means capital is being used more productively, which is why investors compare it with the return available elsewhere.

Measuring profitability is important because it shows how efficiently the business turns its sales and capital into profit, not just how much profit it makes. This lets managers and investors compare performance over time (is the firm improving?) and between firms of different sizes on a fair basis.

Profitability ratios also help locate problems: a falling gross margin points to pricing or direct-cost issues, while a falling operating margin points to rising overheads, so managers know where to act. For investors, ROCE shows whether the return on their capital beats what they could earn elsewhere — the opportunity-cost test.

Therefore measuring profitability gives a clear, comparable picture of efficiency that guides decisions on pricing, costs and investment, which a raw profit figure alone cannot provide.

The first method is to reduce the cost of sales, for example by negotiating cheaper supplies, sourcing from lower-cost suppliers or improving production efficiency. Lower direct costs widen the gross profit margin and, in turn, the operating margin and ROCE, raising profitability without needing to change the price. However, cheaper inputs can reduce quality, which may damage the brand and lose customers — so the cost saving could be offset by falling sales.

The second method is to increase sales volume, for example through marketing, entering new markets or launching new products. Higher volume spreads fixed overheads over more units, improving the operating margin, and increases total profit. The drawback is that marketing and expansion cost money up front and may not deliver the expected sales, so profitability could fall in the short term before it rises.

Therefore both methods can raise profitability, but each has a trade-off. The better choice depends on the cause of weak profitability: if the gross margin is the problem, focus on costs; if overheads are high relative to sales, focus on raising volume to spread them. The actions must not undermine each other — cutting costs so far that quality (and sales) suffer would be self-defeating.

On its own, a rising gross margin is encouraging: it means the firm is keeping a larger proportion of each sale after the direct cost of sales, perhaps because it has raised prices, negotiated cheaper supplies or improved production efficiency. Taken alone, this suggests stronger pricing power or better direct-cost control.

However, ROCE has fallen at the same time, which is a warning. ROCE measures operating profit against all the long-term capital employed, so a fall means the firm is earning a lower return on its capital despite the better gross margin. The two figures together point to a problem below the gross-profit line — either rising overheads (so the operating margin is being squeezed even though the gross margin is healthy) or a larger capital base (e.g. new investment that has not yet generated extra profit) that has diluted the return.

The case that performance is improving. If the falling ROCE is caused by recent investment in new assets that will raise profits later, the firm may simply be in a transition: the gross margin improvement is real, and ROCE should recover once the new capital starts to pay off. In that case no drastic action is needed beyond monitoring.

The case that performance is weakening. If ROCE is falling because overheads have risen while sales have not, the firm has an efficiency problem: it prices and buys well but runs an increasingly expensive operation, so it should investigate and control overheads (administration, marketing, premises). A persistently falling ROCE that drops below the cost of finance would mean the firm is destroying value.

Judgement (criterion). What this tells managers depends on why ROCE has fallen — recent investment versus rising overheads. Managers should first identify the cause: compare the gross and operating margins (if the operating margin has fallen, overheads are the issue) and check whether capital employed has grown. If it is investment, the priority is patience and monitoring; if it is overhead creep, the priority is cost control. The most defensible conclusion is that the rising gross margin is good news but must not be read in isolation: the fall in ROCE shows the firm should examine its overheads and the productivity of its capital before concluding that performance has genuinely improved.

Profitability ratios — the gross and operating margins and ROCE — are powerful, comparable measures of how efficiently a business turns sales and capital into profit. But whether a firm should judge its success mainly by them depends on its objectives, its situation and what the ratios leave out.

The case for judging success mainly by profitability. Profitability ratios get to the heart of commercial performance. They show whether the firm is using its resources efficiently, allow comparison over time and against rivals of different sizes, and, through ROCE, reveal whether investors are earning a worthwhile return relative to the opportunity cost of their capital. For a profit-seeking business, sustained profitability is what funds growth, rewards investors and attracts finance, so high and rising ratios are strong evidence of success. They are objective, quantifiable and central to most firms' main objective of making profit.

The case against relying mainly on profitability. Profitability ratios are only part of the picture. First, they say nothing about liquidity: a highly profitable firm can still run out of cash and fail (overtrading), so success must also be judged by the current and acid test ratios. Second, ratios are historic — they describe the past, not future prospects, and can be distorted by one-off events or different accounting policies. Third, judging by profitability alone ignores other objectives and stakeholders: a firm may legitimately pursue growth, market share, social or environmental goals, employee welfare or long-term brand-building, sometimes sacrificing short-term margins to do so. A firm cutting costs to boost this year's margin may be damaging quality, staff morale and future sales. Finally, ratios must be interpreted in context — a 'good' margin or ROCE depends entirely on the industry.

Weighing it up (criterion). How far a firm should rely on profitability ratios depends on its objectives and the time horizon being judged. For a mature, profit-focused company being assessed by shareholders over the medium term, profitability ratios are the most important single measure of success. For a young, growing or socially driven business, or when judging short-term survival, profitability tells only part of the story and must be set alongside liquidity, growth, market share and qualitative goals.

Judgement. A business should treat profitability ratios as a central but not sole measure of success. They are the best comparable indicator of how efficiently the firm earns profit, so for most profit-seeking firms they should carry significant weight. However, judging success mainly by profitability is too narrow: it must be balanced against liquidity (to confirm survival), against the firm's own objectives (which may include growth, share and ethics), and against qualitative and forward-looking factors. The most defensible conclusion is that profitability ratios are the most important measure of commercial efficiency, but overall success should be judged by profitability alongside liquidity, the firm's objectives and its long-term prospects — not by profitability ratios in isolation.