Making the numbers sing

The BA3 syllabus introduces the student to a wide range of financial accounting topics. 10% of the syllabus is dedicated to the interpretation of financial statements. This involves performing some ratio analysis on figures in the financial statements and being able to identify reasons for the changes in these ratios over a period of time. It is an important skill for any accountant to develop during their career.

This article is going to concentrate on the profitability of an entity. This will involve reviewing three ratios: gross profit margin, operating profit margin and return on capital employed. Analysis begins with an understanding of how the ratios are calculated as this will help determine reasons for the changes in the ratios over time. Once we have considered this, we will then work through a list of business practices that an entity may introduce between one year and the next and think about how these affect the profitability ratios. Finally, we will consider how this topic is examined in the objective test questions.

How to calculate the profitability ratios

In order to understand how a business transaction affects a ratio it is important to know what the elements of the ratio calculation are. Let’s work through the three ratios in turn.

Gross profit margin

This is calculated as Gross profit/Revenue x 100% and is expressed as a percentage.

Hints: Gross profit is calculated as revenue less cost of sales. Changes in the sales volume will affect the gross profit figure but the margin is a relative number and the change in volume will have no effect on the ratio.

Operating profit margin

This is calculated as Operating profit/ Revenue x 100% and is expressed as a percentage.

Hints: Operating profit is gross profit less operating expenses (administration expenses and distribution costs). It is sometimes called ‘profit before interest and tax’ or PBIT. It gives an indication of how well the entity has been controlling its costs.

Return on capital employed (ROCE)

This is calculated as Operating profit/ Capital employed x 100% and is expressed as a percentage.

Hints: Capital employed is made up of share capital plus all reserves plus non-current liabilities. It may also be expressed as total assets less current liabilities.

Changes in business practice: some scenarios

Let’s consider a list of changes in business practice that an entity may introduce over a period of time and consider how individually these will affect the profitability ratios.

Let’s take entity ABC who would like to introduce some changes to improve the business performance. Each will be considered in isolation.

• Decrease the sales price to promote growth in volume, although the cost of each product remains the same.
• Revalue land to recognise in the financial statements at their market value, which is higher than the historic cost.
• Buy inventory in larger order quantities than at present to take advantage of volume discounts. This price reduction will not be passed on to the customer.
• Offer settlement discounts to customers to encourage them to settle the receivables more quickly.

The key to this is to think about what we should see reflected in the financial statements as a result of the transactions. Then it will be straight-forward to consider the effect on the ratios.

Let’s take each one in turn:

Decrease the sales price to promote growth in volume, although the cost of each product remains the same.
If the sales price per unit falls but the cost remains the same this means that the gross profit per unit will decrease, as will the operating profit. To summarise:

Revalue land to recognise in the financial statements at their market value, which is higher than the historic cost.
When the land is revalued the non-current asset account will increase (debit) and the revaluation surplus will increase (credit). As land is not depreciated this will not alter the gross or operating profit. However, the capital employed will increase as the revaluation surplus increases. This will make the denominator of the ROCE increase and so ROCE decreases. To summarise:

Buy inventory in larger order quantities to take advantage of volume discounts. This price reduction will not be passed on to the customer.
If the cost per unit of inventory decreases then the cost of sales will reduce but the revenue per unit remains unchanged. This will increase the gross profit per unit and, assuming no changes in operating costs, the operating profit will increase too. This will have the effect of increasing both profit margins and the ROCE. To summarise:

Offer settlement discount to customers to encourage them to settle the receivables more quickly.
Settlement discounts taken by customers are called discounts allowed and are treated as an operating expense in the statement of profit or loss. They are not deducted from revenue. This means that the gross profit will not change but the operating profit will be reduced as a result of these expenses. This will have the following effect:

How could this be examined?

Multiple choice questions will make the student think about how transactions are accounted for and the effect they will have on the financial statements. Here is an example of how a question could be asked. We will use the same scenarios we used before.

ABC has calculated the following ratios from its financial statements for the last two years:

Which of the following, taken in isolation, would account for the increase in the gross profit margin?

A. Decrease the sales price to promote growth in volume, although the cost of each product remains the same.
B. Revalue land to recognise in the financial statements at their market value, which is higher than the historic cost.
C. Buy inventory in larger order quantities to take advantage of volume discounts. This price reduction will not be passed on to the customer.
D. Offer settlement discount to customers to encourage them to settle the receivables more quickly.

From what we have considered above the answer would be C.

In summary

In order to approach an exam question:

• Learn the calculations of the ratios and the elements of the numerator and denominator.
• Think about the suggested changes in business practice/issues given in the question. How would these affect the elements of the ratio? Would they increase, decrease or remain unchanged?
• Select the correct answer

By Jayne Howson
Jayne Howson is a freelance lecturer specialising in financial management, reporting and taxation.

Publication date: 9 June 2017

Study resource type: Article

Qualification: Certificate in Business Accounting

Syllabus: 

Certificate Level

BA3 Fundamentals of Financial Accounting