I n t e r a c t I v e t e X t foundations in Accountancy/ acca financial accounting (ffa/FA) bpp learning Media is an acca approved Content Provider

FORMULA TO LEARN 

Profit margin  Asset turnover = ROCE 

 

 PBIT     

         Sales           =   

         PBIT        

  

 Sales   

 Capital employed   

 Capital employed 

 

In our example: 

  

Profit

 

Asset

 

 

  

margin

 

turnover

 

ROCE 

(a) 20X8 

 

   $360,245

 

 

$3,095,576

= 

 

$360,245 

  

$3,095,576

  $988,899 

 

$988,899 

  

11.64% 

 

3.13 times

= 

36.4% 

(b) 20X7 

 

   $247,011

 

 $

$1,909,051

= 

 

$247,011 

  

$1,909,051

  $751,969 

 

$751,969 

  

12.94% 

 

2.54 times

= 

32.8% 

In this example, the company's improvement in ROCE between 20X7 and 20X8 is attributable to a 

higher asset turnover. Indeed, the profit margin has fallen a little, but the higher asset turnover has more 

than compensated for this. 

It is also worth commenting on the change in sales revenue from one year to the next. You may already 

have noticed that Furlong achieved sales growth of over 60% from $1.9m to $3.1m between 20X7 and 

20X8. This is very strong growth, and this is certainly one of the most significant items in the statement 

of profit or loss and statement of financial position. 

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CHAPTER 26  

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  INTERPRETATION OF FINANCIAL STATEMENTS 

 

465 

3.4 A warning about comments on profit margin and asset turnover 

It might be tempting to think that a high profit margin is good, and a low asset turnover means sluggish 

trading. In broad terms, this is so. But there is a trade-off between profit margin and asset turnover, and 

you cannot look at one without allowing for the other. 

(a) A 

high profit margin means a high profit per $1 of sales but, if this also means that sales prices 

are high, there is a strong possibility that sales turnover will be depressed, and so asset turnover 

lower. 

(b) A 

high asset turnover means that the company is generating a lot of sales, but to do this it might 

have to keep its prices down and so accept a low profit margin per $1 of sales. 

Consider the following. 

Company A 

 

Company B 

 

Sales revenue 

$1,000,000 

Sales revenue 

$4,000,000 

Capital employed 

$1,000,000 

Capital employed 

$1,000,000 

PBIT $200,000 

PBIT $200,000 

These figures would give the following ratios. 

ROCE = 

  

  $200,000 = 

20% 

ROCE 

= 

  

  $200,000 = 

 20% 

 

   $1,000,000 

 

 

 

 

 $1,000,000   

 

Profit margin 

= 

  

  $200,000 = 

20% 

Profit 

margin = 

  

  $200,000 = 

  5% 

 

   $1,000,000 

 

 

 

 

 $4,000,000   

 

Asset turnover  = 

 

$1,000,000 

= 

1 

Asset turnover  

= 

 

$4,000,000  =  

4   

 

   $1,000,000 

 

 

 

 

 $1,000,000   

 

The companies have the same ROCE, but it is arrived at in a very different fashion. Company A operates 

with a low asset turnover and a comparatively high profit margin whereas Company B carries out much 

more business, but on a lower profit margin. Company A could be operating at the luxury end of the 

market, while Company B is operating at the popular end of the market. 

3.5 Gross profit margin, net profit margin and profit analysis 

Depending on the format of the statement of profit or loss, you may be able to calculate the gross profit 

margin as well as the net profit margin. Looking at the two together can be quite informative. 

For example, suppose that a company has the following summarised statements of profit or loss for two 

consecutive years. 

 

Year 1 

Year 2 

 

$ 

$ 

 

Revenue 

 

70,000 

 

100,000 

 

Cost of sales 

 

42,000 

 

55,000 

 

Gross profit 

 

28,000 

 

45,000 

 

Expenses 

 

21,000 

 

35,000 

 

Profit for the year 

 

  7,000 

 

10,000 

Although the net profit margin is the same for both years at 10%, the gross profit margin is not. 

In Year 1 it is: 

 Gross profit   = 

 

$28,000 = 

40% 

 Revenue 

$70,000 

 

 

and in Year 2 it is: 

 Gross profit  = 

 

 $45,000 = 

45% 

 Revenue 

$100,000 

 

 

The improved gross profit margin has not led to an improvement in the net profit margin. This is because 

expenses as a percentage of sales have risen from 30% in Year 1 to 35% in Year 2. 

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