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Profitability ratios

In this blog I will introduce four profitability ratios and provide comments on each one. I will then attach a table that will show the results using data taken from the Polly Ester case study and conclude by giving an interpretation of each ratio.

The four profitability ratio are:

1. Profit before tax (PBT) expressed as a percentage of total assets.
This is the preferred method when interpreting changes in profitability ratios year-on-year. It does not allow interest paid to be added back since this should only apply when comparing one company against another, i.e. to remove the effect of differences in gearing, one company to another. It also takes total assets as the denominator. In this case an increase in total assets will require, all things being equal, an increase in profit before tax and vice versa.
2 The second option takes profit before tax expressed as a percentage of total assets less current liabilities.
This ratio uses the same numerator as the first option but a different denominator. Total assets less current liabilities is the favoured option in the UK but suffers from its lack of robustness with respect to current liabilities. For example, an increase in short-term borrowings will not require a corresponding increase in profits for a company still to be as profitable. Also, a movement from short-term borrowings to long-term borrowings will reduce profitability. It can be seen that the practice of deducting short-term borrowings from total assets severely affects the profitability of a company.
3. The third option takes profit before tax and before the payment of interest (PBIT) expressed as a percentage of total assets less current liabilities.
This is the favoured profitability ratio used in the UK. It can be seen that it suffers from:
  1. Adding back interest payable for the numerator and,
  2. Deducting current liabilities from total assets for the denominator.
4. The fourth option takes profit before tax and before the payment of interest (PBIT) expressed as a percentage of net assets (total assets less current liabilities less long-term loans).
This ratio has a number of disagreeable features and will tend to overstate profitability.

In Table 1, it can be seen that the first option shows a substantial decrease in profitability for the period 2006. It is caused mainly by a decrease in the profit margin (profit before tax expressed as a percentage of sales). What causes a decrease in the profit margin? Either a decrease in income (selling prices) and/or an increase in costs. From the recent blog on cost analysis statement, it was seen that there was a decrease in the incremental revenues (income) for the period, and a substantial increase in costs.

The cost analysis statement provides us with the explanations for the decline in profitability. This is backed up with the statement in the case study that the decline in profitability was: ‘a loss of margin in overseas core business, substantial start–up losses in Green and Gillies and a sharp increase in interest charges'. Also:

'the reduction in margin can be attributed to the fact that, as sterling based manufacturer, the group has passed the point where they can raise prices to their customers to compensate for the effects on an overvalued pound, particularly in their most important market, North America’.

While this may be true, it does not explain the substantial increase in staff costs, £35.3 million in 2011/12, nor the increase in operating leases and hire charges of £15.1 million for the similar period.

It is interesting to note that the ratio of revenues divided by total assets is fairly constant over the period, unlike the second and third option where the corresponding ratio fluctuates from year to year with an overall increase.

First option (preferred):
Profit before tax ÷ total assets %18.614.711.2–0.7
Profit before tax ÷ revenues %–0.5
Sales ÷ total assets1.411.281.391.37
Second option:
Profit before tax ÷ (TA – CL) %–2.0
Profit before tax ÷ revenues %–0.5
Revenues ÷ (TA – CL)2.132.461.993.74
Third option:
PBIT ÷ (TA – CL) %29.731.220.08.9
PBIT ÷ revenues %13.912.710.02.4
Revenues ÷ (TA – CL)2.132.461.993.74
Fourth option:
PBIT ÷ net assets %34.734.631.79.7
PBIT ÷ revenues %13.912.710.02.4
Revenues ÷ net assets2.502.733.164.07

Table 1 Profitability ratios

In Table 1, it can be seen that the second, third and fourth options tend to overstate profitability, especially the fourth option.

In the second and third options, the ratio of revenues divided by total assets less current liabilities increases from £1.99 to £3.74 for the period 2011/12. This means that either revenues has increased and/or total assets less current liabilities has decreased. Reviewing the basic data shows that revenues increased by 17.5%, while total assets less current liabilities decreased by 37.4%; the result being an increase from £1.99 to £3.74. This does not make sense. Further examination shows that current liabilities increased from £163.9 million to £409.5 million, mainly due to an increase in bank overdraft from £24.4 million to £257.2 million. Here we have a perfect example of changes in short-term financing affecting profitability.

The third option has all the problems just highlighted plus the extra ‘benefit’ from adding back any interest payments to the profit figure. In this option the company is still ‘seen’ to be making a profit. How can this be? The calculation requires that the loss before tax of £4.7 million is adjusted by adding back £26 million of interest payable; this produces a ‘profit figure’ for the numerator of £30.8 million!

The fourth option suffers from much of that contained in option two and three. However, because it also deducts long-term loans, it does not fall into the trap of movements between short and long-term borrowing. This meagre benefit does not overcome its major shortcoming of grossly overstating profitability. In this particular option it can be seen that profitability was relatively steady for the three years 2009 to 2011.

Here we must return to the real world and agree with Horngren that profitability should be measured on operating assets (i.e. total assets) irrespective of how they have been financed – the first option.

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