As we have already covered the profit of a business is calculated by taking the total expenses away from the total revenue generated. All businesses want to maximise their profits and investors want to invest in profitable businesses so they get a better return.

Profitability is a measure of an organisation's profit relative to its expenses. Organisations that are more efficient will generate more profit as a percentage of its expenses than a less-efficient organisation, which must spend more to generate the same profit. 

Investors will look closely at the profitability of businesses before deciding whether or not to invest. This is also a useful tool for business owners and managers to analyse their performance throughout the year.

Ratio analysis allows for a more meaningful interpretation of published accounts by comparing one figure with another. Ratio analysis also allows for both interfirm and intrafirm comparisons. Ratios will be used by internal stakeholders such as managers and employees, as well as external stakeholders such as investors and creditors.

Profitability is a measure of the profit of a firm in relation to another factor. It allows for a more comprehensive assessment of the performance of a firm by comparing one figure to another. Imagine that there are two firms, A and B, both with a profit of £750000 per year- how can we determine which one is performing better. If however you were told that Firm A has sales revenue of £1.5million and Firm B has sales revenue of £3 million then it is clear that Firm A has greater profitability as it is generating the same amount of profit from a lower level of sales. This indicates it is more efficient and better at controlling costs.

There are 4 profitability ratios you will look at here:

1. Gross Profit Margin

2. Mark-up

3. Net Profit Margin

4. Return on Capital Employed

This is calculated using the following formula:

Gross profit/Revenue x 100

This ratio looks at gross profit as a percentage of sales turnover (revenue). It shows us for every £1 made in sales, how much is left as gross profit after the cost of goods sold has been deducted. A gross profit of 88 % means that for every £1 of sales made 88p is left as gross profit.

If gross profit falls from one year to the next or is thought to be too low, a firm may try to reduce the cost of its purchases. This may involve looking for a cheaper supplier, but the firm must try to ensure that this does not affect the quality of the product. Alternatively, it may try to increase sales without increasing the cost of goods sold.

This is calculated using the following formula: 

gross profit/cost of sales x 100

This ratio looks at profit as a percentage of cost of sales. It shows what percentage of cost of sales is added to reach selling price. For example a mark-up of 25% would mean that if the cost of raw materials used to produce a good were £1, it has been sold for £1.25. Businesses want a high mark-up.

This is calculated using the following formula: 

net profit/revenue x 100

This ratio looks at net profit as a percentage of sales turnover. It shows, for every £1 made in sales, how much of it is left as net profit after all expenses have been deducted. A net profit of 31 percent therefore means that, for every £1 of sales made, 31p is left as net profit.

If net profit falls from one year to the next or is thought to be too low, a firm may look to reduce its expenses, for example, by moving to cheaper premises or cutting staff costs. Before taking any action, however, the accountant must try to identify the cause of a falling figure- whether it is related to sales, cost of goods sold or expenses- as all of these factors will impact upon the net profit margin.

This is calculated using the following formula:

net profit before interest and tax/capital employed x 100

This ratio shows the percentage return a business is achieving from the capital (or money) being used to generate that return. It shows, for every £1 invested in the business in owner's capital or retained profits, what percentage is being generated in profit. A ROCE of 5% means that, for every £1 tied up in the business, 5p is being generated in net profit.

Investors will often compare ROCE to the interest rate being offered in a bank or building society to see if their investment is working effectively for them in generating a return.