Accounting - Assignment Example

Accounting Assignment Briefly explain what the three ratios are; how they are calculated and why they are of importance to accounts users: Gross Profit Margin: Gross Profit Margin of a company is the ratio of the gross profit to the total sales recorded in the particular period. It is expressed as a percentage. It is an indication of the percentage of sales revenue that is available as the gross profit after deducting the cost of goods sold. Gross Profit Margin = (Gross Profit / Sales) * 100 % Gross Profit is the difference between the sales revenue and the cost of goods sold. The cost of goods sold includes all the direct – fixed and direct – variable unit costs that are incurred in manufacturing the product or providing the service. This is a very important measure of the profitability of a company as it expresses the amount of funds that is available to be spent on the overheads required for the functioning of the company. It is also imperative to note that the ratio remains almost stable for a business, as the cost of goods sold are relative to the sales revenue. Thus when the Gross Profit Margin recorded for a particular period is low, it is indication that the sales revenue is not in line with the increasing costs. The main drawback of this ratio is that it does not include the operational costs and is not a reliable measure of the profitability of the company. Net Profit Margin: Net Profit Margin of a company is the ratio of the net income to the total sales revenue in a particular period. This is also expressed as a percentage and indicates the percent of the total sales that is available as income to the company. Net Profit Margin = (Net Income / Sales) * 100 % Net Income is computed by deducting all the costs and expenses of the company in a particular period from the sales revenue. The expenses include all the operating expenses, interest expenses and taxes. This ratio indicates the overall profitability of the company and hence is considered very crucial. It expresses the ability of the company to convert revenue into income. The operational efficiency of a company is also estimated based on the net profit margin. The ratio can be compared with that of a benchmark company or the industry average to identify whether the company’s operations are efficient. One of the major drawbacks of this ratio is that it includes depreciation. When a company has invested recently in fixed assets, the depreciation will be higher and will drive down the net profit margin. Return on Capital Employed: Return on Capital Employed (ROCE) is the ratio of the pre – tax operating profit to the capital employed. The pre – tax operating profit does not include any non – operational profits earned by the company. The capital employed is the capital investment required for the business to operate. It is the net of the total assets less the current liabilities. It is also computed as the sum of the fixed assets and the working capital. Return on Capital Employed = Pre – Tax Operating Income / Capital Employed When the company does not have any non – operating profits, the pre – tax operating income is the same as the EBIT (Earnings Before Interest and Tax). Return on Capital Employed, as the name implies, indicates the return the business is able to generate from the assets that have been used. It is also a very important measure as it indicates the profit generating ability of the company from its assets. ROCE is an effective measure to compare the performance of the business over the years to analyze the profits in relation to the amount invested in the business. The major drawback of this measure is that it takes only the book value of the assets and the liabilities in computing the capital employed. For a relatively older company, the ROCE will be higher, as the book value of the assets will be lesser. This results in the Capital Employed not reflecting the effects of inflation whereas the revenue figures used in computing the profits are influenced by inflation. Also, when the company has a high amount invested in assets such as lands, etc., the ROCE will be lesser. 2. Using your judgement – decide which ratios relate to which store and explain your reasoning: Based on the Information given in the scenario, the three sets of ratios are assigned to the three companies as shown below: Store 1. Raffas 2. Andrews 3. Rodgers Gross Profit Margin 30% 48% 19% Net Profit Margin 4% 18% 6% Return on Capital Employed 6% 13% 12% Rationale: The rationale involved in relating the companies and the ratios are discussed below: 1. It is evident from the given case that the Rodgers Sports is a relatively old company and it has been hit recently by the rivals, Raffas. Hence the company with the lowest gross and net profit margins (19 % and 6 % respectively) should be Rodgers. Moreover, the corresponding Return on Capital Employed (12 %) is significant, indicating that the capital employed for the business is low, due to high accumulated depreciation. Hence the store 3 corresponds to Rodgers Sports. 2. The Raffas Bargain Sports Gear shop is a relatively new company and is a low cost mega store. As the company was opened recently, ROCE will be lesser as the capital employed in the business will be higher. As it is a low cost store, the gross profit margin will be relatively less as the selling prices will be low. Due to the large scale of operations (as it is a mega store), the overheads involved in the business will be significant and hence the net profit margin will be lesser than the other two companies. Hence the store 1 corresponds to the Raffas Bargain Sports Gear Shop. 3. As Andrews is an up market shop, the selling prices will be higher and the company will be earning high gross profits. Hence the store 2 with a gross profit margin of 48 % corresponds to Andrews. As the store caters to a niche market and the overheads involved in the business are comparatively low, the net profit margin is also higher (18 %). The high ROCE (13 %) also agrees, as the company has been operating since 1997 and the capital employed based on book values is lesser. Read More