Strategies to Improve Profitability Ratios
- Profitability ratios measure how effectively a business generates profit relative to sales, costs, or capital employed.
- The three key ratios are:
- Gross Profit Margin
- Profit Margin
- Return on Capital Employed (ROCE).
Improving these ratios can enhance a company's financial health and attractiveness to investors.
Gross Profit Margin
- Gross Profit Margin measures the percentage of revenue that remains after deducting the cost of goods sold (COGS).
- It indicates how efficiently a business produces or sources its products.
$$\text{Gross Profit Margin} = \frac{\text{Gross Profit}}{\text{Revenue}} \times 100$$
Strategies to Improve Gross Profit Margin
- Reduce COGS: By purchasing from cheaper supplier, COGS can be reduced.
- Bulk Purchasing: Buying in larger quantities often leads to discounts from suppliers.
- Supplier Negotiations: Renegotiate contracts to secure better terms or lower prices.
- Efficiency Improvements: Streamline production processes to reduce waste and lower costs.
- Increase Prices: If the goods have lesser substitutes, increasing the prices may increase gross profit.
- Value Proposition: Justify higher prices by highlighting unique features or benefits.
- Targeted Pricing: Increase prices selectively for products with inelastic demand.
- Don't assume that higher prices always lead to higher profits.
- If customers are price-sensitive, sales may drop, reducing overall revenue.
Profit Margin
- Profit Margin measures the percentage of revenue that remains as profit after all operating expenses are deducted.
- It provides a broader view of a company's profitability.
$$\text{Profit Margin} = \frac{\text{Profit before Interest and Tax}}{\text{Revenue}} \times 100$$
Strategies to Improve Profit Margin
- Cut Operational Expenses: Reducing costs associated with running a business by optimizing resources, improving efficiency, and eliminating unnecessary expenses.
