23 Profitability performance measures
‘Profit is not the legitimate purpose of business. The legitimate purpose of business is to provide a product or service that people need and do it so well that it’s profitable.’
James Rouse, US real estate developer, civic activist and philanthropist
In a nutshell
Profit is often heralded as the key financial goal of a business.
It is more important, however, to measure profit in the context of the investment required to generate that profit. Return on investment, as opposed to profit alone, is a superior measure of financial success.
To achieve long-run viability a business must ensure that its return on investment is greater than its cost of finance.
Need to know 
Why is this important? 
To achieve long-term success a business should regularly monitor its progress against profitability performance targets.
As profit generation requires investment, return on investment should be a primary financial performance measure for a business.
Four important profit-based performance measures are defined below:
1 Gross profit margin (GPM)
Gross profit margin (GPM) measures the margin between price and direct costs (or cost of sales) (see Chapter 3 Profit and loss (P&L)).
If a business can increase its price or reduce its direct costs, then the GPM will increase.
GPM is different to ‘absolute’ gross profit. Although, selling more will increase gross profit in absolute terms, the gross margin may remain constant or fall depending on the rate that ‘cost of sales’ increases compared with sales.
2 Operating profit margin (OPM)
Operating profit margin (OPM) measures the margin between price and all operating costs, both direct and indirect (overheads). It can be used to assess the ability of a business to control its operating costs.
A larger fall in OPM than in GPM suggests that the business has a significant level of overheads that are nearly or completely fixed and can’t be reduced easily.
3 Net profit margin (NPM)
Net profit is usually EAT/PAT (earnings/profit after tax) and is commonly referred to as the ‘bottom line’ (see Chapter 3 Profit and loss (P&L)).
Net profit margin (NPM) measures the margin between price and all costs (direct, indirect, interest and taxes). It can be used to assess the ability of a business to control all its costs.
4 Return on investment (ROI)
Return on investment (ROI) measures ‘return’ as a percentage of the ‘investment’ required to generate the ‘return’.
| Return | Investment |
|---|---|
| A relevant definition of profit, for example ‘operating profit’ or ‘profit after tax’. | A relevant total taken from the balance sheet, for example ‘net assets’. |
See the Optional detail section below for more information on the definition of ‘return’ and ‘investment’.
From an investment perspective, ROI enables external stakeholders, such as shareholders, to evaluate a business and benchmark it against other competing investments. For large and listed companies, the ratio can be easily calculated from readily available public information and therefore ROI is a popular financial performance measure for analysts and investors.
For many businesses it makes sense to use the same financial performance measures internally that are used to evaluate the business externally, and therefore ROI is also a popular internal performance measure.
In practice 
Maximising ROI
In practice, businesses will use a combination of tactics to maximise their ROI such as:
- ■Increasing prices
- ■Reducing direct costs
- ■Controlling overheads
- ■Lowering the cost of finance
- ■Increasing activity (or volume) without proportionally increasing overheads
- ■Minimising versus maximising investment
- ■Changing the product, service or business mix.
Two of these practices are reviewed in more detail below.
Minimising versus maximising investment
Businesses can take a short-run or a long-run approach to maximising ROI.
On a short-term basis, simply cutting back on investment, or letting assets depreciate in value (see Chapter 9 Tangible fixed assets and depreciation), will increase ROI. Consequently, using this measure can sometimes encourage short-term behaviour. ROI can be potentially distorted through short-term decisions, which result in negative long-term consequences. For example, old machinery impacting on efficiency and product quality, costs of machine breakdown and growing maintenance costs.
A more successful approach to maximising ROI is to focus on long-term returns. Investing in the business is the way to grow overall long-term profitability and thus ROI. For example, a business may invest in new retail outlets; plant and machinery; or research and development.
Changing the product, service or business mix
Adding new products, services or even acquiring new businesses, with higher ROIs will enable a business to boost its overall ROI.
Unilever is a good example of a company which is continually reviewing its brand portfolio. For example:
- ■In 2017 it sold its relatively lower margin spreads (butter and margarine) business.
- ■In 2018 it acquired the relatively higher margin Horlicks brand.
- ■In 2019 it acquired the UK’s leading healthy snacking brand, Graze.
- ■In 2021 it sold its relatively lower margin tea business.
In 2021, Unilever CEO Alan Jope was quoted in the Financial Times as saying, ‘the clock is ticking for brands that don’t have good growth potential.’1
Nice to know 
Drivers of ROI
As a single ratio, ROI is simply a target. To be useful in managing a business, it should be divided into its component parts.
To analyse ROI’s drivers, we can relate ‘revenue’ to both ‘operating profit’ and ‘investment’. See the Optional detail section for other ways to calculate ROI.
| 1 Operating profit margin (OPM) As covered earlier. | 2 Asset turnover (AT) AT looks at revenue in relation to investment. It measures utilisation of assets or activity. Although it is a less popular measure than OPM, its contribution to ROI is as important as OPM. |
The interrelationship is therefore:
Illustrative example
By using two contrasting examples we can see the interrelationship between the drivers of ROI and how there are different routes to improvement.
| Company A | Company B |
|---|---|
| A supermarket with low operating profit margins of say 3% and high asset turnover of say five times. This shows that a supermarket’s route to success is through activity (or volume). Despite operating with low margins, supermarkets can be profitable and achieve a healthy ROI of say 15%. | A heavy manufacturer with high operating profit margins of say 25% and a low asset turnover of say 0.6 times. A heavy manufacturer requires considerable investment in plant and machinery and therefore its route to success is through its profit margins. This enables company B to achieve a ROI of 15%, comparable to company A. |
The examples of company A and company B show that in business there are different ways to achieve a reasonable ROI. The examples also demonstrate the importance of understanding the drivers of ROI.
Optional detail 
Although the concept of return on investment is widely used, there are many ways to calculate the ratio and different definitions of the numerator ‘return’ and the denominator ‘investment’.
| Possible definitions of ‘return’ | Possible definitions of ‘investment’ |
|---|---|
| Operating profit | Total (or gross) assets |
| PBIT (profit before interest and tax) | Capital employed (or TALCL*) |
| PBT (profit before tax) | Net assets |
| PAT (profit after tax) | Equity (or invested capital) |
| *Total assets less current liabilities. |
As each of the above definitions could be used, it means there are a number of possible ways to calculate ROI. Common ROI formulae are:
| Acronym | Full name | Description | Typical calculation |
|---|---|---|---|
| ROTA | Return on total assets | Calculates return relative to a company’s entire asset base. Useful to compare the efficient use of assets by companies in asset intensive industries, irrespective of their financing and capital structure. | |
| ROCE | Return on capital employed | As above except uses capital employed (or TALCL) as the investment base. It can be argued that this is a more relevant figure for investment to compare to operating profit. Useful in assessing management performance and probably the most popular ROI measure. | |
| ROE | Return on equity | This measure focuses on equity investment. Profit after tax, i.e. profit available to the shareholders of the business, is therefore a more relevant as a numerator. Calculates return relative to the amount invested by shareholders. Sometimes referred to as ROIC (return on invested capital). Useful from a shareholders’ perspective and for companies with similar capital structures. ROE will usually be higher than ROTA and ROCE due to financial leverage (see Chapter 30 Debt finance and Chapter 26 Long-term solvency performance measures). ROE represents the return after finance costs, i.e. the return after commitments to debt finance providers, have been fulfilled. | |
| RONA | Return on net assets | Alternative calculation to ROE, using Net assets (Total Assets less Long-term and Current liabilities). See Chapter 4 Balance sheet. |
Reflect and embed your understanding 
- 1What is the most effective way to maximise ROI?
- 2Which methods of maximising ROI will work in the short run yet may be detrimental in the long run?
- 3For an example organisation, consider the best way to measure its ROI, i.e. what should be the numerator and what should be the denominator?
- 4Choose an example listed company, such as Greggs plc, which discloses ROI. Are the adjustments made and its method of calculating ROI reasonable?
For the authors’ reflections on these questions please go to financebook.co.uk
Where to spot in company accounts 
The ratios are straightforward to calculate using figures from the P&L and balance sheet.
Some companies will display profitability ratios in their annual reports as alternative performance measures. The method of calculating these ratios will be disclosed as different companies may use adjusted totals.
Extract from Greggs plc 2020 annual report and accounts
Greggs plc’s method of calculating return on capital employed is disclosed at the back of the annual report and accounts together with the calculation of other alternative performance measures. An extract follows.
Return on capital employed – calculated by dividing profit before tax by the average total assets less current liabilities for the year.
| 2020 £m | 2019 Underlying £m | 2019 Including exceptional items £m | |
|---|---|---|---|
| (Loss)/profit before tax | (13.7) | 114.2 | 108.3 |
| Capital employed: | |||
| Opening | 580.1 | 559.3 | 559.3 |
| Closing | 589.8 | 580.1 | 580.1 |
| Average | 584.9 | 569.7 | 569.7 |
| Return on capital employed | (2.3%) | 20.0% | 19.0% |
Consolidate and apply
To see how the concepts covered in this chapter have been applied within Greggs plc, review Chapter 36, p. 412.
Watch out for in practice 
- →Although ROI is a good starting point to measure financial performance, don’t use it as a single measure. Consider ROI together with its drivers, profit margin and asset turnover.
- →Subsequently, investigate the drivers of both profit margin and asset turnover to analyse financial performance further.
→For profit margin, calculate each cost category as a percentage of revenue, for example employee costs as a percentage of turnover.
→For asset turnover, calculate each of the major asset categories (fixed assets, stocks and debtors) as a percentage of turnover.
- →It is always useful to benchmark financial performance ratios against other companies in the same industry.
- →Always check the definition of ROI being used. Check which ‘profit’ figure is being used and how ‘investment’ is made up.
- →The value of ‘investment’ is dependent on a company’s valuation of its assets, the age of its assets and its depreciation policies (see Chapter 9 Tangible fixed assets and depreciation and Chapter 17 Revaluation).