Topic list Syllabus reference

Alpha Co		Brava Co
Sales revenue	$1,000,000	Sales revenue	$4,000,000
Capital employed	$1,000,000	Capital employed	$1,000,000
PBIT	$200,000	PBIT	$200,000

These figures would give the following ratios.

ROCE	=	$200,000 $1,000,000	= 20%	ROCE	=	$200,000 $1,000,000	= 20%
Profit margin	=	$200,000 $1,000,000	= 20%	Profit margin	=	$200,000 $4,000,000	= 5%
Asset turnover	=	$1,000,000 $1,000,000	= 1	Asset turnover	=	$4,000,000 $1,000,000	= 4

The companies have the same ROCE, but it is arrived at in a very different fashion. Alpha Co operates with a low asset turnover and a comparatively high profit margin whereas Brava Co carries out much more business, but on a lower profit margin. Alpha Co could be operating at the luxury end of the market, whilst Brava Co is operating at the popular end of the market.

4. 
   Gross profit margin, net profit margin and profit analysis
   

Depending on the format of the statement of profit or loss, you may be able to calculate the gross profit margin as well as the net profit margin. Looking at the two together can be quite informative.
For example, suppose that Fashion Co has the following summarised statement of profit or loss for two consecutive years.

	Yearl	Year 2
	$	$
Revenue	70,000	100,000
Cost of sales	42,000	55,000
Gross profit	28,000	45,000
Expenses	21,000	35,000
Profit for the year	7,000	10,000

Although the net profit margin is the same for both years at 10%, the gross profit margin is not.

In year 1 it is: $28,000 - 40%
$70,000
and in year 2 it is: $45,000 = 45%
$100,000
The improved gross profit margin has not led to an improvement in the net profit margin. This is because expenses as a percentage of sales have risen from 30% in year 1 to 35% in year 2.

In the case of Fashion, the expenses need to be investigated in more detail. The increase in depreciation, although an additional cost, may be a sign that the company is buying new machinery or investing in the shops or showroom. Additional personnel costs may indicate new staff being employed prior to launching or developing a new product. The increase in costs may be for positive reasons. Equally, there may be reasons such as additional borrowing costs (interest, bank charges or penalties from suppliers for late payments), provisions for warranties or allowances for irrecoverable debts (suggesting trade customers are failing, or highlighting issues within the industry itself). Perhaps there are legal costs, such as trade union or accident liability costs, or additional insurance costs following a large claim by the company.
Review the information provided, especially if it only mentions a potential problem, such as industrial or economic issues external to the business. Consider the wider picture that the business may be faced with.

5. 
   Historical vs current cost
   

In this chapter we are dealing with interpretation of financial statements based on historical cost accounts.
It is worth considering how the analysis would change if we were dealing with financial statements based on some form of current value accounting (which we will go on to look at in Chapter 22).
These are some of the issues that would arise:

• 
  Non-current asset values would probably be stated at fair value. This may be higher than depreciated historical cost. Therefore capital employed would be higher. This would lead to a reduction in ROCE.
  
• 
  Higher asset values would lead to a higher depreciation charge, which would reduce net profit.
  
• 
  If opening inventory were shown at current value, this would increase cost of sales and reduce net profit.
  

So you can see that ROCE based on historical cost accounts is probably overstated in real terms.