Topic list Syllabus reference

Formula to learn
Profit margin x Asset turnover = ROCE
PBIT x Sales = PBIT
Sales Capital employed Capital employed
In our example:

Profit margin	Asset turnover	ROCE
(a) 20X8 $360,245 x	$3,095,576	$360,245
$3,095,576	$1,009,899	$1,009,899
11.64% x	3.07 times	35.7%
Profit	Asset
margin	turnover	ROCE
(b) 20X7 $247,011 x	$1,909,051	$247,011
$1,909,051	$768,769	$768,769
12.94% x	2.48 times	32.1%

In this example, the company's improvement in ROCE between 20X7 and 20X8 is attributable to a higher asset turnover. Indeed the profit margin has fallen a little, but the higher asset turnover has more than compensated for this.

It is also worth commenting on the change in sales revenue from one year to the next. You may already have noticed that Furlong achieved sales growth of over 60% from $1,9m to $3.1 m between 20X7 and 20X8. This is very strong growth, and this is certainly one of the most significant items in the statement of profit or loss and statement of financial position.

1. 
   A warning about comments on profit margin and asset turnover
   

It might be tempting to think that a high profit margin is good, and a low asset turnover means sluggish trading. In broad terms, this is so. But there is a trade-off between profit margin and asset turnover, and you cannot look at one without allowing for the other.

1. 
   A high profit margin means a high profit per $1 of sales, but if this also means that sales prices are high, there is a strong possibility that sales revenue will be depressed, and so asset turnover lower.
   

(b) A high asset turnover means that the company is generating a lot of sales, but to do this it might have to keep its prices down and so accept a low profit margin per $1 of sales.
Compare a business which sells affordable furniture to a wide market, which is likely to offer a lower profit margin, but a higher turnover of inventory (and potentially revenue) than a high quality furniture manufacturer offering bespoke, luxury items, with a lower inventory turnover, which will have fewer sales but potentially better profit margins.

Consider the following.