Accounting Business Reporting for Decision Making

CHAPTER 8 Analysis and interpretation of financial statements 333

The ROE indicates the annual return (in cents) that the entity is generating for owners for each dollar

of owners’ funds invested in the entity. It is advantageous for this ratio to show an upward trend over

time. However, a sustained high ROE will attract new competitors to the industry and eventually erode

excess ROE. The adequacy of the ROE is assessed by comparing it with the returns on alternative invest-

ment opportunities (of equivalent risk) available to owners. An inability to generate an adequate ROE

will restrict an entity’s capacity to attract new capital investment and adversely affect its ability to be

sustainable in the long term.

The ROE is a ratio that reflects an entity’s profitability, efficiency and capital structure. Changes in the

ratio over time, and differences in the ratio across entities, will reflect the direction of an entity’s profit-

ability, asset efficiency and capital structure. We will now consider the ratios that have an impact on an

entity’s ROE.

Return on assets

The return on assets (ROA) is a profitability ratio that compares an entity’s profit to the assets avail-

able to generate the profits. Effectively, the ratio reflects the results of the entity’s ability to convert sales

revenue into profit, and its ability to generate income from its asset investments. In the numerator, profit

or the EBIT figure can be used. For the purpose of our analysis, the profit figure is used. The ratio can

be calculated including (or excluding) the effect of significant items from the profit figure. The ratio is

calculated as:

Profit (loss)

×100 = x%

Average total assets

Given that the ROA reflects an entity’s profitability (ability to convert income dollars into profit) and

asset efficiency (ability to generate income from investments in assets), the change in the ROA can be

explained by changes in the entity’s profitability and asset efficiency. The profitability ratios that reflect

the ability of the entity to generate profits from income include the gross profit margin and the profit

margin, as discussed below.

Profit margin ratios

Ratios that relate profit to sales revenue generated by the entity include the gross profit margin and the

profit margin. The gross profit margin compares an entity’s gross profit to its sales revenue, reflecting

the proportion of sales revenue that results in gross profit. Given that gross profit is sales revenue less

cost of sales, 100 per cent less the gross profit margin is the cost of sales as a percentage of sales

revenue. The gross profit margin calculation is:

Gross profit

×100 = x%

Sales revenue

Both the numerator and denominator are sourced from the statement of profit or loss. The gross profit

margin reflects the gross profit (in cents) generated per dollar of sales revenue and reflects an entity’s

pricing strategy. It is not possible to specify a gross profit range that would be desirable. This is because

the gross profit is interrelated with sales volume. Entities with high (low) turnover tend to have smaller

(larger) gross margins. For example, the gross margin for a supermarket is between 2 and 5 per cent.

This is sustainable given the high volume turnover of a supermarket. However, a gross profit margin of

between 2 and 5 per cent would not be satisfactory for a luxury car sales business, as the volume of trade

would not justify such a low margin.