Question 10.A.5: Calculate the gross profit margin for Alexis Ltd for the year...

Gross profit margin = \frac{409}{2,681} \times 100 = 15.3%

The 2017 ROSF ratio is very poor by any standards; a bank deposit account will normally yield a better return than this. We need to try to find out why things went so badly wrong in 2017. As we look at other ratios, we should find some clues.

The ROCE ratio tells much the same story as ROSF; namely, a poor performance, with the return on the assets being less than the rate that the business has to pay for most of its borrowed funds (i.e. 10% for the loan notes).

The operating profit ratio shows a very weak performance compared with that of 2016. In 2016, for every $1 of sales revenue an average of 10.8¢ (i.e. 10.8%) was left as operating profit, after paying the cost of the carpets sold and other expenses of operating the business. By 2017, however, this had fallen to only 1.8¢ for every $1. It seems that the reason for the poor ROSF and ROCE ratios was partially, perhaps wholly, a high level of expenses relative to sales revenue. The gross profit ratio should provide us with a club as to how the sharp decline in this ratio occurred.

The decline in the gross profit ratio means that was lower relative to sales revenue in 2017 than it had been in 2016. Bearing in mind that:

Gross profit = Sales revenue – Cost of sales (or cost of goods sold)

this means that cost of sales was higher relative to sales revenue in 2017 than in 2016. This could mean that sales prices were lower and/or that the purchase price of carpets had increased. It is possible that both sales prices and purchase prices had reduced, but the former at a greater rate than the latter. Similarly, they may both have increased, but with sales prices having increased at a lesser rate than purchase prices.

Clearly, part of the decline in the operating profit margin ratio is linked to the dramatic decline in the gross profit margin ratio. After paying for the carpets sold, for each $1 of sales revenue 22.1¢ was left to cover other operating expenses in 2016, this was only 15.3¢ in 2017.

We can see that the decline in the operating profit margin was 9% (i.e. 10.8% to 1.8%), whereas that of the gross profit margin was only 6.8% (i.e. from 22.1% to 15.3%). This can only mean that operating expenses were greater, compared with sales revenue in 2017, than they had been in 2016. The declines in both ROSF and ROCE were caused partly, therefore, by the business incurring higher inventories’ purchasing costs relative to sales revenue, and partly through higher operating expenses compared with sales revenue. We would need to compare these ratios with their planned levels before we could usefully assess the business’s success.

The analyst must now carry out some investigation to discover what caused the increases in both cost of sales and operating expenses, relative to sales revenue, from 2016 to 2017. This would involve checking on what had happened with sales and inventories prices over the two years. Similarly, it would involve looking at each of the individual areas that made up operating expenses to discover which ones were responsible for the increase, relative to sales revenue. Here, further ratios—for example, staff expenses (wages and salaries) to sales revenue—could be calculated in an attempt to isolate the cause of the change from 2016 to 2017. In fact, as we discussed when we took an overview of the financial statements, the increase in staffing may well account for most of the increase in operating expenses.