Question
To assist you with your analysis you have been given the following ratios from the company's financial statements: Required: (a) Evaluate the profitability of the company by analysing the two ratios provided Your evaluation must cover what each ratio represents and the potential reasons behind the observed changes in each ratio. (8 marks) (b) Identify and briefly explain two potential implications of the observed trend in profitability for the company. (6 marks) (c) Based on your evaluation recommend two specific actions/strateg ies that the manager can take to improve the
Answer
4.1
(203 Votes)
Bruce
Elite · Tutor for 8 years
Answer
(a) Gross profit margin : Year 2021: 41%, Year 2022: 36%. Operating profit margin: Year 2021: 24%, Year 2022: 12%(py Transformations and Implications【/b)(c) Suggested strategies: 1. Cutting operational, production and overhead costs 2. Applying Premium pricing strategies if favorable conditions exist.
Explanation
Profitability ratios are financial metrics that business stakeholders use to evaluate a business's ability to generate profits as compared to its expenses and other relevant accounts during a specific time period. Here, two types of profitability ratios are mentioned: Gross profit margin and Operating profit margin. The Gross profit margin illustrates the sales profit, excluding the costs of goods sold, while the Operating profit margin represents profit earned from core business operations.(a) Let's assess both of these ratios year-over-year:1. Gross profit margin: This margin slipped from 41% in 2021 to 36% in 2022. The Gross profit margin expresses the effectiveness of a company's direct cost control pertaining to the cost of producing the goods or services the company sells. A reduction in Gross profit margin could indicate that direct production costs have increased or prices of company's products have dropped.2. Operating profit margin: This margin significantly decreased from 24% in 2021 to just 12% in 2022. This profitability metric accounts for both direct costs and indirect costs such as overhead expenses (like rent, wages, utilities etc.). Reduction in operating profit margin is a serious concern, as it implies higher increase in indirect operational costs compared to the revenue or the sales prices have been considerably dropped or direct production costs have escalated significantly.(b) The decreasing trend in the gross and operating profit margins has two important implications. 1. Efficiencies lost: The fall in these ratios indicates that the company lost its efficiencies whether in production or operation process.2. Impact on Shareholders: The downward trend of Operating Profit Margin especially can dent the confidence of shareholders and investors as it direclty impacts the net income which for temrs means smaller earning per share (EPS).(c) For improvements in the company's profitability, the manager could consider several strategies;1. Cutting Costs: In the short term, costs relating to operations, production and overhead can be analyzed and efficiently managed to instigate an increase in overall profitability.2. Premium Pricing Strategies: If the company’s products have a good market standing and reputation, a premium pricing strategy could be evaluated. This involves selling goods at a higher price to reflect their perceived quality and exclusivity which in turn could increase profit margins.