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Profitability ratios (Return on capital employed (Profit before interest…
Profitability ratios
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Return on equity
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Measures an entity's efficiency, the higher the ratio the more efficient and profitable the company is likely to be
The level of gearing of a company is likely to have an impact on ROE: companies which are highly geared are likely to have a higher ROE. By using debt, companies expand their capacity to earn profits and servicing debt is less expensive than servicing equity
Return on investment
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The average investment amount is usually used and is calculated by taking account of the scrap value of the investment at the end of its economic useful life:
Average investment =initial investment + scrap value / 2
If the expected rate of return on the investment is greater than the required rate of return then the investment should be undertaken
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Net profit
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The profit after tax figure is sometimes used in place of the profit before tax to calculate the net profit margin. The profit before tax figure is often the more appropriate measure, the effects of taxation should usually be stripped out to provide a more meaningful comparison of either two companies on different tax rates or a company's year on year net profit where there has been a change in the rate of taxation
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The higher the ratio, the more profit the business will make for each £1 of revenue
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A rise in profits does not always mean the profit margin is improving. The company may simply have sold more goods at the existing margin rather the margin itself improving or revenues may have increased at a slower rate than costs of goods sold because sales prices have been reduced to get more market share
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