Gross profit margin, net profit margin, and the average rate of return — how to calculate them and what they tell us.
Financial ratios allow businesses to analyse their financial performance. Rather than just looking at raw profit figures, ratios express performance as a percentage — making it easier to compare performance over time or against competitors of different sizes.
Shows what percentage of revenue is left after deducting the cost of sales (direct costs only). Measures production efficiency.
Shows what percentage of revenue is left after all costs including overheads. Measures overall profitability.
Measures how profitable an investment is as a percentage of its cost. Used to compare two investment options.
| Scenario | Raw Profit | What a Ratio Reveals |
|---|---|---|
| Company A | £500,000 | Revenue £10m → Net margin 5% — not very efficient |
| Company B | £500,000 | Revenue £2m → Net margin 25% — very efficient |
| Same business, year 2 vs year 1 | Both £300k profit | If revenue doubled, margin halved — efficiency fell |
Financial ratios are calculated from the profit and loss account. Remember the order:
| Item | Formula |
|---|---|
| Revenue | Price × Quantity |
| Cost of Sales | Direct costs — materials, production wages |
| Gross Profit | Revenue − Cost of Sales |
| Expenses / Overheads | Rent, admin, marketing, interest |
| Net Profit | Gross Profit − Expenses |
GPM shows how efficiently a business produces and sells its goods. A falling GPM might mean raw material costs are rising, or the business is discounting prices too heavily.
Revenue: £480,000 | Cost of Sales: £192,000
Gross Profit = £480,000 − £192,000 = £288,000
GPM = (£288,000 ÷ £480,000) × 100 = 60%
This means 60p of every £1 of sales remains after paying for direct costs.
NPM shows the overall profitability of the business after paying all costs. It tells us how much of each pound of sales actually becomes profit for the owners.
Gross Profit: £288,000 | Expenses: £144,000
Net Profit = £288,000 − £144,000 = £144,000
NPM = (£144,000 ÷ £480,000) × 100 = 30%
This means 30p of every £1 of revenue is kept as net profit.
| Change | Possible Cause | Possible Solution |
|---|---|---|
| GPM falls | Raw material costs up; prices cut to compete | Find cheaper suppliers; raise prices; reduce waste |
| GPM rises | Negotiated better supplier prices; premium pricing | Maintain and build on these efficiencies |
| NPM falls (GPM unchanged) | Overheads risen — rent, wages, marketing spend | Cut expenses; improve operational efficiency |
| NPM rises | Revenue grown faster than overheads | Scale further to maintain the effect |
ARR measures how profitable an investment is as a percentage of what it cost. Businesses use it to decide between two investment options — the one with the higher ARR is generally the better financial choice.
Calculate the total profit over the investment's lifetime:
Total Returns − Initial Investment
Calculate the average annual profit:
Total Profit ÷ Number of Years
Apply the ARR formula:
(Average Annual Profit ÷ Initial Investment) × 100
Compare the ARR of both options. The higher % is the better financial investment.
A business is choosing between two machines. Which should it buy?
| Item | Machine A | Machine B |
|---|---|---|
| Initial Cost | £50,000 | £80,000 |
| Year 1 Return | £15,000 | £25,000 |
| Year 2 Return | £18,000 | £28,000 |
| Year 3 Return | £22,000 | £30,000 |
| Year 4 Return | £20,000 | £27,000 |
| Total Returns | £75,000 | £110,000 |
| Total Profit | £25,000 | £30,000 |
| Avg Annual Profit | £6,250 | £7,500 |
| ARR | 12.5% | 9.4% |
Machine A has the higher ARR (12.5% vs 9.4%), so it is the better financial investment despite Machine B generating more total profit in pounds. The ARR accounts for the different investment costs.
Click a term on the left, then its definition on the right.