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Business Finance · Interpreting company accounting information

Profitability Ratios: ROCE, ROE and Profit Margins Explained

Updated 11 October 2026 · Fact-checked

Profitability ratios measure how well a company turns sales and capital into profit. Margins (gross, operating, net) divide a profit figure by revenue. ROCE divides operating profit by capital employed. ROE divides profit for equity holders by shareholders' equity. Calculate each, compare with prior years or peers, then explain the cause of any change.

Understand Profitability Ratios

A company earns profit from sales and from the money invested in it. Profitability ratios link profit to one of these two bases. Profit on sales gives the margins. Profit on money invested gives the returns, ROCE and ROE.

There are three margins. Gross margin shows what is left of revenue after the direct cost of sales. It reflects pricing and production cost. Operating margin goes further and deducts running costs such as selling and administration. It shows how efficient the whole business is before financing. Net margin is after interest and tax, so it also reflects how the company is financed and taxed.

ROCE (return on capital employed) asks how much operating profit the business earns on all long-term money in it, from both lenders and shareholders. Capital employed is usually total assets less current liabilities, which equals equity plus long-term debt. Because profit is taken before interest, ROCE does not depend on how the firm is financed. You can compare it with the cost of borrowing.

ROE (return on equity) asks how much profit the shareholders earn on their own money. It uses profit after interest and tax, less preference dividends if any, over equity. Gearing affects it. Borrowing at a cost lower than ROCE raises ROE, but it also raises risk. This is the key difference between ROCE and ROE.

A ratio alone means little. In the exam, you must compare it with an earlier year, a competitor or the industry, and give reasons. A fall in ROCE can be traced to margin or to asset use, since ROCE = operating margin × asset turnover (revenue ÷ capital employed).

Key rules to remember

Gross profit margin
Gross profit ÷ Revenue × 100%
Gross profit = Revenue − Cost of sales.
Operating profit margin
Operating profit ÷ Revenue × 100%
Operating profit is profit before interest and tax (PBIT), unless the question defines it otherwise.
Net profit margin
Profit after tax ÷ Revenue × 100%
Some questions use profit before tax. State which you use.
Return on capital employed (ROCE)
Profit before interest and tax ÷ Capital employed × 100%
Capital employed = Total assets − Current liabilities = Equity + Non-current liabilities.
Return on equity (ROE)
(Profit after tax − Preference dividends) ÷ Ordinary shareholders' equity × 100%
Equity is often taken at year end. Average equity is also acceptable if you state it.
ROCE breakdown
ROCE = Operating margin × (Revenue ÷ Capital employed)
Use it to explain whether margin or asset use caused a change.

How to solve Profitability Ratios questions

Use this method for any profitability ratio question, numerical or written.

  1. 1Read the question and note which definitions it gives. If it defines a ratio, use that definition.
  2. 2Pull out the figures: revenue, cost of sales, operating profit, interest, tax, profit after tax, equity and long-term debt.
  3. 3Work out capital employed as equity plus non-current liabilities, or total assets less current liabilities. Check that both give the same figure.
  4. 4Calculate each ratio, show the formula and keep the same basis for every year or company.
  5. 5Compare: current year with prior year, or company with peer. Note the direction and size of each change.
  6. 6Explain the cause. Link margin changes to prices, costs and mix. Link ROCE changes to margin or asset turnover. Link ROE changes to gearing, interest and tax.
  7. 7Conclude with a judgement and mention limits, such as differing accounting policies or one-off items.

Quickest way: Margin times turnover shortcut

When to use it: Use it in multiple-choice questions or when you must explain a change in ROCE quickly.

  1. Compute operating margin and asset turnover (revenue ÷ capital employed) for both periods.
  2. Multiply them to check ROCE.
  3. See which of the two moved. That is your explanation.
  4. For ROE, compare ROE with ROCE. If ROE is well above ROCE, gearing is boosting returns.
  5. Write one line of cause and one line of judgement.

Common mistakes in Profitability Ratios

  • Using profit after interest in ROCE

    Students grab the bottom-line profit because it is easy to find.

    Fix: ROCE uses profit before interest and tax, as capital employed includes debt.

  • Leaving out non-current liabilities from capital employed

    Students use equity alone, which is the ROE base.

    Fix: Add long-term debt to equity, or subtract current liabilities from total assets.

  • Not deducting preference dividends in ROE

    Students stop at profit after tax.

    Fix: Ordinary shareholders' return is profit after tax less preference dividends, over ordinary equity.

  • Mixing bases between years

    Year-end capital used in one year and average capital in another.

    Fix: Choose one basis, state it, and use it for all periods.

  • Stating the ratio without explaining it

    Students think calculation earns the full marks.

    Fix: After each figure, give a cause and a comparison, such as higher input costs or better asset use.

  • Calling a higher ROE always good

    Students ignore gearing.

    Fix: Check whether ROE rose because of more debt. If so, mention higher financial risk.

Worked examples

Example 1

A company has revenue of ₹50,00,000, cost of sales ₹30,00,000, operating expenses ₹12,00,000, interest ₹1,00,000 and tax ₹2,10,000 on profit before tax. Calculate gross, operating and net margins.

Show the solution
  1. Gross profit = 50,00,000 − 30,00,000 = ₹20,00,000.
  2. Gross margin = 20,00,000 ÷ 50,00,000 = 40%.
  3. Operating profit = 20,00,000 − 12,00,000 = ₹8,00,000.
  4. Operating margin = 8,00,000 ÷ 50,00,000 = 16%.
  5. Profit before tax = 8,00,000 − 1,00,000 = ₹7,00,000.
  6. Profit after tax = 7,00,000 − 2,10,000 = ₹4,90,000.
  7. Net margin = 4,90,000 ÷ 50,00,000 = 9.8%.

Answer: Gross margin 40%, operating margin 16%, net margin 9.8%.

Example 2

A company has operating profit of ₹8,00,000, interest of ₹1,00,000, profit after tax of ₹4,90,000, ordinary equity of ₹35,00,000 and long-term debt of ₹10,00,000. There are no preference shares. Calculate ROCE and ROE and explain why they differ.

Show the solution
  1. Capital employed = 35,00,000 + 10,00,000 = ₹45,00,000.
  2. ROCE = 8,00,000 ÷ 45,00,000 × 100% = 17.78%.
  3. ROE = 4,90,000 ÷ 35,00,000 × 100% = 14%.
  4. ROE is lower here because ROE is measured after interest and tax, while ROCE is before both.
  5. Debt costs 1,00,000 ÷ 10,00,000 = 10% before tax, which is below the ROCE of 17.78%, so the borrowing adds to equity returns. The gap to ROE is mainly the tax charge.

Answer: ROCE is about 17.8% and ROE is 14%. ROE is lower mainly because it is after tax. The debt is earning more than it costs, which helps shareholders.

Exam tips

  • Write the formula before the numbers. Method marks are given even if the arithmetic slips.
  • State your definition of profit and capital employed when the question leaves it open.
  • Comparison questions need both calculation and reasons. Aim for one explanatory sentence per ratio.
  • In multiple-choice questions, check the base: before or after interest, equity or total capital.
  • Mention limits such as one-off items, different accounting policies and year-end versus average balances.

Practice questions from Interpreting company accounting information

Profitability Ratios in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Profitability Ratios: frequently asked questions

What is the difference between ROCE and ROE?

ROCE measures operating profit against all long-term capital, so it is before interest and tax. ROE measures profit for ordinary shareholders against their equity only. ROE is affected by gearing and tax, while ROCE is not affected by how the firm is financed.

How do I calculate return on capital employed?

Divide profit before interest and tax by capital employed and multiply by 100. Capital employed is total assets less current liabilities, which equals equity plus non-current liabilities.

Which profit do I use for net profit margin?

Normally profit after tax divided by revenue. Some definitions use profit before tax. Follow the question's definition and state your choice.

Why can ROE rise while ROCE falls?

Higher gearing can raise ROE even if operating returns fall, provided profit after interest still grows relative to equity. This also adds risk, so mention it in your answer.