Profitability ratios: five questions to try now
Real past-paper questions, the answer key from the mark scheme, and the explanation that goes with it. No account needed to answer them.
Question 1
A company purchases a product that costs $120. The company expects to make a gross margin of one-third.
What is the company’s mark-up?
Answer: B.
Margin is measured on revenue, so a gross margin of one third means the profit is one third of the selling price, not one third of the $120 cost. If profit is one third of revenue then cost is the other two thirds, so revenue is $120 divided by two thirds, which is $180, and the gross profit is $60. Mark-up is the amount added to cost, so the answer is B, $60, which happens to be 50% of cost. A of $40 applies the one third to cost instead of to revenue, which is the wrong base. C of $160 is the selling price that the same wrong base produces, and D of $180 is the correct selling price rather than the amount added to cost.
Question 2
The following information is available for a company.
sales revenue for the year $1 600 000
debenture interest paid $60 000
gross profit margin 20%
operating expenses to revenue ratio 12%
return on capital employed 16%
What is the company’s capital employed?
Answer: C.
Build the profit down the statement first. Gross profit is 20% of $1 600 000, which is $320 000, and operating expenses are 12% of revenue, which is $192 000, so profit from operations is $128 000. ROCE is profit from operations over capital employed, so capital employed is $128 000 over 0.16, which is $800 000, answer C. B of $425 000 deducts the $60 000 of debenture interest first, but ROCE uses profit BEFORE interest, precisely because the debentures themselves sit inside capital employed. D of $2 000 000 divides gross profit by 16% and never takes the operating expenses off, and A of $256 000 simply takes 16% of revenue, which is not what the ratio says.
Question 3
The following information is available for the year ended 31 December 2021. $ revenue 1 400 000
inventory as at 1 January 2021 140 000
inventory as at 31 December 2021 148 000
The trader uses a mark-up of 60% on all purchases.
What was the value of purchases for the year?
Answer: D.
Mark-up is on cost, so revenue of $1 400 000 is 160% of cost and cost of sales is $1 400 000 over 1.6, which is $875 000. Purchases are then cost of sales adjusted for the inventory movement, goods sold plus what is left at the end less what was there at the start, so $875 000 plus $148 000 less $140 000, which is $883 000 and answer D. C of $875 000 stops at cost of sales and ignores the $8000 rise in inventory, which tempts because it is the one clean figure in the list. B of $867 000 has the cost of sales right but reverses the inventories, deducting the closing balance and adding the opening one. A of $848 000 works back from cost of sales of $840 000, which is 60% applied straight to revenue instead of revenue divided by 1.6.
Question 4
A company’s return on capital employed decreased to 10% in the current year from 15% in the previous year.
The directors have noted the following changes during the current year. Which changes could explain the decrease in the return on capital employed?
Answer: B.
1 and 3. Return on capital employed is profit from operations over capital employed, so a fall comes from a smaller numerator or a bigger denominator. New debentures are long term finance and go INTO capital employed, so a big debenture funded investment enlarges the denominator. A higher expenses to revenue ratio cuts profit from operations and shrinks the numerator. The other two miss on both counts: current liabilities are excluded from capital employed, and overdraft interest is charged BELOW profit from operations, so neither figure in the ratio moves.
Question 5
A business provided the following information.
gross margin 20% $ sales 275 325
opening inventory 25 450
closing inventory 55 975
What were the total purchases?
Answer: C.
Take cost of sales from the margin, then work back to purchases. A 20% gross margin leaves 80% as cost of sales, so 275 325 times 0.8 is $220 260. Purchases are cost of sales plus closing inventory less opening inventory, which is 220 260 plus 55 975 less 25 450, giving $250 785. Reversing the inventory adjustment gives $189 735, and stopping at cost of sales gives $220 260.
What this practice covers
These questions are drawn from past CIE 9706 Accounting papers and filtered to profitability ratios. You answer, you find out immediately whether you were right, and you get the reasoning for the correct option and for each distractor. Wrong answers go to a mistakes locker so you can come back to exactly those.
Practice is free. You need an account only so your progress and your mistakes are still there next time.
What examiners see students get wrong here
These are the errors that cost marks on profitability ratios, taken from our own topic notes. Read them before you practise and you will recognise the traps in the questions.
- Using profit after interest in ROCE while including the loan in capital employed.
- Confusing mark-up with margin. Mark-up is on cost, margin is on revenue.
- Saying gross margin fell "because costs rose" without saying which costs. Expenses do not affect gross margin at all.
- Quoting the ratio again as the explanation of the ratio.
- Comparing ROCE across different industries and drawing a conclusion.
- Recommending "cut costs" with no specific cost and no consequence.
- Forgetting that a percentage can rise while the money profit falls, if revenue fell further.
Revise it first
If any of the above is unfamiliar, work through the notes before practising: Profitability ratios revision notes.