What it means
Management accounting arranges ratios in a pyramid, with one headline figure at the apex and supporting ratios beneath that explain how the headline was reached. The primary ratio is that apex: operating profit divided by capital employed, expressed as a percentage.
Capital employed is normally total assets minus current liabilities, which is the same thing as shareholders equity plus long term debt. It represents the money tied up in the business for the long haul, regardless of whether owners or lenders supplied it.
The pyramid's real value is that the primary ratio splits neatly into two secondary ratios: operating profit margin and asset turnover. Multiply those two together and you arrive back at the primary ratio, so any change in performance can be traced either to pricing and cost control or to how hard the assets are working.
That decomposition makes it a diagnostic tool rather than just a score. A discount retailer and a jeweller can both earn 20%, one through thin margins and rapid stock turnover, the other through fat margins on slow moving items, and the pyramid shows you which is which.
The usual cautions apply. Capital employed is measured at a single point in time, so averaging opening and closing figures gives a fairer answer for a business that grew during the year, and leased assets, revalued property and large idle cash balances all distort the denominator.
Beneath the two secondary ratios sit tertiary ratios that break the pyramid down further, such as gross margin, overheads as a percentage of sales, stock turnover and debtor days. Working down the levels turns a vague complaint that returns are falling into a specific finding, for example that stock days have crept up by three weeks.
In practice
Real-world examples.
Example
A distribution business improves its primary ratio from 14% to 18% without raising prices. The pyramid shows margin unchanged at 6% while asset turnover rose from 2.3 to 3.0, because a warehouse consolidation released capital.
Example
A manufacturer's primary ratio falls from 22% to 15% after building a new plant. Margin actually improved, but capital employed grew faster than profit, which is normal in the first two years of a large investment.
Example
A group finance director sets a hurdle of 15% for any capital request, meaning a proposed $4,000,000 investment must be expected to add at least $600,000 of annual operating profit before it will be approved. Two of the four projects submitted that year fall short and are sent back for rework rather than rejected outright.
Think of it
“Primary ratio shows the fundamental return your assets generate-basic earning power.
Formula
Calculation
Primary ratio = (operating profit / capital employed) x 100, where capital employed = total assets - current liabilities
It also equals operating profit margin x asset turnover
A components manufacturer reports revenue of $18,000,000 and operating profit of $1,800,000. Its balance sheet shows total assets of $12,000,000 and current liabilities of $3,000,000, so capital employed is $12,000,000 - $3,000,000 = $9,000,000.
The primary ratio is ($1,800,000 / $9,000,000) x 100 = 20%.
Breaking it down, the operating profit margin is $1,800,000 / $18,000,000 = 10%, and asset turnover is $18,000,000 / $9,000,000 = 2.0 times. Multiplying gives 10% x 2.0 = 20%, which matches the primary ratio and confirms the decomposition.Case study
Seen in the real world.
This is an illustrative and fictional example. Pinewood Ceramics, an invented tile maker, had two divisions reporting almost identical operating profit of about $900,000 each, and management treated them as equally successful.
Calculating the primary ratio for each told a different story. The retail division used $3,000,000 of capital employed, giving 30%, while the contract division used $9,000,000, giving 10%, and the pyramid showed the difference was entirely asset turnover rather than margin, because the contract division held nine months of slow moving stock.
The illustrative management team set an inventory reduction target for the contract division rather than a pricing target. Freeing $3,000,000 of stock over two years lifted that division's primary ratio to 15% while its profit margin barely changed at all.
Watch out
Common mistakes.
- Using net profit after tax in the numerator, which mixes financing and tax effects into a measure designed to judge trading performance against capital.
- Taking capital employed from the year end balance sheet alone, which can be unrepresentative if the business raised money or bought assets late in the year.
- Comparing the primary ratio across industries, where capital intensity differs so much that the numbers cannot be read side by side.
Questions
People also ask.
Is the primary ratio the same as return on capital employed?
Yes, primary ratio is the older management accounting name for the same calculation, still common in UK textbooks and exam syllabuses.
Why is it called primary?
Because it sits at the top of the ratio pyramid and every secondary and tertiary ratio beneath it exists to explain how that headline figure was produced.
What is a good primary ratio?
Comfortably above the company's cost of capital, which for many businesses means something in the 12% to 20% range, though capital intensive sectors run lower.
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