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4.3

## RMIT University

Profitability ratios

# Profitability ratios

Profitability ratios deal with the wealth for owners – profits.

They include:

Gross Profit Margin

Comparing the income from sales with the cost of the goods sold as a percentage. The formula is:

Net Profit Margin

This allows you to identify your profit after covering the cost of the goods sold and the other expenses of the business as a percentage. The formula is:

Return on equity

This ratio helps you identify the return on your investment. The formula is:

Activity

Paul needs to construct his profitability ratios. He has identified the following information from his statement of financial position and income statement:

• Sales: $22,500 • Gross Profit:$11,250
• Net Profit: $2,140 • Equity:$14,978

Applying the formulas above, calculate Paul’s ‘Gross Profit Margin’, ‘Net Profit Margin’, and ‘Return on Equity’.

Earlier on we identified that Paul wanted a return on his investment of 25%. Discuss whether you think Paul’s return on equity is acceptable, and if not what you would suggest to improve the ‘Return on Equity’ ratio.