Profitability ratios deal with the wealth for owners – profits.
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:
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.
Post your ideas to the Comments section.
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