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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:

Gross Profit Margin

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:

Net Profit Margin

Return on equity

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

Return on Equity


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.

Post your ideas to the Comments section.


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This article is from the free online course:

Online Business: Pricing for Success

RMIT University

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