Question

-Ratio Analysis

Describe profit margin and gross profit ratios. (In detail)

Explain the importance of each ratio and how each ratio assists the investor in evaluating a company's performance.

Answer 1

Both the Profit Margin and gross profit ratios are profitability ratios used to measure the company’s financial health.

1. Gross Profit Ratio:

Gross profit Ratio is a profitability ratio that calculates the company’s percentage of Revenue that exceed the cost of goods sold (COGS). In other words, it measures the ability of the company to generate revenue from the direct costs involved in the production, like direct materials and direct labor cost.

Formula:

Gross profit Ratio = Total sales – Cost of Goods Sold

                                             Total Sales

E.g. Mark Company has been producing pens. The figures for their year- end were:

Total Sales - $10,000

Cost of Material-$4000

Cost of Labor-     $2000

So, Gross profit Ratio will be 10000- (4000+2000)

                                                             10000

                                           = 0.4 times

Importance and Uses

The gross profit ratio is important because it shows management and investors how profitable the core business activities are without taking into consideration the indirect costs. It shows how efficiently a company can produce and sell its products.

The investors understands the health of the company from the point of view of its core business.

They understand the flow of revenue and cost from the core business. It may happen a company can have positive net margin but gross profit margin negative, in that case income may be coming from some non -core activity and one time income.

Investors can use it for comparison from period to period or from industry to industry.

2. Profit Margin:

Profit margin is a percentage measurement of profit that expresses the amount a company earns per dollar of sales. If a company makes more money per sale, it has a higher profit margin.

The profit margin ratio, also called the Net profit Ratio, is a profitability ratio that measures the amount of net income earned with per dollar of sales. This compares the net income and net sales of a company.

All the direct and indirect expenses are reduced from the net sales here. In other words it takes into account the overhead expenses too.

Formula:

Profit Margin = Net Income

                              Net Sales

E.g. Mark Company has been producing pens. The figures for their year- end were:

Total Sales - $10,000

Cost of Material-$4000

Cost of Labor-     $2000

Office rent- $500

Administrative cost $2000

Sales returned- $500

So, Profit margin will be 10000- (4000+2000)-(500+2000)-500

                                                             10000-500

                                           = 1000/9500

                                           =0.11

Importance and Uses

Investors use this ratio to measure how effectively a company can convert sales into net income.

They will the efficiency of the company in turning up the profits and payment of dividends.