Question

1.How and why does a company's profit margin stay the same but its gross margin increases?

2.How and why can a company's current ratio decrease but their acid test ratio increase?

3.What is the difference between gross margin and profit margin?

Answer 1

1) Company's profit margin is basically the net profit which is after all the other expenses. On the other hand gross margin considers only operating expenses. If the Company is able to reduce operating expenses as compare to previous year, then gross margin for the year will be improved. In the same year, if Company's administrative expenses (i.e. other expenses) increased (say by same % as operating expenses decreased) then net profit margin for the Company will stay same as in the previous year. Hence it is only possible when operating expenses and other expenses shows reverse trend.

2) Acid ratio includes liquid assets where as current ratio includes current assets. This is possible when the Company has more liquid assets as compare to current assets.

There may be items such as goods in transit (i.e. inventory item) which will decrease current ratio but increase in acid test ratio. Purchase for Goods in transit entry is booked at year end which same amount of liability to vendors. This entry reduces the current ratio while effect of this entry is not considered while computing acid test ratio.

3) As explained above, gross margin is the difference between revenue minus operating expenses. While net profit margin is revenue - all the expenses. Gross margin reflects mainly the operational performance of the Company while net profit margin explains the overall Performance of the Company.