Question

Ratio analysis of financial statements allows us to see how well a company is operating versus its past and in relation to other companies. Pick one type of ratios d and share how the ratio is calculated and what the results mean.

If you could explain one so that I, a non accounting major who is struggling to understand, might get it.

Answer 1

PROFITABILITY RATIOS :

The profitability ratios analyze a firm’s profitability. In a sense, these profitability ratios are the most important ratios that you can calculate. They typically provide terribly useful insights into how profitable a firm is and why.

1.GROSS MARGIN PERCENTAGE

Also known as the gross profit margin ratio, the gross margin percentage shows how much a firm has left over after paying its cost of goods sold. The gross margin is what pays the operating expenses, financing expenses (interest), and, of course, the profits.

Gross margin percentage ratio = gross margin/sales

NOTE :the higher the gross margin percentage, the better.

2.NET OPERATING MARGIN PERCENTAGE

Net operating margin percentage = operating income/sales

In the case of a business with an operating income of $60,000 and sales of $150,000, this formula returns the value 0.4.

A 0.4 operating margin percentage, which is equivalent to 40 percent, indicates that a firm’s operating income equals 40 percent of its sales.

You want your operating margin percentage to be close to or better than those of your competitors’ net operating margin percentages.

3.PROFIT MARGIN PERCENTAGE

The profit margin percentage works like the net operating margin percentage; it expresses the firm’s net income as a percentage of sales, as shown in the following formula:

net income/sales

For example, the formula returns a financial ratio of 0.33. This indicates that the firm’s net income equals roughly 33 percent of its sales.

4.RETURN ON ASSETS

The return on assets shows the return that the firm delivers to stockholders and the interest that the firm pays to lenders as the percentage of the firm’s assets. Some businesses (banks, for example) use return on assets to evaluate the business’s profitability.

Return on assets =(net income + interest)/total assetst

NOTE :the return on assets must exceed the capital charges on the assets.

5.RETURN ON EQUITY

The return on equity financial ratio expresses a firm’s net income as a percentage of its owner’s equity or shareholders’ equity (shareholder’s and owner’s equity are the same thing).

Return on equity =net income/owner's equity

A rising ROE suggests that a company is increasing its ability to generate profit without needing as much capital. .