Practice of Profitability Ratios
Profitability Measures
The income statement contains several figures that might be used in profitability analysis. In
general, the primary financial analysis of profit ratios should include only the types of income
arising from the normal operations of the business.
GROSS PROFIT MARGIN
Gross profit equals the difference between net sales revenue and the cost of goods sold. The cost
of goods sold is the beginning inventory plus purchases minus the ending inventory. It is the cost
of the product sold during the period. Changes in the cost of goods sold, which represents such a
large expense for merchandising and manufacturing firms, can have a substantial impact on the
profit for the period. Comparing gross profit to net sales is termed the gross profit margin.
Compute the gross profit margin as follows:
Gross Profit Margin = Gross Profit/Net Sales*100
OPERATING INCOME MARGIN
The
operating income margin
includes only operating income in the numerator. Compute the
operating income margin as follows:
Operating Profit Ratio = Operating Profit/Net Sales*100
Operating Income Margin = Operating Income/Net Sales*100
NET PROFIT MARGIN
A commonly used profit measure is return on sales, often termed net profit margin.
Net Profit Ratio = Net Profit/Net Sales*100
Net Profit Margin = Net Income/Net Sales*100
OPERATING ASSET TURNOVER
This ratio measures the ability of operating assets to generate sales dollars. Compute operating
asset turnover as follows:
Operating Asset Turnover = Net Sales/Average Operating Assets
TOTAL ASSET TURNOVER
Total asset turnover measures the activity of the assets and the ability of the firm to generate
sales through the use of the assets. Compute
total asset turnover
as follows:

Total Asset Turnover = Net Sales/ Average Total Assets
RETURN ON ASSETS
Return on assets measures the firm’s ability to utilize its assets to create profits by comparing
profits with the assets that generate the profits. Compute the
return on assets
as follows:
Return on Assets = Net Income/Average Total Assets*100
RETURN ON INVESTMENT (ROI)
The
return on investment (ROI)
applies to ratios measuring the income earned on the invested
capital. These types of measures are widely used to evaluate enterprise performance. Since return
on investment is a type of return on capital, this ratio measures the ability of the firm to reward
those who provide long-term funds and to attract providers of future funds.
Return on Investment = Net Income/Average Investment*100
Return on Investment = Net Income/Average (Long-Term Liabilities+Equity*100)
RETURN ON TOTAL EQUITY
The
return on total equity
measures the return to both common and preferred stockholders.
Compute the return on total equity as follows:
Return on Total Equity = Net Income/Average Total Equity
RETURN ON COMMON EQUITY
This ratio measures the return to the common stockholder, the residual owner. Compute the
return on common equity
as follows:
Return on Common Equity = Net Income /Average Common Equity
THE RELATIONSHIP BETWEEN PROFITABILITY RATIOS

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