Practice of Profitability Ratios (1).docx - Practice of Profitability Ratios Profitability Measures The income statement contains several figures that

Practice of Profitability Ratios (1).docx - Practice of...

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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:
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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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  • Fall '19
  • Revenue, Generally Accepted Accounting Principles

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