Profitability ratios deal with the wealth for owners – profits.
Gross Profit Margin
Comparing the income from sales with the cost of the goods sold as a percentage. The formula is:
Net Profit Margin
This allows you to identify your profit after covering the cost of the goods sold and the other expenses of the business as a percentage. The formula is:
Return on equity
This ratio helps you identify the return on your investment. The formula is:
Paul needs to construct his profitability ratios. He has identified the following information from his statement of financial position and income statement:
- Sales: $22,500
- Gross Profit: $11,250
- Net Profit: $2,140
- Equity: $14,978
Applying the formulas above, calculate Paul’s ‘Gross Profit Margin’, ‘Net Profit Margin’, and ‘Return on Equity’.
Earlier on we identified that Paul wanted a return on his investment of 25%. Discuss whether you think Paul’s return on equity is acceptable, and if not what you would suggest to improve the ‘Return on Equity’ ratio.
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