Accounting & Bookkeeping (STUDENT EDITION) Unit 19: Profitability Ratios 19.1 Introduction Operating Margin Ratio analysis is important for a variety of reasons. A company can compare itself against its competitors as well as against itself over time, an auditor can use ratio analysis to look for anomalies and possible errors in reported information, investors can use ratio analysis to select which company to invest in, and creditors can use ratio analysis to determine the creditworthiness of a potential borrower. This Unit looks at profitability ratios. To calculate the operating margin you divide the operating income by net sales, similar to how we calculated the gross margin: 19.2 Calculating Margins There are three important margins: gross margin, operating margin and net profit margin. Operating margin = Operating income Net sales Suppose the business has $750,000 in net sales and its operating income is $124,350. Let’s calculate its operating margin: $124,350 $750,000 = 16.58% Gross Margin Net Profit Margin The gross margin looks at how profitable your sales were before considering operating expenses. Your gross margin needs to be high enough to cover the Cost of Goods Sold as well as the rest of your expenses, and hopefully have enough left to earn a profit. The gross margin looks at how much you spend on the goods or services you sold versus how much sales they produced. The net profit margin is calculated by taking net income and dividing by net sales: To calculate the gross margin percentage you take the gross profit and divide it by net sales: Gross margin = Gross profit Net sales Let’s assume a company has $750,000 in Net Sales and a Cost of Goods Sold of $475,000. The Gross profit would be $750,000 - $475,000 = $275,000. So we would calculate the gross margin by: $275,000 $750,000 = 36.67% Net profit margin = Net Income Net sales Continuing with the same information, the net sales are $750,000, and let’s assume the Net Income is $72,345. Here’s the calculation for the net profit margin: $72,345 $750,000 = 9.65% 19.3 Other Ratios In addition to knowing your profits, you also want to measure your success in making money based on your sales, your assets and your equity. Let’s look at three calculations that enable you to do that: Return on Sales (ROS), Return on Assets (ROA) and Return on Equity (ROE). That means the Cost of Goods Sold uses up 63.33% of this company’s sales. 1 © 2013 Excel With Business Accounting & Bookkeeping (STUDENT EDITION) Unit 19: Profitability Ratios Return on Sales (ROS) Return on Equity (ROE) You can test how efficiently you run your business by calculating you ROS. This ratio measures how much profit your company makes per dollar of sales. You do this calculation using two lines from the Income Statement: net income before taxes and net sales or revenue. Here’s the formula: Your investors will want to measure how well your company earns money based on the investment they put into the company. You calculate ROE using this formula: Return on sales = Return on equity = Income before taxes Net sales Assume a company’s net sales are $750,000 and their net income before taxes is $115,325. Here is how you would calculate its ROS: $115,325 $750,000 = 15.38% Return on Assets (ROA) You can measure how well your company uses its assets by calculating your ROA. The higher the percentage, the better. To calculate ROA you use this formula: Net income Return on assets = Average total assets This ratio shows you how much your company earns from its assets. You and your investors can test how well your company manages its assets to turn a profit. Whenever you combine an Income Statement amount (in this case net income) with a Balance Sheet amount (total assets) you have to average the Balance Sheet figure. This is because the Income Statement figure covers a period of time, and the Balance Sheet figure is a snapshot on the last day that is covered by the Income Statement. Averaging the Balance Sheet figure (which will now span the same period of time as the Income Statement figure) provides better information. Net income Average shareholders’ equity As with any ratio, comparing your company’s results with others in the industry will give you a good idea of how well you are doing. Earnings Per Share (EPS) One of the most popular and widely used ratios is Earnings Per Share (EPS). EPS tells you how much net income is available to common shareholders per share. The forumla is: Earnings per share = Net income - Preferred stock dividends Average Common shares outstanding Price-Earnings Ratio (PE) Another ubiquitous ratio is the Price-Earnings Ratio (PE), which compares the EPS to the market price of the stock. The PE ratio formula is: Price earnings ratio = Market price per share Earnings per share ROA can vary significantly depending on the type of industry. Companies with significant fixed assets, such as a manufacturing company, will have lower ROAs than companies that don’t have to invest in heavy machinery, such as service companies. 2 © 2013 Excel With Business