Page 170 - CalcBus_Flipbook

20-14 Profitability & Performance Measures CH 20]

Solution algorithm:
Net Sales
Asset Turnover Ratio = —————————
Average Total Assets
Net Sales
——————————————-
Asset Turnover Ratio = (Beginning Assets + Ending Assets)
—————————————————-
2

$90,000
——————————
Asset Turnover Ratio = ($150,000 + $300,000)
———————————
2
$90,000
—————
= ($450,000)
——————
2
$90,000
= —————
$225,000

Asset Turnover Ratio = 0.40 : 1 ≈ 40 : 100

Profitability and Profitability Ratios
The primary goal of any business is to make a profit. Profitability ratios are derived from
the firm’s income statements and show the firm’s ability to generate profits in its market
serving its target customers from its operations. Profitability ratios bring a focus to the
return on investment in a firm. These ratios show how well the firm can achieve profits from
its operations.
Investors and creditors use profitability ratios to evaluate the firms’ return on
investment based on its relative level of resources and assets. These ratios relate to a firm’s
efficiency to generate profits, and is indicative of its solvency. Solvency being the ability of
the firm to pay its debts.
The key ratios to consider when judging how profitable a company should be or its
efficiency in terms of its profits are:
 Gross Profit Margin Ratio
 Profit Margin
 Return on Assets
 Return on Capital Employed
 Return on Equity

Gross Profit Margin Ratio. Gross profit margin ratio is a profitability ratio that
measures how much of every dollar of revenues is left over after paying cost of goods sold
(COGS). There are many elements that go into the Gross Profit Margins Ratio, these are
derived from the Income Statement and are calculated using revenue (or total revenue),
gross profit, and net profit.

 Revenue (or Total Revenue): All income derived from the sales of goods or services.
The equation is: Quantity of Goods Sold x Price of Goods; or the summation of all
goods sold.
 Gross profit: What's left after deducting the cost of making and selling the product.
The equation is: Gross Profit = Revenue - Cost of Goods Sold.
 Net profit: What's left after subtracting from Gross Profit all other business
operating expenses, such as interest and taxes. The equation is:
Net Profit = Gross Profit – (Operating expenses + taxes)

Gross Profit Margin Ratio is a quick and meaningful way to compare companies as
competitors in an industry. The Gross Profit Margin Ratio is expressed as a decimal value or
as a percentage.
When a business sells its inventory to make a profit, the cost of its inventory is marked
up to generate a profit for the firm. As such the Gross Profit Margin measures how
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