The Mathematics of Money

Copyright © 2008, The McGraw-Hill Companies, Inc.

Definitions 12.3.1 and 12.3.2

Ratio Formula What It Tells You

Gross profi t

margin^

Gross profi t

___________Net sales

expressed as a percent

The percent of net sales that goes

toward profi t or costs other than cost

of merchandise.

A high gross profi t margin indicates

that the business is able to charge

prices for merchandise well above cost.

Net profi t

margin

___Net incomeNet sales

expressed as a percent

The percent of net sales that ends up

as actual profi t.

A high net profi t margin indicates

that the business earns high profi ts in

relation to sales.

Both gross and net profit margins can vary quite a bit, depending on the type of business.

A profit margin that might be considered very high for a grocery store might be considered

quite low for a specialty clothing boutique, for example.

Example 12.3.1 From the fi nancial statements given at the start of this chapter,

determine Thomas Hydrometer Sales’ gross profi t margin and net profi t margin for

2007. Explain what these ratios tell you about the company’s fi nancial performance.

Gross profi t margin  $26,585,926____________

$74,438,275

 35.72%

Net profi t margin  ____________$5,833,777

$74,438,275

 7.84%

The gross profi t margin of 35.72% of the company’s sales represents income over their

merchandise cost. After expenses are taken out, 7.84% of the company’s sales translated

into net profi t.

Effectiveness ratios are intended to measure how effectively the business puts its resources

to work to generate profits. The commonly used effectiveness ratios are return on assets

and return on equity. The values of these ratios are calculated by using an annual financial

statement.

Definitions 12.3.3 and 12.3.4

Ratio Formula What It Tells You

Return on assets

(ROA)

Net income___Total assets

(usually expressed as a percent)

ROA compares the business’s

profi ts against the assets used

to generate those profi ts. A high

ROA means that the company

is putting its assets to work to

generate a comparatively large

profi t.

Return on equity

(ROE)

_____Owners’ equityNet income

(usually expressed as a percent)

ROE compares profi ts against

the net assets used to generate

those profi ts. ROE is intended

to measure how effectively the

business’s owners “own” assets

are being put to use. A high

ROE means that profi ts are

large in comparison to net assets.

12.3 Financial Ratios 509