# 19.1 Introduction Operating Margin Unit 19: Profitability Ratios

```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
to measure your success in making money based on
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.
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Accounting & Bookkeeping
(STUDENT EDITION)
Unit 19: Profitability Ratios
Return on Sales (ROS)
Return on Equity (ROE)
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.
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