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Profitability Ratios Related to Sales

These ratios are based on the premise that a firm should earn sufficient profit on each rupee or sales. If adequate profits are not earned on sales, there will be difficulty in meeting the operating expenses and no returns will be available to the owners. These ratios consist of (i) profit margin, and (ii) expenses ratios.

Profit Margin  The profit margin measures the relationship between profit and sales. As the profits may be gross or net, there are two types of profit margins: Gross profit margin and Net profit margin.

Gross Profit Margin  is also known as gross margin. It is calculated by dividing gross profit by sales. Thus,

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If the sales of a firm amount to Rs 40,00,000 and its gross profit is Rs 10,00,000, the gross margin would be 25 per cent (Rs 10,00,000 + Rs 40,00,000). If the gross margin (25 per cent) is deducted from 100, the result (75 per cent) is the ratio of cost of goods sold to sales. The former measures profits in relation to sales, while the latter reveals the relationship between cost of production and sale price.

Gross profit is the result of the relationship between prices, sales volume and costs. A change in the gross margin can be brought about by changes in any of these factors. The gross margin represents the limit beyond which fall in sales prices are outside the tolerance limit. Further, the gross profit ratio/margin can also be used in determining the extent of loss caused by theft, spoilage, damage, and so on in the case of those firms which follow the policy of fixed gross profit margin in pricing their products.

A high ratio of gross profit to sales is a sign of good management as it implies that the cost of production of the firm is relatively low. It may also be indicative of a higher sales price without a corresponding increase in the cost of goods sold. It is also likely that cost of sales might have declined without a corresponding decline in sales price. Nevertheless, a very high and rising gross margin may also be the result of-unsatisfactory basis of valuation of stock, that is, overvaluation of closing stock and/or undervaluation of opening stock.

A relatively low gross margin is definitely a danger signal, warranting a careful and ‘detailed analysis of the factors responsible for it. The important contributory factors may be (i) a high cost of production reflecting acquisition of raw materials and other inputs on favorable terms, inefficient utilization of current as well as fixed assets, and so on ; and (ii) a low selling price resulting from severe competition, inferior quality of the product, lack of demand, and so on. A thorough investigation of the: factors having a bearing on the low gross margin is called for.

A firm should have a reasonable grows margin to adequate coverage for operating expenses of the firm and sufficient return to the owners of the business, which is reflected in the net profit margin.

Net Profit Margin   is also known as net margin. This measures the relationship between net profits and sales of a firm. Depending on the concept of net profit employed, this ratio can be computed in three ways:

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The net profit margin is indicative of management’s ability to operate the business with sufficient success from revenue of the period, the cost of merchandise or series, the expenses of operating the business (including depreciation) and the cost of the borrowed funds, but also to a margin of reasonable compensation to the owners for providing their capital at risk. The ratio of net profit (after interest and taxes) to sales essentially expresses the cost price effectiveness of the operation

A high net profit margin would ensure adequate return to the owners as well as enable a firm to withstand adverse economic conditions when selling price is declining, cost of production is rising and demand for the product is falling.

A low net profit margin has the opposite implications. However, a firm with a low profit margin, can earn a high rate of return on investments if it has a higher inventory turnover. This aspect is covered in detail in the subsequent discussion. The profit margin should, therefore, be evaluated in relation to the turnover ratio. In other words, the overall rate of return is the product of the net profit margin and the investment turnover ratio. Similarly, the gross profit margin and the net profit margin should be jointly evaluated. The need for joint analysis arises because the two ratios may show different trends. For example, the gross margin may show a substantial increase over a period of time but. the net front margin may (i) have remained constant, or (ii) may not have increased as fast as the gross margin, or (iii) may actually have declined. It may be clue to the fact that the increase in the operating expenses individually may behave abnormally. On the other hand, if either as a whole or individual items of operating expenses decline substantially, a decrease in gross margin may he associated with an improvement in the net profit margin.

Expenses Ratio

Another profitability ratio related to sales is the expenses ratio. It is computed by dividing expenses by sales. The term expenses includes (i) cost of goods sold, (ii) administrative expenses, (iii) selling and distribution expenses, (iv) financial expenses but excludes taxes, dividends and extraordinary losses due to theft of goods, good destroyed by fire and so on.

There are different variants of expenses ratios. That is

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