These ratios measure the ability of a business to generate earnings in relation to sales, equity and assets. They act as an indicator of how effectively the profitability of business is being managed. Commonly used profitability ratios includes: return on capital employed (ROCE), gross profit margin and net profit margin
The gross profit margin ratio indicates the percentage of revenue available to cover operating and other expenditures. The gross margin of a business should be stable.
Gross profit margin = (Revenue – COGS)/ Revenue
This shows that after cost of sales is deducted from sales, 50% is left to cover operating and other expenses. This ratio needs to be compared with previous years to be more meaningful.
Net Profit Margin indicates how much revenue is left when all expenses or other forms of income have been catered for, regardless of their nature (Goel, 2014). A higher net profit margin ratio is desirable though it needs to be compared with other similar businesses. Also needs to be compared with previous years to detect whether profitability is falling or improving
Net Margin = (Net Income or Loss) / Sales
Return on capital employed (ROCE) indicates how well the business is using capital deployed to generate returns/profits. Trend analysis plus industry analysis is vital in drawing meaningful conclusions regarding profitability of an entity. Background knowledge of the nature of business is also key in ratio analysis.