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Gross Profit Margin (ratio)

In profitability ratios return on capital employed is the most comprehensive and meaningful ratio. But we have

observed (previously) that ROCE studied with margin and assets utilization ratios gives more insight regarding the changes in ROCE. Gross Profit Margin is one of the margin ratios that should be studied for deep understanding of ROCE.

FORMULA

 

    Gross Profit Margin  =

    Gross Profit


    Sales

     

EXAMPLE

Both Gross Profit and Sales figures can be extracted directly from face of Statement of Comprehensive Income.

Gross Profit Margin  =

3,601,400


7,468,110

Gross Profit Margin  =

48.22 %

Data used in calculating ratio is extracted from Hypothetical Financial Statements. (See Hypothetical Financial Statements used in calculation).

    MEASUREMENT UNIT

    ROCE ratio is measured in Percentages.
    Using the above example, for every 1$ sales by the company, the company has earned 48.22 cents.

    INTERPRETATION

    How to interpret the ratio

    As we have already discussed ROCE should be studied with margin ratios. We should also calculate last year margin and compare it with current year to know whether it has increased or decreased thus giving information of changes in ROCE.

    Gross profit is arrived at by subtracting cost of sales from sales revenue for the year. Thus gross profits Margin is the measure of how well (efficient) the company has made sales and controlled the ancillary expenses i.e. cost of sales.
    Change in gross profit margin will be due to either increase or decrease in sales figure or cost of sales figure. Cost of sales gives information about whether management is successful in controlling its direct expenses (that are necessary for making sales) or not. Sales figure gives information how well management has made sales e.g. increased sales price to earn with same sales volume or reduced profit margins to sell more volumes or find a new marketing segment etc (making sales in itself is a full topic which is studies under “Marketing”.)

    Users’ needs addressed by the ratio

    Shareholders are most common users of profitability ratios as they have invested in the company for earning return in the form of dividends which are distributed from the profits generated by the management during the year (the more the profits, the more the dividend).

    Lenders are also interested as they have forwarded the long term loan to company and they want to ensure that company can pay yearly interest as well as principal back to lenders.

    Management monitors the Gross Profit Margin to control its performance since management is primarily responsible for using the assets of the company with great efficiency for generating sufficient profits. This ratio tells management where they are standing at the moment and what they should do to improve it.

    (You must have an understanding of users’ needs of financial statements; please refer the topic 1- financial statement users for details).

 

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