###### Interpret Cash Flow to the firm

Evaluating Free CashFlow Recall that it is important for operating cash flows to... **Read More**

Conversion of the income statement to a common-size income statement facilitates an assessment of a company’s performance across time periods (time series analysis) and across companies (cross-sectional analysis).

Common-size analysis of the income statement is performed by stating each line item on the income statement as a percentage of revenue. Benefits of common-sizing the income statement include:

- It allows for meaningful comparison between companies concerning the percentage of expenses and profit relative to sales.
- It emphasizes variations in company strategies, prompting further investigation. For instance, if there’s a difference in the gross profit to sales ratio between two companies, it warrants additional research to comprehend the underlying reasons and their potential impact on the companies’ future performance.

Profitability describes one aspect of a company’s financial performance. Financial ratios and common-size income statements can assist in measuring profitability aside from offering quick insights into changes in a company’s financial performance.

Several financial ratios can assist in measuring profitability. The net and gross profit margins are two ratios that may be found through common sizing of the income statement.

A company’s return on sales or net profit margin measures the income generated for each dollar of revenue. In the form of an equation:

$$ \text{Net Profit Margin}=\frac{\text{Net Income} }{\text{Revenue}} $$

A higher level of net profit margin indicates a higher level of profitability.

The gross profit margin is another measure of profitability which is calculated as follows:

$$ \text{Gross profit margin}=\frac{\text{Gross profit} }{\text{Revenue}} $$

Where gross profit = revenue minus the cost of goods sold.

As the equation indicates, the gross profit margin measures the gross profit a company generates for each dollar of revenue. Like in the case of the net profit margin, a higher gross profit margin indicates a higher level of profitability.

**Other Ratios**

Other income statement ratios used by analysts include the operating profit margin and the pretax margin, whose formulas are as follows:

$$\text{Operating profit margin}=\frac{\text{Profit from operations}}{\text{Revenue}}$$

$$\text{Pretax margin}=\frac{\text{Profit before tax}}{\text{Revenue}}$$

## Question

The table below provides summary financial data for a company for the periods ended December 31, 2015, and December 31, 2016.

$$ \begin{array}{l|r|r}

& \text{December 31, 2016} & \text{December 31, 2015} \\ \hline

\text{Revenue} & 2,500,000 & 1,700,000 \\ \hline

\text{Cost of goods sold} & 1,200,000 & 600,000 \\ \hline

\text{Net profit} & 950,000 & 250,000

\end{array} $$Which of the following statements is

mostaccurate?

- The company’s net profit margin was the same in both years.
- The company’s gross profit margin in 2016 was higher than in 2015.
- The company’s gross profit margin in 2015 was higher than in 2016.

SolutionThe correct answer is

C.The gross profit margin was higher in 2015 than in 2016, given that

$$ \begin{align*}

\text{Gross profit margin in 2015} & =\frac{(\$1,700,000-\$600,000) }{\$1,700,000}=64.71\% \\

\text{Gross profit margin in 2016} & =\frac{(\$2,500,000-\$1,200,000) }{\$2,500,000}=52.00\%

\end{align*} $$

A is incorrectbecause the net profit margin in \(2015 =\frac{\$250,000 }{\$1,700,000}=14.71\%\)

B is incorrectbecause the gross profit margin was higher in 2015 than in 2016, as previously calculated.while net profit margin in \(2016 =\frac{\$950,000}{\$2,500,000}=38\%\). Therefore, the net profit margin is not the same in both years.