Profitability describes one aspect of a company’s financial performance. Financial ratios and common-size income statements can assist in measuring this profitability and can also provide quick insights into changes in a company’s financial performance.
There are several financial ratios which can assist in measuring profitability. The net profit margin and gross profit margin are two such ratios which may be found through common-sizing the income statement.
Net Profit Margin
A company’s return on sales or net profit margin measures the amount of income that the company generated for each dollar of revenue. In the form of an equation:
$$ \text{Net Profit Margin}=\cfrac {\text{Net Income}}{\text{Revenue}} $$
A higher level of net profit margin indicates a higher level of profitability.
Gross Profit Margin
The gross profit margin is another measure of profitability which is calculated as follows:
$$ \text{Gross profit margin}=\cfrac {\text{Gross profit}}{\text{Revenue}} $$
Where gross profit = revenue minus cost of goods sold.
As the equation indicates, the gross profit margin measures the amount of gross profit that a company generated for each dollar of revenue. Similar to the net profit margin, a higher level of gross profit margin indicates a higher level of profitability.
Question
The table below provides summary financial data for a company for the periods ended December 31, 2015, and December 31, 2016.
$$ \begin{array}{ccc} {} & {\text{December } 31,2016} & {\text{December } 31,2015} \\ {} & {$} & {$} \\ {\text{Revenue}} & {2,500,000} & {1,700,000} \\ {\text{Cost of goods sold}} & {1,200,000} & {600,000} \\ {\text {Net profit}} & {950,000} & {250,000} \\ \end{array} $$
Which of the following statements is most accurate?
A. The company’s gross profit margin in 2016 was higher than in 2015.
B. The company’s net profit margin was equal in both years.
C. The company’s gross profit margin in 2015 was higher than in 2016.
Solution
The correct answer is C.
The gross profit margin was higher in 2015 than in 2016 given that
gross profit margin in 2015 \(=\cfrac {($1,700,000- $600,000)}{$1,700,000} = 64.71\%\); and
gross profit margin in 2016 \(=\cfrac {($2,500,000- $1,200,000)}{$2,500,000} = 52.00\%\).
Option A is incorrect because the gross profit margin was higher in 2015 than in 2016 as previously calculated.
Option B is incorrect because net profit margin in 2015 \( =\cfrac {$250,000}{$1,700,000} = 14.71\%\),
while net profit margin in 2016 \(= \cfrac {$950,000}{$2,500,000} = 38\%\). Therefore the net profit margin is not equal in both years.
Reading 21 LOS 21j:
Evaluate a company’s financial performance using common-size income statements and financial ratios based on the income statement
