 # An Evaluation of ABC’s Profitability Ratios

An Evaluation of ABC’s Profitability Ratios

• Calculation of the ratios.

Gross Margin Ratio

This ratio assesses how profitable a particular firm ca ton sell its stock. The gross margin ratio of ABC can be computed as follows:

Gross margin Ratio = Gross Margin divided by sales

The Gross margin = the cost of goods sold subtracted from the net sales

Net Sales is arrived at by deducting returns on sales from the gross sales revenues.

Gross Margin Ratio= 325000/525000

ROA evaluates how effectively a firm can earn on investment on its assets.

ROA of ABC can be computed as follows:

ROA= Net Profit divided by Average Total Assets

= 77000/272000

= 0.2831

Profit Margin Ratio

The Profit Margin ratio is used to evaluate how much income is produced at a certain level of sales. The Profit margin ratio of ABC can be calculated as bellow:

Profit margin Ratio = Net Profit after Taxes ÷ Sales

Net Profit is determined by Total Revenues – Total Expenses

Profit Margin Ratio of ABC = 77000/525000

= 0.1467

• Purpose and information each ratio conveys

Gross Margin Ratio

The primary purpose of gross profit ratio is to enable business analysts to measure how profitable a company can sell its inventory. Higher gross margin ratios are always more favorable than lower ones. Therefore, a firm with a higher gross margin ratio will have more funds to settle its operating expenses like rent, salaries, and utilities.

ABC’s gross profit ratio is 0.619. This means that 0.619 dollars are made from every one dollar generated in sales. In simple terms, a cost of 0.381(1-0.619) is incurred by the company for every one dollar it takes from sales. Therefore for every one dollar generated by ABC, 0.381 dollars are used to pay for products it sells and the remaining 0.619 remains in the firm to pay for the operating costs, dividends and income taxes among other expenses.

ROA (Return on Assets Ratio)

ROA evaluates how effectively an enterprise utilizes its assets to earn income. ABC’s Return on total assets is 0.2831. This typically means that the firm made 0.2831 dollars on every dollar it invested into assets. In other terms, for every dollar that ABC invested into its total assets, it generated 0.2831 dollars in after-tax profits.

Companies purchase assets to generate profits. Therefore, the higher the Return on Assets Ratio, the more admirable (Stable) a firm is considered. Also, a higher ROA indicates that a firm is utilizing its assets more effectively to generate income. Conversely, lower ROAs indicate that the company is not using its assets efficiently to generate profits hence the company is less stable.

Profit Margin Ratio

This ratio analyzes the number of profits which can be earned by a company at a specific sales level. As calculated above, ABC’s net profit margin is 0.1467. This means that 0.1467 dollars are made from every one dollar (\$1) realized from sales. In simple terms, a cost of 0.8533 dollars (1-0.1467) is incurred by ABC for every one dollar it takes in from sales. Therefore for every one dollar made by the firm, 0.8533 dollars are used to pay for operating expenses, buying products, and taxes. The remaining 0.1467 dollars remains in the firm or is distributed to the shareholders (owners)

A higher net profit margin is more desirable. This is because, the higher the Net Profit Margin, the more stable a firm is considered. It indicates that a firm is more profitable after all taxes and other expenses have been settled. Conversely, if the Net profit Margin is low, it means that the firm has less money to pay for its expenses and taxes and therefore the company is unstable.

• What I learned about ABC Company by reviewing the three ratios

Gross Margin

After reviewing the gross margin ratio of ABC, I have learned that the firm has a high gross margin of 61.9%. This means that it is stable and able to pay its operating expenses. For instance, it only incurs a cost of 0.381 from every one dollar of sales it makes. The remaining 0.619 is available for the company to conveniently pay for its operating costs.

Return on Assets.

By reviewing ABC’s return on assets ratio, I have learned that the company has a relatively low return on assets of 28.31 percent. This means that for every one dollar investment the firm made on its assets, only a profit of 0.2831 dollars were made. The company is, therefore, the firm is utilizing its assets less effectively to generate income.

Profit Margin Ratio

After reviewing ABC’s Profit Margin Ratio, I have learned that the firm is less profitable after paying all its operating expenses and taxes. This is because, for every one dollar made, 0.8533 dollars are used to pay for operating expenses, buying products, and taxes thus only 0.1467 dollars remain in the firm. Therefore, I would consider the firm to be less stable.

I will use Debt-equity ratio, current ratio, and profit before taxes/net worth to evaluate the success of ABC relative to the industry average. First, Debt-Equity ratio is calculated by dividing an organization’s total liabilities by its stockholders’ equity. It indicates how much debt a firm is using to finance its assets as compared to the value of equity.  Lower debt-equity ratios mean that the firm is healthy enough to borrow funds now and in the future. The debt-equity ratio of ABC is 0.74(116000/156000) while the industry average is 3.9. Thus, the Debt-equity ratio of ABC is below the industry average, meaning that it is healthy enough to borrow funds to finance its operations now and in the future. Another criterion is by using the profits before taxes/ net worth to determine the success of ABC. This ratio enables the company to determine the rate of return on owners’ equity. For ABC it is 0.49(77000/156000), while the industry average is 0.556. It is apparent that 0.49 is not very far from the industry average. This means that ABC‘s management has been efficient in deriving high returns from owner’s equity. 