Interpretation of profitability ratios
As always with ratios, you need a series of ratios and the equivalent data for other firms in the same industry to be able to make useful comparisons. You must also be sure which profit has been used to calculate the ratios. Remember, a firm may well make a gross profit, but this may become a loss when the value is converted to trading profit.
It is also useful to have the interest rate to hand, as this puts rates of profit into perspective. Is the return the firm is making more than the existing market rate of interest? In fact, the more you know about the state of the economy and how it has changed over the period of your comparisons the better.
Interpretation is all about trends and comparisons in context.
Improving the ratios
Profitability ratios are symptoms, so improvements in themselves mean little.
Profit margins can change in different ways as the result of a single action. Imagine the following scenario:
A firm reduces the price of its product and increases sales revenue as a result. The costs and expenses of the firm remained unchanged. The gross profit margin will fall, but the net profit margin will rise.
Follow the link below to look at the example with some numbers added.
Calculation of ratios
Follow the link below to get the balance sheet and profit and loss account for Student Computers plc and use them to work out the gross profit margin and net profit margin ratios - it will be good practice. Jot down some notes on how well the firm has performed and the difference between the ratios. Once you have had a go, and then follow the answer link below to see how you got on. N.B. Calculate the ratios for both years to compare them.