Profitability ratios show how much profit a business keeps from its sales. The three you need are gross profit margin, net profit margin and mark-up.
This lesson is part of financial statement analysis.
What are the formulas?
| Ratio | Formula |
|---|---|
| Gross profit margin | Gross profit ÷ Sales × 100 |
| Net profit margin | Net profit ÷ Sales × 100 |
| Mark-up | Gross profit ÷ Cost of sales × 100 |
Margin always uses sales as the base. Mark-up always uses cost of sales.
Worked example: a fictional shop
An original set of figures, in RM.
| Item | Amount |
|---|---|
| Sales | 80 000 |
| Cost of sales | 52 000 |
| Expenses | 19 600 |
Step 1: gross profit. 80 000 − 52 000 = 28 000.
Step 2: net profit. 28 000 − 19 600 = 8 400.
Step 3: ratios.
- Gross profit margin = 28 000 ÷ 80 000 × 100 = 35%
- Net profit margin = 8 400 ÷ 80 000 × 100 = 10.5%
- Mark-up = 28 000 ÷ 52 000 × 100 = 53.8%, to one decimal place
For every ringgit of sales the shop keeps 35 sen after goods, and 10.5 sen after all expenses. On goods bought, it adds about 53.8% to reach its selling amount.
The mistake that costs marks
The slip is to divide the gross profit by cost of sales when the question asks for margin. The figure looks like a normal percentage, so it is not noticed.
| Step | Wrong | Right |
|---|---|---|
| Gross profit margin | 28 000 ÷ 52 000 = 53.8% | 28 000 ÷ 80 000 = 35% |
| Denominator | Cost of sales | Sales |
| What it shows | Mark-up | Margin |
Check the word in the question. “Margin” means sales. “Mark-up” means cost.
Check yourself
A business has sales of RM150 000, expenses of RM30 000 and a cost of sales of 105 000. Find the gross profit margin, net profit margin and mark-up.
Answer
Gross profit = 150 000 − 105 000 = 45 000. Net profit = 45 000 − 30 000 = 15 000.
Gross profit margin = 45 000 ÷ 150 000 × 100 = 30%. Net profit margin = 15 000 ÷ 150 000 × 100 = 10%. Mark-up = 45 000 ÷ 105 000 × 100 = 42.9%.
What to study next
Go on to calculating liquidity ratios. To see where profit and cash part ways, try the cash-profit timeline, and record slips in the mistake log.
If you want a teacher to hear your choice of denominator, see online one-to-one Accounting tuition.