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Profitability ratios indicate how well the enterprise has operated during the year. These ratios answer such questions as: Was the net income adequate? What rate of return does it represent? What is the rate of net income by operating segment or activity? What amount was paid in dividends? What amount was earned by different equity claimants? Generally, the ratios are either computed on the basis of sales or on an investment base such as total assets. Profitability is frequently used as the ultimate test of management effectiveness.
7. Profit Margin on Sales
The profit margin on sales is computed by dividing net income by net sales for the period. Anetek's ratio is:
This ratio indicates that Anetek is achieving an above-average rate of profit on each sales dollar received. It provides some indication of the buffer available in case of higher costs or lower sales in the future.
Employment of this ratio in conjunction with the asset turnover ratio offers an interplay that leads to a rate of return on total assets. This relationship is expressed as follows:
The profit margin on sales does not answer the question of how profitable the enterprise was for a given time period. Only by determining how many times the assets turned over during a period of time is it possible to ascertain the amount of net income earned on the total assets.
Many enterprises have a small profit margin on sales and a high turnover. Grocery and discount stores are examples. Other enterprises, such as jewelry and furniture stores, have a relatively high profit margin but a low inventory turnover.
8. Rate of Return on Assets
Rate of return on assets is computed by using as a numerator net income and as a denominator average total assets. The ratio for Anetek is:
Anetek's rate of return is slightly above the average of the industry and is a result of Anetek's relatively high profit margin on sales.
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