After liquidity, solvency, and activity, the last big question a reader of financial statements asks is simply: how profitable is this business, relative to its sales and relative to what the owner has invested? Three ratios answer that from different angles.
| Ratio | Formula | What it measures |
|---|---|---|
| Gross Profit Margin | Gross Profit ÷ Net Sales | How much mark-up is left after covering only the cost of the goods themselves |
| Net Profit Margin | Net Income ÷ Net Sales | How much of every sales dollar survives all the way to the bottom line, after EVERY expense |
| Return on Equity (ROE) | Net Income ÷ Owner's Equity | How hard the owner's own invested dollars are working — the return earned on their investment |
Using accounting information to make decisions
- A falling Gross Profit Margin, with pricing unchanged, points to a purchasing problem — the cost of goods is rising faster than selling prices.
- A falling Net Profit Margin while Gross Profit Margin holds steady points to an operating-expense problem — selling or administrative costs are creeping up.
- A strong Return on Equity attracts new investment; a weak one may push an owner to reconsider the business, sell assets, or change strategy.
- Ratios are almost always more useful compared across TIME (this year vs. last year) or across SIMILAR businesses than viewed in isolation.
Limitations of ratio analysis
Ratios summarize, and summaries lose detail. Two businesses can report an identical Net Profit Margin for very different reasons — one growing sales fast with thin margins, another shrinking but cutting costs aggressively. Ratios also rely on accounting figures that involve estimates (like bad debts or depreciation), can be affected by one-time or seasonal events, and say nothing directly about the quality of management, brand strength, or where the industry itself is heading. A single ratio is a clue, never a verdict — good decisions combine several ratios with judgment about the business itself.