Question

1. What three ratios of profitability appear on a common size income statement?

2. What would explain how a firm having a high gross profit margin and a low net profit margin?

3. A firm's ROE is typically not equal to its ROA. Why? When would a firm's ROA equal its ROE?

Answer 1

1.The three profitability ratios are :

• Gross profit margin : Gross profit/sales
• net profit margin : net profit/sales
• operating margin : Ebit/ sales

2. When a firm has high level of expenses which does not include the cost of goods sold, then the net profit margin of the firm is lower than the gross profit margin as the interest expenses are significantly high which lowers the net income of the firm.

3. A company will have the ROE equal to the ROA, when the firm is financed all by equity.

ROE = NET INCOME/ EQUITY

ROA = NET INCOME/TOTAL ASSETS,

So, ROE is not equal to ROA typically as the firm has debt in it's capital structure. In case, the assets of the firm is financed all by equity, then the ROE is equal to the ROA.