How to calculate profitability ratios

Analysis and Interpretation of Financial Statements for Decision Making

What you need

• A complete Income Statement showing sales, cost of sales, gross profit, total expenses and net profit.
• The Statement of Financial Position or the owner's capital figure at the relevant date.
• A calculator and a basic grasp of percentages, that is divide first and then multiply by 100.
• An understanding of the difference between gross profit and net profit so the correct figure enters each formula.

Step by step

1. 1

   Gather the base figures from the statements

   Refer to the Income Statement of Perniagaan Setia for the year ended 31 December 2024. Note the main figures: Sales RM100,000, Cost of sales RM60,000, Gross profit RM40,000, Total expenses RM25,000 and Net profit RM15,000. From the Statement of Financial Position at the same date, note Capital RM75,000. Every profitability ratio comes from these figures, so double-check them for copying errors before you calculate.

2. 2

   Confirm gross profit and net profit

   Before calculating ratios, confirm the numerators. Gross profit = Sales - Cost of sales = RM100,000 - RM60,000 = RM40,000. Net profit = Gross profit - Total expenses = RM40,000 - RM25,000 = RM15,000. These two figures become the numerators of their respective ratios, so their accuracy determines the accuracy of every percentage calculated afterwards.

3. 3

   Calculate the markup (tokokan)

   Markup compares gross profit with cost of sales. Formula: Markup = (Gross profit / Cost of sales) x 100. For Perniagaan Setia: (RM40,000 / RM60,000) x 100 = 66.67%. This means every RM100 of cost of sales earns RM66.67 of gross profit. Note that the denominator here is cost of sales, not sales.

4. 4

   Calculate the gross profit margin

   Gross profit margin compares gross profit with sales. Formula: Gross profit margin = (Gross profit / Sales) x 100. For Perniagaan Setia: (RM40,000 / RM100,000) x 100 = 40%. This means every RM100 of sales contributes RM40 of gross profit. Contrast this with markup: here the denominator is sales, not cost of sales.

5. 5

   Calculate the net profit margin

   Net profit margin compares net profit (after all expenses) with sales. Formula: Net profit margin = (Net profit / Sales) x 100. For Perniagaan Setia: (RM15,000 / RM100,000) x 100 = 15%. This means every RM100 of sales yields only RM15 of net profit, because the RM25,000 of expenses has reduced the gross profit.

6. 6

   Calculate the return on capital

   Return on capital measures net profit against the capital the owner has invested. Formula: Return on capital = (Net profit / Capital) x 100. For Perniagaan Setia: (RM15,000 / RM75,000) x 100 = 20%. This means every RM100 of capital earns a return of RM20 a year. Make sure you use the capital figure the question asks for, whether opening capital or closing capital.

7. 7

   Cross-check markup against margin

   Markup and gross profit margin are closely related, so use this relationship to check your work: Margin = Markup / (1 + Markup). Test with Perniagaan Setia: 0.6667 / 1.6667 = 0.40 or 40%, matching the gross profit margin calculated earlier. This check confirms the calculation is correct and lets you convert between the two ratios in a question that gives only one of them.

8. 8

   Interpret and compare the ratios

   Compare each ratio with last year or with another business to reach a judgement. A gross profit margin of 40% against a net profit margin of 15% shows that much of the gross profit is absorbed by the RM25,000 of expenses, so the owner might review expense control. A return on capital of 20% is satisfactory if it exceeds the usual return on savings. State the percentage unit (%) and round to two decimal places such as 66.67% in the final answer.

Second example

Take Kedai Harmoni for the year ended 31 December 2024: Sales RM80,000, Cost of sales RM56,000, Gross profit RM24,000, Net profit RM8,000 and Capital RM50,000. Gross profit margin = (RM24,000 / RM80,000) x 100 = 30%; markup = (RM24,000 / RM56,000) x 100 = 42.86%; net profit margin = (RM8,000 / RM80,000) x 100 = 10%; and return on capital = (RM8,000 / RM50,000) x 100 = 16%.

Suppose that in 2023 the gross profit margin of Kedai Harmoni was 35%. The fall to 30% in 2024 signals that cost of sales rose relative to sales, perhaps because purchase prices increased or selling prices were cut. The owner should review purchase costs, pricing policy and expense control, because the net profit margin of 10% and return on capital of 16% are also lower than those of Perniagaan Setia in the main example.

Common mistakes

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