In this section we discuss the following financial ratios which involve amounts reported on a company’s income statement:
- Ratio #6 Gross margin (gross profit percentage)
- Ratio #7 Profit margin
- Ratio #8 Earnings per share
- Ratio #9 Times interest earned (interest coverage ratio)
These ratios, which are often based on transactions that occurred during the previous year, are most meaningful when they are compared to:
- The company’s own ratios from another year
- The company’s targeted or planned ratios
- The ratios of other companies in the same industry during the same accounting period
- Averages for the industry in which the company operates
Ratio #6 Gross Margin (Gross Profit Percentage)
In the context of financial ratios, the term gross margin is the percentage of net sales remaining after subtracting the cost of goods sold. In this context, gross margin means the same as the gross profit as a percentage of net sales.
NOTE:
Net sales = gross sales – sales discounts – sales returns – sales allowances
You should also be aware that some people will use the term gross margin to mean the dollars of gross profit.
Example 6
Last year, XYZ Corporation had net sales of $8,000,000 and its cost of goods sold was $6,000,000. As a result, XYZ’s gross profit was $2,000,000. In the context of financial ratios, the gross margin is a percentage of net sales as shown in this formula:
Gross margin = gross profit / net sales
Gross margin = $2,000,000 / $8,000,000
Gross margin = 0.25 or 25%
Generally, net sales and the cost of goods sold are the two largest amounts on the income statements of companies that sell goods. Accordingly, a company’s gross margin (as a percentage of net sales) is monitored closely by financial analysts who want to see if the company was able to increase selling prices when the company experienced increased costs, or if the company was able to maintain its gross margin when faced with increased competition.
Even when comparing a company’s gross margin to other companies in the same industry, some differences can be the result of how accounting principles are applied. For instance, some U.S. companies use the last-in, first-out (LIFO) method for assigning actual costs to inventory and to the cost of goods sold. Other companies in the same industry may be using the first-in, first-out (FIFO) method. During periods of inflation (or deflation), this will result in a difference in the companies’ gross margins. (You can learn more about this in our topic Inventory and Cost of Goods Sold.)
Gross margins (as a percent of net sales) can also vary within the same industry due to marketing strategies. For example, one retailer may sell goods at their full selling prices and provide extensive customer service. Its gross margins will be higher than another retailer who sells goods at discounted prices and provides a minimum of customer service. (However, the retailer providing the extensive customer service will likely experience higher selling expenses that offset some of its larger gross margins.)
Ratio #7 Profit Margin
A company’s profit margin (as opposed to gross margin) is the percentage of net sales remaining after all expenses are subtracted from net sales. Expenses that are subtracted from net sales include the following:
- Cost of goods sold
- Interest expense
- Income tax expense (perhaps)
A company’s profit margin can be calculated before income tax expense, and/or after income tax expense as shown in these formulas:
Profit margin before tax = net income before tax / net sales
Profit margin after tax = net income after tax / net sales
Example 7
Assume that XYZ is a regular corporation which had $8,000,000 of net sales (gross sales minus sales discounts, returns and allowances). Its expenses were: cost of goods sold of $6,000,000; SG&A expenses of $1,250,000; interest expense of $30,000; and income tax expense of $160,000.
XYZ’s profit margin before tax is calculated as follows:
Profit margin before tax = net income before tax / net sales
Profit margin before tax = [$8,000,000 – ($6,000,000 + $1,250,000 + $30,000) / $8,000,000]
Profit margin before tax = ($8,000,000 – $7,280,000) / $8,000,000
Profit margin before tax = $720,000 / $8,000,000
Profit margin before tax = 9%
XYZ’s profit margin after tax is calculated as follows:
Profit margin after tax = net income after tax / net sales
Profit margin after tax = [$8,000,000 – ($6,000,000 + $1,250,000 + $30,000 + $160,000) / $8,000,000]
Profit margin after tax = ($8,000,000 – $7,440,000) / $8,000,000
Profit margin after tax = $560,000 / $8,000,000
Profit margin after tax = 7%
Whether the corporation’s 9% pretax profit margin or its 7% after-tax profit margin is good depends on several factors, including:
- The profit margins in its industry
- The corporation’s profit margins that were attained in prior years
- The corporation’s planned profit margins (perhaps the goal was to improve each by a minimum of one percentage point) for the current year
NOTE:
Included in the salaries and fringe benefits expenses on a regular corporation’s income statement is the compensation earned by stockholders who work in the corporation. This is different from a sole proprietorship or partnership income statement where owners do not receive salaries and other compensation. (Instead they get draws, which are not listed as an expense.) Therefore, the profit margin of sole proprietorship or partnership cannot be directly compared to that of a regular corporation.
When comparing companies’ profit margins, there can be a difference in the reporting of income tax expense. The income statement of a regular corporation includes the corporation’s income tax expense. On the other hand, the income statement of a sole proprietorship or partnership does not report income tax expense. (The reason is that the income tax for the sole proprietorship or partnership is reported on the owners’ personal income tax returns.)
In summary, the regular corporation’s income statement will have two expenses that do not appear on the income statement of a sole proprietorship or partnership:
- Salaries and fringe benefits expense for the owners
- Income tax expense
Ratio #8 Earnings Per Share
Corporations with only common stock outstanding
If a corporation’s common stock is publicly traded, the corporation must also report its net income after tax as earnings per share (EPS) on the face of its income statement.
If a corporation has only common stock (no preferred stock, no securities convertible into common stock) and the corporation had the same number of shares of common stock outstanding throughout the entire accounting year, the calculation of the earnings per share is simple:
Earnings per share = net income after tax / number of shares of common stock outstanding
Example 8A
Assume that XYZ is a corporation with common stock that is publicly traded. If XYZ’s net income after tax was $560,000 and it had 100,000 shares of common stock outstanding throughout the entire year, XYZ’s earnings per share is calculated as follows:
Earnings per share = net income after tax / number of shares of common stock outstanding
Earnings per share = $560,000 /100,000 shares
Earnings per share = $5.60
Corporations with both common stock and preferred stock outstanding
If a corporation has common and preferred stock and no change in the number of common shares outstanding during the entire year, the EPS calculation requires two steps:
- Earnings available for common stock = net income after tax – required dividend on the preferred stock
- Earnings per share = earnings available for common stock / number of shares of common stock outstanding
Example 8B
Assume that XYZ is a corporation with 100,000 shares of common stock that is outstanding and publicly traded. In addition, XYZ has 1,000 shares of preferred stock which requires an annual dividend of $40,000. (The dividends on common and preferred stock are not expenses of the corporation.) Assuming that XYZ’s net income after tax was $560,000 and it had 100,000 shares of common stock outstanding throughout the entire year, its earnings per share is calculated as follows:
Earnings available for common stock = net income after tax – required dividend on preferred stock
Earnings available for common stock = $560,000 – $40,000
Earnings available for common stock = $520,000Earnings per share = earnings available for common stock / number of shares of common stock outstanding
Earnings per share = $520,000 / 100,000 shares
Earnings per share = $5.20
The calculations of earnings per share will be more complicated when any of the following have occurred:
- Additional shares of common stock were issued during the year
- The corporation purchased some of its shares of common stock during the year
- There are securities or financial instruments that are convertible into the corporation’s common stock
NOTE:
Sometimes a corporation uses its cash to purchase shares of its own common stock. If the shares are not retired, the shares are known as treasury stock.
Whenever a corporation purchases shares of its common stock, the number of outstanding shares of common stock will decrease. Hence, the corporation’s net income after tax will be divided by a smaller number of outstanding shares of common stock. This will cause the corporation’s earnings per share (EPS) to increase. This in turn often causes an increase in the market value of each share of common stock.
The purchase of its own common stock may be an attractive option for a corporation with no lucrative investments available and its stockholders do not want to receive taxable dividends. However, purchasing shares of its own stock does reduce the corporation’s cash available to meet future obligations including unforeseen problems. In terms of financial ratios, this use of cash will decrease the corporation’s working capital, current ratio, and quick ratio.
Whether a corporation’s earnings per share (EPS) amount is good depends on many factors including the corporation’s goals, the corporation’s rate of growth in the EPS amount, the competitors’ rate of growth in their EPS, stock market’s expectation of the corporation’s EPS, and more.
Ratio #9 Times Interest Earned (Interest Coverage Ratio)
Times interest earned, which is also known as the interest coverage ratio, is an indicator of a corporation’s ability to pay the interest on its debt, such as loans payable and bonds payable.
The times interest earned ratio is calculated by dividing a corporation’s net income before income taxes and before interest expense for a recent year by the interest expense for the same year. The formula for the interest coverage ratio is:
Times interest earned = net income before interest and income tax expense / interest expense
Example #9
Assume that XYZ Corporation had net income after income tax (commonly referred to as earnings) of $560,000. Also assume that the income statement had reported interest expense of $30,000 and income tax expense of $160,000. From this information, we need to determine the net income before tax and before interest expense. This can be done by adding the interest expense and income tax expense to the net income after tax. The calculation of the times interest earned ratio is:
Times interest earned = net income before interest and income tax expenses / interest expense
Times interest earned = ($560,000 net income after tax + $30,000 + 160,000) / $30,000
Times interest earned = $750,000 / $30,000
Times interest earned = 25 times
A high times interest earned ratio gives the lender comfort that the borrower will be able to make the interest payments when they are due.
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