In analyzing a firm’s vertical / horizontal income statement over a four-year period, you observe that the firm’s gross margin percentage has steadily increased. Over the same period, its net income margin percentage has steadily decreased. How would you interpret this?

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Profitability ratios assess a companys ability to earn profits from its sales or operations balance sheet assets or shareholders equity Profitability ratios indicate how efficiently a company generates profit and value for shareholders Higher ratio results are often more favorable but these ratios provide much more information when compared to results of similar companies the companys own historical performance or the industry average For most profitability ratios having a higher value relative to a competitors ratio or relative to the same ratio from a previous period indicates that the company is doing well Profitability ratios are most useful when compared to similar companies the companys own history or average ratios for the companys industry Gross profit margin is one of the most widely used profitability or margin ratios Gross profit is the difference between revenue and the costs of productioncalled cost of goods sold COGS Some industries experience seasonality in their operations For example retailers typically experience significantly higher revenues and earnings during the yearend holiday season Thus it would not be useful to compare a retailers fourthquarter gross profit margin with its firstquarter gross profit margin because they are not directly comparable Comparing a retailers fourthquarter profit margin with its fourthquarter profit margin from the previous year would be far more informative Examples of Profitability Ratios Profitability ratios are one of the most popular metrics used in financial analysis and they generally fall into two categoriesmargin ratios and return ratios Margin ratios give insight from several different angles on a companys ability to turn sales into a profit Return ratios offer several different ways to examine how well a company generates a return for its shareholders Some common examples of profitability ratios are the various measures of profit margin return on assets ROA and return on equity ROE Others include return on invested capital ROIC and return on capital employed ROCE Profit Margin Different profit margins are used to measure a companys profitability at various cost levels of inquiry including gross margin operating margin pretax margin and net profit margin The margins shrink as layers of additional costs are taken into considerationsuch as the COGS operating expenses and taxes Gross margin measures how much a company makes after accounting for COGS Operating margin is the percentage of sales left after covering COGS and operating expenses The pretax margin shows a companys profitability after further accounting for nonoperating expenses The net profit margin is a companys ability to generate earnings after all expenses and taxes Return on Assets ROA Profitability is assessed relative to costs and expenses and analyzed in comparison to assets to see how effective a company is deploying assets to generate sales and profits The use of the term return in the ROA measure customarily refers to net profit or net incomethe value of earnings from sales after all costs expenses and taxes ROA is net income divided by total assets The more assets a company has amassed the more sales and potential profits the company may generate ... View the full answer