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Definition of terms

A shortage is a disparity between the demand for a product or  service and its supply in a market.

Specifically, a shortage occurs when there is excess demand; therefore, it is the opposite of

a shortage.

A shortage occurs whenever quantity demanded is greater than quantity supply at the market

 price. More people are willing and able to buy the good at the current price than what is

currently available. hen a shortage exists, the market is in dise!uilibrium. At e!uilibrium, the

!uantity demanded e!uals the !uantity supplied at the market price.

Background

the !uantity being demanded by the consumers. "his disparity implies that the current market

e!uilibrium at a given price is unfit for the current supply and demand relationship, noting that

the price is set too low. #t could also indicate that the desired good has a low level of affordability

 by the general public, and can be a dangerous societal risk for necessary commodities. #ndeed,

$arrett %ardin emphasi&ed that a shortage of supply could also be perceived as a 'longage' of

demand, as the two are inversely related. (rom this vantage point shortages can be attributed to

 population growth as much as resource scarcity.

)rofitability is the primary goal of all business ventures. ithout profitability the business will

not survive in the long run. So measuring current and past profitability and pro*ecting future profitability is very important.

)rofitability is measured with income and expenses. #ncome is money generated from theactivities of the business. (or example, if crops and livestock are produced and sold, income is

generated. %owever, money coming into the business from activities like borrowing money do

not create income. "his is simply a cash transaction between the business and the lender togenerate cash for operating the business or buying assets.

+xpenses are the cost of resources used up or consumed by the activities of the business. (orexample, seed corn is an expense of a farm business because it is used up in the production

 process. esources such as a machine whose useful life is more than one year is used up over a period of years. epayment of a loan is not an expense, it is merely a cash transfer between the business and the lender.

Proftability Ratio Defnition

A profitability ratio is a measure of profitability, which is a way to measure a company's

 performance. )rofitability is simply the capacity to make a profit, and a profit is what is left over

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from income earned after you have deducted all costs and expenses related to earning the

income. "he formulas you are about to learn can be used to *udge a company's performance and

to compare its performance against other similarly-situated companies.

)rofitability ratios compare income statement accounts and categories to show a company's

ability to generate profits from its operations. )rofitability ratios focus on a company's return on

investment in inventory and other assets. "hese ratios basically show how well companies can

achieve profits from their operations.

#nvestors and creditors continuously evaluate the financial strength and performance of a

company to monitor their investments. "his evaluation fre!uently utili&es financial ratios to

analy&e profitability of a company, and to compare the results with competitors that operate in

the same industry. All profitability ratios focus on the bottom line, but each variation reports it

from a different perspective

$ross Margin

$ross margin ratio is a profitability ratio that compares the gross margin of a business to the net

sales. "his ratio measures how profitable a company sells its inventory or merchandise. #n other

words, the gross profit ratio is essentially the percentage markup on merchandise from its cost.

"his is the pure profit from the sale of inventory that can go to paying operating expenses.

Gross margin tells you about the profitability of your goods and services. #t tells you how much

it costs you to produce the product. #t is calculated by dividing your gross profit $)/ by your net

sales 0S/ and multiplying the !uotient by 1223

• $ross Margin 4 $ross )rofit50et Sales 6 122

o $M 4 $) 5 0S 6 122

$ross margin ratio is a profitability ratio that measures how profitable a company can sell its

inventory. #t only makes sense that higher ratios are more favorable. %igher ratios mean the

company is selling their inventory at a higher profit percentage.

)rofit Margin

"he profit margin ratio, also called the return on sales ratio or gross profit ratio, is a profitability

ratio that measures the amount of net income earned with each dollar of sales generated by

comparing the net income and net sales of a company. #n other words, the profit margin ratio

shows what percentage of sales are left over after all expenses are paid by the business.

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"he profit margin ratio directly measures what percentage of sales is made up of net income. #n

other words, it measures how much profits are produced at a certain level of sales.

"his ratio also indirectly measures how well a company manages its expenses relative to its net

sales. "hat is why companies strive to achieve higher ratios. "hey can do this by either

generating more revenues why keeping expenses constant or keep revenues constant and lower

expenses.

7perating Margin

Operating margin takes into account the costs of producing the product or services that are

unrelated to the direct production of the product or services, such as overhead and administrative

expenses. #t is calculated by dividing your operating profit 7)/ by your net sales 0S/ and

multiplying the !uotient by 1223

• 7perating Margin 4 7perating )rofit 5 0et Sales 6 122

o 7M 4 7) 5 0S 6 122

eturn on Assets

"he return on assets ratio, often called the return on total assets, is a profitability ratio that

measures the net income produced by total assets during a period by comparing net income to the

average total assets. #n other words, the return on assets ratio or 7A measures how efficiently a

company can manage its assets to produce profits during a period.

Return on Assets measures how effectively the company produces income from its assets. 8ou

calculate it by dividing net income 0#/ for the current year by the value of all the company's

assets A/ and multiplying the !uotient by 1223

• eturn on Assets 4 0et #ncome 5 Assets 6 122

o 7A 4 0#5A 6 122

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"he return on assets ratio measures how effectively a company can turn earn a return on its

investment in assets. #n other words, 7A shows how efficiently a company can covert the

money used to purchase assets into net income or profits.Since all assets are either funded by

e!uity or debt, some investors try to disregard the costs of ac!uiring the assets in the return

calculation by adding back interest expense in the formula

eturn on +!uity

eturn on capital employed or 79+ is a profitability ratio that measures how efficiently a

company can generate profits from its capital employed by comparing net operating profit tocapital employed. #n other words, return on capital employed shows investors how many dollars

in profits each dollar of capital employed generates.

Return on equity measures how much a company makes for each dollar that investors put intoit. 8ou calculate it by taking the net income earned 0#/ by the amount of money invested byshareholders S#/ and multiplying the !uotient by 1223

• eturn on +!uity 4 0et #ncome 5 Shareholder #nvestment 6 122

o 7+ 4 0# 5 S# 6 122

"he return on capital employed ratio shows how much profit each dollar of employed capital

generates. 7bviously, a higher ratio would be more favorable because it means that more dollars

of profits are generated by each dollar of capital employed.

NET PRO!T "ARG!N

• "he 0et )rofit Margin ratio shows a company's after tax profit per dollar of sales. Sub-

 par profit margins indicate the firm's selling prices are relatively low or that its expenses

are relatively high, or both. %ere's how the net profit margin is calculated;

 0et )rofit Margin 4 0et income after taxes

Sales

%ow shortage may also affect

Sales

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Sales are an important factor in determining profitability. "he return on sales ratio measures

 profits after taxes based upon the current year's sales. #f sales numbers are high, a company is

 better prepared to handle adverse market conditions and economic downtrends. "he gross profit

margin is a measure of gross profit earned on sales. An effective sales strategy is essential in

increasing a company's profitability.

Pricing

)rice setting is a key factor in determining profit. 9areful analysis is necessary in determining

the correct pricing strategy for a company. A business owner must look at what competitors are

charging and determine what prices he should charge to maximi&e profits. An important factor to

consider in pricing strategy is determining what price customers are willing to pay for a product.

9ustomers will pay more for niche products or services that are not readily available elsewhere.

A business owner does not want to leave money on the table by undercutting the price charged

for products and services.

Expenses

(or a company to become profitable, income must exceed expenses. +xpenses can be defined as

the cost of resources used in the activities of a business. )rofits for the company are determined

 by analy&ing what is left over after expenses are subtracted from total revenue. Any cost-saving

measures initiated by a company will bring expenses down and increase overall profitability.

Cost o Staying in Business

A consideration of a company's overall profitability is the cost of staying in business. eturn on

net worth shows how much profit a company generates on the money e!uity shareholders have

invested. "he return on net worth should at least be e!ual to the rate a business can borrow

money from its creditors to achieve the cost of staying in business. A company that is showing a

 profit but has a low return on net worth still has profitability issues

Pricing

hen a business prices a product, it will need to incorporate how much the product costs to

 produce, the anticipated sales of the product and how much profit that business would like to

make selling the product. 9onsidering these factors allows the business to calculate a reasonable

and realistic price for the product. Additionally, when considering the cost element of the pricing

model, the business should always evaluate overhead costs. 7verhead costs are a type of fixedcost and include costs such as rent of the warehouse space, the price of utilities and interest

 payments on loans.

Sales Volume

"he demand for a product will greatly influence the sales volume of the product. "he basic

 pricing strategy for a product attempts to maximi&e sales volume and profit. "his re!uires the

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 business to find the right price that will allow the product to sell while allowing the business to

ade!uately profit from the sale. :nder a basic pricing strategy, if the sales volume of a product is

too low, the business will generally lower the price point to increase sales. "his will, however,

also result in a reduced profit on the item for the business. #n many cases, lowering the price of a

 product will result in a higher sales volume.

9onclusion

Profitability Ratios #ummary$ 

#n summary, profitability ratios are of great importance to investors since they measure how

effectively management is generating profits from the company's assets and from the owner's

investments. "he most common profitability ratios include; gross profit margin ratio, net profit

margin ratio, return on total assets ratio, and the return on e!uity ratio. "he gross profit margin is

calculated by subtracting the cost of goods sold from the sales and dividing by the sales. "he net

 profit margin is calculated by dividing a company's net income after taxes by its sales. eturn on

"otal Assets is calculated by dividing a company's net income after taxes by its total assets.

eturn on +!uity is calculated by dividing a company's net income after taxes by its total e!uity.