Profitability Ratios

Profitability Ratios is an accounting ratio measuring the profitability of the business. And Efficiency is measured by profitability.

Further, different ratios are determined using accounting information collected from the financial statements.

Profitability ratio shows the final result of the company. In addition it is used to judge company’s performance, to generate income as compared to its expenses .

Importance of profitability ratios

Profitability ratio shows the final result of the company. And also represents how profitable owners fund have been utilized in the company.

Types of profitability ratios

There are various types of profitability ratios are as follows:

1. Gross profit ratio
2. Net profit ratio
3. Operating profit ratio
4. Operating ratio
5. ROI/ROCE ratio

1.Gross profit ratio

Gross profit ratio establishes the relationship of gross profit and revenue from operations i.e. Net sales of an enterprise. This ratio measures the marginal profit of the company.

Gross profit ratio = Gross profit ratio/Revenue from operation(i.e. net sales)x100

Whereas Gross profit= Sales+ closing stock-opening stock – purchases-direct expenses

2.Net profit ratio

Net profit profit ratio establishes the relationship of net profit and revenue from operations i.e. Net sales of an enterprise. It shows the percentage of net profit earned on revenue from operation. Further, this ratio measures the overall profitability of the company considering all direct as well as indirect cost.

Net profit ratio = Net profit/Net salesx100

Whereas, Net profit = Gross profit+ indirect incomes-indirect expenses

In addition to above, net profit ratio is an indicator of overall efficiency of the business . Higher the net profit ratio , better the business.

3.Operating profit ratio

Operating profit ratio establishes the relationship between operating profit and revenue from operations i.e. Net sales . It is used to determine the operational efficiency of the business.

Operating profit ratio = Operating profit/Net salesx100

Operating profit = Gross profit+ operating income- operating expenses

4. Operating ratio

This ratio establishes the relationship between operating costs and revenue from operations i.e. Net sales.

Operating costs are those cost which are associated with the operating activities of the business. It shows the proportion of cost of revenue from operations or cost of goods sold and operating expenses to revenue from operations i.e. net sales.

Operating Costs- COGS + Operating expenses

Operating ratio = cost of revenue from operations+ Operating expenses/net sales x 100

or

Operating costs/net sales x 100

This ratio is used to assess the operational efficiency of the business. It shows the percentage of revenue from operation i.e. net sales that is absorbed by the cost of goods sold or cost of revenue from operations and operating expenses. Further, rise in operating ratio indicates decline in efficiency.

Note: Operating profit ratio and Operating ratio are complementary to each other. Thus, if one of two ratio is deducted from 100 , another ratio is obtained.

Operating ratio + Operating profit ratio = 100

5. Return on Investment (ROI)/Return on capital Employed ratio

It shows the relationship of profit (profit before interest and tax) with capital employed. This ratio assess the overall performance of the enterprise. It measures how efficiently the resources of the business are used.

Further, ROI is a fair measure of the profitability of any concern with the result that the performance of different industries may be compared.

The sources i.e. fund used in the business to earn this ( profit or loss) are proprietors (shareholders) fund and loans.

ROI = Net profit before interest, tax and dividend / Capital Employed x 100

How to compute capital employed?

Capital employed is computed following either i) liabilities approach or ii) asset approach.

1) Liabilities Approach : When liability approach is followed , capital employed is computed by adding:

a) Shareholders fund ( Share capital, Reserves and surplus)

b) Non-current liabilities (Long term borrowing and long term provisions)

2) When asset approach is followed, capital employed is computed by adding:

a) Non-Current Asset -Fixed Assets , Non-Current Investments , Long-Term Loans and Advances

b) Working Capital (Current Assets- Current Liabilities)