Meaning

Profitability ratios are calculated to judge the earning capacity of the business. Ratios used to judge the profitability of the business are:

1. Gross Profit Ratio.

2. Operating Ratio.

3. Operating Profit Ratio.

4. Net profit Ratio.

5. Return on Investment (ROI) or Return on Capital Employed (ROCE).

6. Return on Net Worth.

7. Earnings per Share.

8. Dividend per share

9. Dividend Payout Ratio.

10. Price Earnings Ratio.

 

1. Gross Profit Ratio

It is computed to have an idea about gross margin.

Gross Profit Ratio = Gross Profit/Revenue from Operations × 100

Gross Profit = Revenue from Operation – Cost of Revenue from Operations

Cost of Revenue from Operation = Opening Inventory (excluding Spare Parts and Loose Tools) + Net Purchases + Direct Expenses – Closing Inventory (excluding Spare Parts and Loose Tools)

or

Revenue from Operation – Gross Profit

Significance:

It indicates gross margin. It also indicates the margin available to cover operating expenses, non-operating expenses, etc.

Change in gross profit ratio may result from change in selling price or cost of sales or a combination of both.

A low ratio may indicate unfavorable purchase and sales policy. Higher ratio is always a good sign.

 

2. Operating Ratio

It is computed to judge cost of operations in relation to sales.

Operating Ratio = [(Cost of Revenue from Operations + Operating Expenses)/ Revenue from Operations] × 100

Cost of Revenue from Operations = Opening Inventory (excluding Spare Parts and Loose Tools) + Net Purchases + Direct Expenses – Closing Inventory (excluding Spare Parts and Loose Tools)

or

Revenue from Operation – Gross Profit

Operating Expenses = Office, Administrative, Selling and Distribution Expenses, Employees Benefit expenses, Depreciation & Amortization

Significance:

It indicates the operational efficiency of the business. As it is a cost ratio, lower ratio is considered better.

 

3. Operating Profit Ratio

It is calculated to reveal operating margin.

Operating Profit Ratio = Operating Profit/ Revenue from Operations × 100

Operating Profit = Net Profit (After Tax) + Non Operating Expenses / Losses – Non Operating Incomes

or

Gross Profit + Operating Income – Operating Expenses

Non Operating Expenses = Interest on Long Term Borrowing + Loss on sale of Fixed or Non Current Assets

Non Operating Income = Interest received on investments + Profit of sale of Fixed Assets or Non-Current Assets

This ratio can also be calculated as under:

Operating Profit Ratio = 100 – Operating Ratio

Significance:

It helps to judge the performance and operational efficiency of the business. It is useful for inter-firm as well as intra-firm comparisons.

 

4. Net Profit Ratio

It expresses the relationship of Net sales to net profit after operating and non-operating expenses and incomes.

Net Profit Ratio = Net Profit before Interest & Tax / Revenue from Operations × 100

Net Profit before Interest & Tax = Gross Profit + Other Incomes – Indirect Expenses

Significance:

It is a measure of net profit margin in relation to sales. It shows the overall efficiency of the business.

 

5. Return on Investment (ROI) or Capital Employed (ROCE)

It explains the overall utilization of funds by a business enterprise.

Return on Investment (or Capital Employed) = Profit before Interest and Tax (PBIT)/ Capital Employed × 100

Net Profit before Interest, Tax and Dividend = Gross Profit + other Income – Indirect Expenses

Capital Employed may be calculated by any of the following two Methods.

(1) Liabilities Approach

Shareholder’s Fund (Share Capital + Reserves & surpluses) + Non-Current liabilities (Long term-borrowing + long term Provisions,

(2) Assets Approach

Non-Current Assets (Tangible Assets + Intangible Assets + Non-Current investment + Long-term Loans & Advances) + Working Capital

Working Capital = Current Assets -Current Liabilities

(It is assumed that all Non-Current Investments are Trade Investments only)

(Interest on Non-Trade Investments should be deducted from Profit before Interest, Tax and Dividend. Therefore it cannot be a part of Non-Current Investments).

Significance:

It shows the efficiency of the business in utilization of funds and is considered a good measure of profitability for inter-firm comparison. It also helps in assessing whether the firm is earning a higher return on capital employed as compared to the interest rate paid.

 

6. Return on Shareholders’ Funds

This ratio expresses the relationship of profit after tax and shareholders’ funds.

Return on Shareholders’ Fund =Profit after Tax/Shareholders’ Funds

Significance:

This ratio is very important from shareholders’ point of view in assessing whether their investment in the firm generates a reasonable return or not. It should be higher than the return on investment otherwise it would imply that company’s funds have not been employed profitably.

 

7. Earnings per Share (EPS)

EPS = Profit available for equity shareholders/ No. of Equity Shares

Profit available for equity shareholders = Profit after Tax –Preference Dividend

Significance:

This ratio is very important from equity shareholders point of view and for the share price in the stock market. This also helps in making comparison with that of other firms to ascertain its reasonableness and capacity to pay dividend.

 

8. Dividend per share (DPS)

DPS=Total Dividend Paid/ No. of Equity shares

 

9. Dividend Payout Ratio

This refers to the proportion of earning that is distributed against the shareholders.

Dividend Payout Ratio =Dividend per Share/ Earnings per Share

Significance:

This reflects company’s dividend policy and growth in owner’s equity.

 

10. Price Earning Ratio

P/E Ratio = Market price of a Share/Earnings per Share

Significance:

It reflects investors’ expectation about the growth in the firm’s earnings and reasonableness of the market price of its shares. P/E ratios vary from industry to industry and company to company in the same industry depending upon investors’ perception of their future.

Precaution: All the ratios should be studied in relation to meaningful combinations only, for better conclusions.

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