Profitability is a measure of efficiency and control. It indicates the efficiency or effectiveness with which the operations of the business are carried on. Poor operational performance may result in poor sales and therefore low profits. Low profitability may be due to lack of control over expenses resulting in low profits.
Profitability ratios are employed by management in order to assess how
efficiently they carry on business operations. Profitability is the main base
for liquidity as well as solvency. Creditors, banks and financial institutions
are interested in profitability ratios since they indicate liquidity or
capacity of the business to meet interest obligations and regular and improved
profits enhance the long term solvency position of the business. Owners are
interested in profitability for they indicate the growth and also the rate of
return on their investments. The importance of measuring profitability has been
stressed by Hingorani, Ramanathan And Grewal in these words: “a
measure of profitability is the overall measure of efficiency”.
An
appraisal of the financial position of any enterprise is incomplete unless its
overall profitability is measured in relation to the sales, assets, capital
employed, net worth and earnings per share. The following ratios are used to
measure the profitability position from various angles:
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Gross
Profit Ratio
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Net
Profit Ratio
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Return On
Capital Employed
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Operating
Ratio
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Operating
Profit Ratio
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Return On
Owners’ Equity
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Earnings
Per Share
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Dividend
Pay Out Ratio
Gross Profit Ratio:
The gross
profit ratio or gross profit margin ratio expresses the relationship of gross
profit on sales / net sales. B.r.rao opines that “gross profit
margin ratio indicates the gross margin of profits on the net sales and from
this margin only, all expenses are met and finally net income emerges”. The
basic components for the computation of this ratio are gross profits and net
sales. `net sales’ means total sales minus sales returns and
`gross profit’ means the difference between net sales and cost of goods sold.
The formula used to compute gross profit ratio is:
Gross
Profit
Gross Profit Ratio =
------------------ X 100
Sales
Gross profit
ratio indicates to what extent the selling prices of goods per unit may be
reduced without incurring losses on operations. A low gross profit ratio will
suggest decline in business which may be due to insufficient sales, higher cost
of production with the existing or reduced selling price or the all-round
inefficient management. A high gross profit ratio is a sign of good and
effective management.
Net Profit Ratio:
Net
profit is a good indicator of the efficiency of a firm. Net profit ratio or net
profit margin ratio is determined by relating net income after taxes to net
sales. Net profit here is the balance of profit and loss account which is
arrived at after considering all non-operating incomes such as interest on
investments, dividends received, etc. And non-operating expenses like loss on
sale of investments, provisions for contingent liabilities, etc. This ratio
indicates net margin earned on a sale of rs.100. The formula for calculating
the ratio is:
Net Profit
Net Profit Ratio = ----------------
X 100
Sales
This ratio is widely used as a
measure of overall profitability and is very useful for proprietors. A higher
ratio indicates better position.
Return On Capital Employed:
The prime
objective of making investments in any business is to obtain satisfactory
return on capital invested. Hence, the return on capital employed is used as a
measure of success of a business in realising this objective. Otherwise known
as return on investments, this is the overall profitability ratio. It indicates
the percentage of return on capital employed in the business and it can be used
to show the efficiency of the business as a whole. The
formula for calculating the ratio is:
Operating
Profit
Return On Capital Employed = --------------------- X 100
Capital
Employed
The term
“capital employed” means [share capital + reserves and surplus + long term
loans] minus [non-business assets + fictitious assets] and the term “operating
profit” means profit before interest and tax. The term `interest’ means
interest on long-term borrowings. Non-trading income should be excluded for the
above purpose. A higher ratio indicates that the funds are invested profitably.
Operating Ratio:
This
ratio establishes the relationship between total operating expenses and sales.
Total operating expenses includes cost of goods sold plus other operating
expenses. A higher ratio indicates that operating expenses are high and the
profit margin is less and therefore lower the ratio, better is the position.
The operating ratio is an index of the efficiency of the conduct of business
operations. An ideal norm for this ratio is between 75% to 85% in a
manufacturing concern. The formula for calculating the operating ratio is thus:
Cost
Of Goods Sold + Operating Experience
Operating Ratio =
----------------------------------------------------- X 100
Sales
Operating
Profit Ratio: this ratio indicates net-margin earned on a sale of rs.100. It is
calculated as follows:
Net Operating Profit
Operating Profit Ratio =
------------------------- X 100
Sales
The
operating profit ratio helps in determining the efficiency with which affairs
of the business are being managed. An increase in the ratio over the previous
period indicates improvement in the operational efficiency of the business
provided the gross profit ratio is constant. Operating profit is estimated
without considering non-operating income such as profit on sale of fixed
assets, interest on investments and non-operating expenses
such as loss on sale of fixed assets. This is thus, an effective tool to
measure the profitability of a business concern.
Return On Owners’ Equity (Or)
Shareholders’ Fund (Or) The Net Worth:
The ratio
of return on owners’ equity is a valuable measure for judging the profitability
of an organisation. This ratio helps the shareholders of a firm to know the
return on investment in terms of profits. Shareholders are always interested in
knowing as to what return they earned on their invested capital since they bear
all the risk, participate in management and are entitled to all the profits
remaining after all outside claims including preference dividend are met in
full. This ratio is computed as a percentage by using the formula:
Net
Profit After Interest And Tax
Return On Owners’ Equity =
------------------------------------------ X 100
Owners’
Equity (Net Worth)
This is
the single most important ratio to judge whether the firm has earned a
satisfactory return for its equity-shareholders or not. A higher ratio
indicates the better utilisation of owners’ fund and higher productivity. A low
ratio may indicate that the business is not very successful because of
inefficient and ineffective management and over investment in assets.
Earnings Per Share (EPS):
The
profitability of a firm from the point of view of the ordinary shareholders is
analysed through the ratio `EPS’. It measures the profit available to the
equity shareholders on a per share basis, i.e. The amount that they can get on every
share held. It is calculated by dividing the profits available to the
shareholders by the number of the outstanding shares. The profits available to
the ordinary shareholders are represented by net profit after taxes and
preference dividend.
Net
Profit After Tax – Preference Dividend
Earnings Per Share =
----------------------------------------------------
This ratio is an important index
because it indicates whether the wealth of each shareholder on a per-share basis
has changed over the period. The performance and prospects of the firm are
affected by eps. If eps increases, there is a possibility that the company may
pay more
dividend or issue bonus shares.
In short, the market price of the share of a firm will be affected by all these
factors.
Dividend Pay Out Ratio:
This
ratio measures the relationship between the earnings belonging to the ordinary
shareholders and the dividend paid to them. In other words, the dividend pay
out ratio shows what percentage share of the net profits after taxes and
preference dividend is paid out as dividend to the equity shareholders. It can
be calculated by dividing the total dividend paid to the owners by the earnings
available to them. The formula for computing this ratio is:
Dividend
Per Equity Share
Dividend Payout Ratio =
-------------------------------
Earnings Per Share
This
ratio is very important from shareholder’s point of view as its tells him that
if a firm has used whole, or substantially the whole of its earnings for paying
dividend and retained nothing for future growth and expansion purposes, then
there will be very dim chances of capital appreciation in the price of shares
of such firms. In other words, an investor who is more interested in capital
appreciation must look for a firm having low payout ratio.