Home | ARTS | Accounting For Managers | Analysis Of Profitability - Gross Profit Ratio | Net Profit Ratio | Return On Capital Employed | Operating Ratio | Operating Profit Ratio | Return On Owners’ Equity | Earnings Per Share | Dividend Pay Out Ratio | Gross Profit Ratio

Accounting For Managers - Ratio Analysis

Analysis Of Profitability - Gross Profit Ratio | Net Profit Ratio | Return On Capital Employed | Operating Ratio | Operating Profit Ratio | Return On Owners’ Equity | Earnings Per Share | Dividend Pay Out Ratio | Gross Profit Ratio

   Posted On :  27.01.2018 10:23 pm

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:

ՖՖ   Gross Profit Ratio


ՖՖ   Net Profit Ratio


ՖՖ   Return On Capital Employed


ՖՖ   Operating Ratio


ՖՖ   Operating Profit Ratio


ՖՖ   Return On Owners’ Equity


ՖՖ   Earnings Per Share


ՖՖ   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





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



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





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





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 = ----------------------------------------------------


                              Number Of Equity Shares


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.

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