# Q. 3. Explain Profitability Ratio With Examples Written by True Tamplin, BSc, CEPF®
Updated on August 31, 2021

## Profitability Ratio

The main aim of all business enterprises is to earn profit. Moreover, profit earning is considered essential for business prosperity. The profit is like an engine which drives the business forever. It is also the entire business efficiency. Profits are always measured in terms of sales or investment. These ratios are expressed in terms of percentage and always on sales.
The following important formulae are as under:

### (i) Gross Profit Ratio

It measures the relationship of gross profit to net sales. In general, this percentage is calculated on sales and always on percentage.
G.P Ratio = (Sales – Cost of Goods Sold) x 100 / Net Sales
Net sales = \$3,20,000, Sales return = \$20,000, Cost of goods sold = \$2,00,000
Thus, Net sales = \$3,20,000 – 20,000 = \$3,00,000
G.P. = Net sales – Cost of goods sold
= 3,00,000 – 2,00,000 = \$1,00,000
G.P. Ratio = (G.P. x 100) / Net Sales = (1,00,000 x 100) / 3,00,000
G.P. Ratio = 33.33%

### (ii) Operating Ratio

This ratio is useful in establishing relationship between cost of goods sold and other operating expenses on one hand and sales on the other hand. Here operating cost is divided by net sales. Thus:
Operating ratio = (Operating cost x 100) / Net sales
Operating Cost = (Cost of goods sold + Operating exp.) x 100 / Net sales
Example:
Cost of goods sold: \$3,00,000
Selling exp.: 40,000
Total net sales: 6,00,000

### Solution

Operating Ratio = (Operating Cost x 100) / Net sales
\$3,00,000 + 40,000 + 60,000 = 4,00,000
= 4,00,000 x 100 / 6,00,000
= 66.66%
Comments: Two-third of the sales is consumed by operating cost and the balance is to cover up interest change, income tax, dividend and retention of profits.

### (iii) Operating Profit Ratio

This percentage speaks of how much sales is consumed by operating cost. Higher operating ratio is always
harmful as a small margin is left for interest, income tax, dividend and reserves. It is a test of operating efficiency.
Operating Profit = Net sales – Operating cost or Net sales – Cost of goods sold + Operating cost.
Thus, Net Operating profit = Net Profit + Non-Operating Exp. – Net Operating income – Operating Profit Ratio
= 100 – Operating Ratio

### Example

From the following calculate Operating Profit Ratio when:
Cost of goods sold: \$4,00,000
Selling Exp.: \$50,000
Sales net: \$6,00,000

### Solution

Operating profit ratio = (Operating profit x 100) / Net sales
= 6,00,000 – (4,00,000 + 30,000 + 50,000) = \$1,20,000
Operating profit ratio = 1,20,000 x 100 / 6,00,000
= 20%

### (iv) Expense Ratio

Various expenses show their relationship to total net sales. The lower ratio is an indicator of greater profitability whereas higher the ratio, lower is profitability.

### Formula:

Expense ratio = (Specific expenses x 100) / Net Sales

### (v) Net Profit Ratio

Net profit ratio = (Net profit x 100) / Net Sales
While calculating net profit there are two schools of thought regarding net profit.
(a) Net profit after tax and (b) Net Profit before tax.
This ratio is very useful for the shareholder’s point of view.

### (vi) Return on Shareholders Investment or Net Worth

This ratio is popularly known as ROI ( Return on Investment) and indicates the relationship between net profit after interest and tax And the proprietor’s fund.
Thus ROI = Net Profit (After tax and interest) x 100 / shareholder’s funds
Here Net Profit means: Out of Profit – Interest and income.
Shareholder’s fund means: Equity + Preference share capital, share premium, Retained earnings + surpluses, General Reserves.

### Example

20,000 equity shares of \$10 each: 2,00,000
2,000 10% Preference shares of 100 each: 2,00,000
Total: \$4,00,000
Reserved and Surplus

 Revenue reserves 40,000 Capital reserves 30,000 Reserves for emergencies 30,000 1,00,000 Net profit before tax and interest 2,00,000 Interest Charges 40,000 Tax rate 50%

Calculate Return on shareholder’s investment.

### Solution

Shareholder’s investment
Share Capital \$2,00,000 + 2,00,000 + 1,00,000 = \$5,00,000

 Net profit before interest and tax = 2,00,000 Less: Interest 40,000 1,60,000 Less: 50% tax 80,000 80,000

Return on shareholder’s investment = Net Profit after Tax x 100 / Shareholder’s investment
= 80,000 x 100 / 5,00,000 = 16%
Comment on ROI: The ratio is most useful to measure the profitability of the company. This ratio is useful to shareholders and management of the company. Higher the ratio reveals how efficiently the company has
used shareholder’s fund.