Q. 3. Explain Profitability Ratio With Examples
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
Cost of goods sold: $3,00,000
Selling exp.: 40,000
Admn. Exp.: 60,000
Total net sales: 6,00,000
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
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
From the following calculate Operating Profit Ratio when:
Cost of goods sold: $4,00,000
Admn. Exp.: $30,000
Selling Exp.: $50,000
Sales net: $6,00,000
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
(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.
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.
20,000 equity shares of $10 each: 2,00,000
2,000 10% Preference shares of 100 each: 2,00,000
Reserved and Surplus
|Reserves for emergencies||30,000||1,00,000|
|Net profit before tax and interest||2,00,000|
Calculate Return on 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: 50% tax||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.