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Ratio Analysis- ( Profitability Ratios)
The ratios are based on that technique. The ratios are the relation between the different accounting figures. Analysis of the ratio allows the management and other users of the financial statements in assessing the viability of the Enterprise and its financial status. From this analysis, profitability, solvency, liquidity and business efficiency can be easily determined.
Profitability Ratios
These ratios are measurement of the firm’s profitability in three dimensions namely the sales, investments and on capital employed.
a. Gross profit ratio
The ratio elucidates the relationship in between the gross profi t and the sales volume. It determines the profit earning capacity of the firm out of the manufacturing or trading operations.
Gross Profit Ratio = Gross Profit/ Sales × 100
Remember: Turnover = Sales Gross Profit = Net Sales - Cost of Sales Cost of Sales = Opening Stock + Net Purchases + Other Direct Expenses – Closing Stock
The gross profit margin ratio tells us the profit a business makes on its cost of sales, or cost of goods sold. It is a very simple idea and it tells us how much gross profit per Rs1 of turnover our business is earning. Gross profit is the profit we earn before we take off any administration costs, selling costs and so on. So we should have a much higher gross profit margin than net profit margin.
Example – ABC enterprises has earned a gross profit of ` 4,00,000 in the first quarter. Calculate the gross profit ratio if the corresponding sales amounted to a value of ` 20,00,000. What does it imply?
Gross Profit Ratio = Gross Profit/ Sales × 100
Gross Profit Ratio = 4,00,000/ 20,00,000 × 100
= 20 : 1
b. Net profit ratio
The ratio expresses the relation between the net profit and the amount of the sales. It facilitates the representation of the Enterprise's overall operational effectiveness. The net profit ratio is an indicator of the firm's overall earning capacity in terms of sales volume return.
Net Profit Ratio = Net Profit/ Sales × 100
Example – ABC enterprises has earned a gross profit of Rs. 4,00,000 in the first quarter. Calculate the gross profit ratio if the corresponding sales amounted to a value of Rs. 40,00,000. What does it imply?
Net Profit Ratio = Net Profit/ Sales × 100
Net Profit Ratio = 4,00,000/ 40,00,000 × 100
=1:1
c. Operating Profit Ratio
The operating ratio is establishing the relationship in between the cost of goods sold and operating expenses with the total sales volume.
Operating Ratio = Cost of Goods Sold + Operating expenses/ Net Sales × 100 d. Return on Assets Ratio
This ratio demonstrates the relationship between the profits and the total assets employed in the business. The ratio also highlights the firm's successful use of assets by assessing the return on total assets hired.
Return on Assets = Net profit after taxes/ Average total assets × 100
Example: If Enterprise XYZ has an income of ` 1 crore and total assets of ` 10,00,000, what will be the return on assets if net profi t after taxes is ` 500000?
Return on Assets = Net profit after taxes/ Average total assets × 100
= 5,00,000/1,00,0000 × 100
= 50%
e. Return on Capital Employed
The ratio indicates how much return is received out of the total capital employed in the form of Net profit after taxes. The capital employed is nothing but a blend of the non-current liabilities and the equity of the shareholders. The ratio expresses the relation between the total after- tax earnings and the total capital employed
Return on total capital employed = Net profit after taxes/ Total capital employed × 100
