Profitability Ratios

Profitability ratios indicate how well the firm is operating its activities in a profitable manner. Owners want a reasonable rate of return on their investment. So, the firm has to generate profits to meet the expectations of shareholders and also for further expansion of the business. The following are the common profitability ratios.

It is the ratio between gross profit and net sales. It is expressed as a percentage.

Gross Profit Ratio =
(Gross Profit / Net sales) x 100

Gross profit = Net sales – Cost of goods sold
(or)
= (Sales + Closing stock) – (Opening stock + Purchases)
Net sales = Total sales – Sales returns
Cost of goods sold = Opening stock + Net purchases + Production expenses – Closing stock
(or)
= Net sales – Gross profit

Example: Net sales are Rs. 50,000 for a firm, and the cost of goods sold is Rs. 20,000. Calculate the gross profit ratio.

Gross Profit Ratio =
(Gross Profit / Net sales) x 100
= (30,000 / 50,000) x 100 = 60%

Gross profit = Net sales – Cost of goods sold = 50,000 – 20,000 = 30,000

It is the ratio between net profit after tax and net sales. It is expressed as a percentage.

Net Profit Ratio =
(Net Profit after tax / Net sales) x 100

Net Profit after Tax = (Operating Profit + Non-operating Income) – (Non-operating Expenses + Taxes)
Operating Profit = (Net Sales – Operating Cost)
Operating Cost = (Cost of goods sold + Operating expenses)
Operating Expenses = (Office and Administration expenses + Sales and Distribution expenses)

It is the ratio between cost of goods sold plus operating expenses and net sales. It is expressed as a percentage of sales.

Operating Ratio =
(Operating cost / Net sales) x 100

Operating Cost = (Cost of goods sold + Operating expenses)
Operating Expenses = (Office and Administration expenses + Sales and Distribution expenses)
Operating Profit Ratio = 100 – Operating Ratio

Example: Calculate operating ratio from the following data.
Net sales: Rs. 50,000
Cost of goods sold: Rs. 20,000
Administration Expenses: Rs. 3,000
Selling and Distribution expenses: Rs. 4,000
Loss on sale of fixed assets: Rs. 3,000
Interest on investment received: Rs. 2,000
Tax: 20%

Operating Ratio =
(Operating cost / Net sales) x 100
= (27,000 / 50,000) x 100 = 54%

Operating cost = (Cost of goods sold + Operating Expenses)
= (20,000 + 3,000 + 4,000) = 27,000

This ratio is also called Return On Capital Employed (ROCE). The firm is interested in assessing the return on capital employed.

Return On Investment =
(PBIT / Net Assets or Capital Employed) x 100

Profit Before Interest and Tax (PBIT) = Gross profit – All expenses and losses + All incomes
Capital employed = Equity share capital + Preference share capital + Reserves + Long-term loans + Debentures – Intangible assets
(or)
= Fixed assets + Current assets – Current liabilities

The equity shareholders are interested in assessing the return on equity capital employed.

Return On Equity =
(PAT – Preference dividend / Equity shareholders’ Funds) x 100

Equity Shareholders’ Funds = Equity Share capital + Reserves and Surpluses

EPS is the relationship between net profit and the number of equity shares outstanding at the end of a given period.

Earnings Per Share =
(PAT – Preference dividend / No. of equity shares)

Example: Given that the number of shares is 10,000 and the net profit after taxes for a given period is Rs. 450,000, the EPS can be calculated as follows:

Earnings Per Share =
(PAT – Preference dividend / No. of equity shares)
= (450,000 – 0) / 10,000 = Rs. 45

Yield means the total return the investor will receive for a given period for the amount of their investment. Dividend yield refers to the percentage return on the price paid for shares. It is calculated as follows:

Dividend Yield Ratio =
(Dividend Per Share / Market Value Per Share) x 100

Example: Given that the current market price of a share is Rs. 300, the face value of the share is Rs. 100, and the percentage of the dividend declared is 20%, the yield is:

Dividend Yield Ratio =
(Dividend Per Share / Market Value Per Share) x 100
= (20 / 300) x 100 = 6.67%

Dividend Per Share = Face value of share * 20/100 = 100 * 20/100 = 20

This is the ratio of the market value of a share and Earnings Per Share.

Price-Earnings Ratio =
(Market Value of Equity Share / Earnings per Share)

Example: Given that the market price of a share is Rs. 340 and EPS is 10, calculate the P/E ratio.

Price-Earnings Ratio =
(Market Value of Equity Share / Earnings per Share)
= 340 / 10 = 34