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PROFITABILITY RATIOS
3.1. INTRODUCTION:
Profitability ratios are to measure the operating efficiency of the company.
Besides management, lenders and owners of the company are interested in the
analysis of the profitability of the firm. If profits are adequate, there would be no
difficulty for lenders, normally, to get payment of interest and repayment of principal.
Owners want to get required rate of return on investment.
3.2. TYPES OF PROFITABILITY RATIOS:
Generally, two major types of profitability ratios are calculated:
1. Profitability ratios based on sales
2. Profitability ratios based on investment
Importance: The ratio reflects the efficiency with which a firm produces/sells its
different products.
High gross profit ratio is a sign of good management. Reasons could be:
Net profit includes non-operating income so the later may be deducted to arrive
at profitability arising from operations.
Importance:
Net Profit ratio indicates the overall efficiency of the management in
manufacturing, administering and selling the products. Net profit has a direct
relationship with the return on investment. If net profit is high, with no change in
investment, return on investment would be high. If there is fall in profits, return on
investment would also go down. For a meaningful understanding, both the ratios
gross profit ratio and net profit ratio have to be interpreted together. If gross
margin increases but net margin declines, this indicates operating expenses have
gone up. Further analysis has to be made which operating expense has contributed
to the declining position for control. Reverse situation is also possible with gross
margin declining, and net margin going up. This could be due to increase of cost of
production, without any change in selling price, and operating expenses reducing
more to compensate the change.
3.
to be calculated. While some of the expenses may be increasing and other may be
declining. To know the behaviour of specific items of expenses, the ratio of each
individual operating expense to net sales should be calculated.
Operating expense ratio = Operating expenses X 100
Net sales
Operating expenses includes cost of goods produced/sold, general and
administrative expenses, selling and distributive expenses
The various variants of expenses are:
4.
Importance:
utilized.
It indicates the efficiency of the management of various departments as funds
ROE indicates how well the firm has used the resources of owners.
Earning a satisfactory return is the most desirable objective of a business.
This ratio is of greatest interest to the management as it is their responsibility