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CHAPTER - 3

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

3.2.1. PROFITABILITY RATIOS BASED ON SALES


1.
2.
3.
4.

Gross profit margin or ratio


Net profit margin or ratio
Operating expenses Ratio
Operating profit margin

1. Gross Profit Ratio


The first ratio in relation to sales is gross profit ratio or gross margin ratio. The
ratio can be calculated by

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:

High sales price, cost of goods remaining constant

Lower cost of goods sold, sales price remaining constant

A combination of factors in sales price and costs of different products,


widening the margin

An increase in proportion of volume of sales of those products that carry a


higher margin and

Overvaluation of closing stock due to misleading factors.

Reasons for fall in gross profit ratio: Reasons may be:

Purchase of raw materials, at unfavourable rates

Over investment and/ or inefficient utilisation of plant and machinery, resulting


in higher cost of production

Excessive competition, compelling to sell at reduced prices

2. Net Profit Ratio


Net profit is obtained, after deducting operating expenses, interest and taxes
from gross profit. The net profit ratio is calculated by

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.

Operating Expenses Ratios


To identify the cause of fall or rise in net profit, each operating expense ratio is

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.

Operating profit margin/ ratio:


Operating profit margin/ratio establishes the relationship between operating

profit and net sales. It is calculated by

Operating profit/Operating margin = Operating Profit X 100


Net sales
Operating profit is the difference between net sales and total operating expenses.
(Operating profit = Net sales cost of goods sold administrative expenses selling
and distribution expenses.)

3.2.2. PROFITABILITY RATIOS BASED ON INVESTMENT:


Equity shareholders are the owners of the company. Profits belong to the
owners of the firm who have invested their funds, in anticipation of return. If
preference shares exist, then profits, after tax and dividend due to preference
shareholders, are to be considered for calculation of the return to equity
shareholders. It is not important, whether the profits are distributed to the equity
shareholders or left in the firm as retained earnings. The profitability of a firm can be
analyzed from the point of view of owners in different perspectives, as follows:
(A) Return on Investment
(B) Return on Equity

(A) Return on Investment


1. Return on Total Assets:
Total assets is the total amount appearing on the assets side of the balance
sheet. However, in calculating total assets, fictitious assets like preliminary
expenses, accumulated losses and discount on issue of shares are to be excluded.
However, intangible assets like goodwill, patents and trademarks are to be included.
Reason is these intangible assets contribute for the development of sales and
business, while the fictitious assets do not add anything for the growth in business.
When return on investment is calculated on total assets, it is called ROTA.
Total assets are related to operating profit. Operating profit is EBIT, in the absence of
other income. EBIT is arrived at by adding financial charges (interest etc.) and tax to
net operating profit. By this, we are separating financing effect from the operating
effect. The formula is

2. Return on Capital Employed:


Another way to calculate return on investment is through capital employed or
net assets.
Capital employed can be calculated in two ways: Capital Employed = Net Worth +
Long-term Borrowings OR = Net Fixed Assets + Current Assets Current Liabilities
Return on net assets is called RONA. As net assets are equal to capital
employed, the terms RONA and ROCE indicate the same. This ratio indicates the
overall efficiency of business, before tax. The formula for calculation is

Importance:

ROI (ROTA and RONA) measure the overall efficiency of business.


The owners are interested in knowing the profitability of the firm, in relation to
the total assets and amount invested in the firm. A higher percentage of return
on capital employed will satisfy the owners that their funds are profitably

utilized.
It indicates the efficiency of the management of various departments as funds

are kept at its disposal for making investment in assets


Inter-firm comparison would be useful. Both the ratios of a particular firm
should be compared with the industry average or its immediate competitor to
understand the efficiency of the management in managing the assets,
profitably. So, a higher rate of return on capital employed, without comparison,
does not imply that the firm is managed, efficiently. Once a comparison is
made with other firms, having similar characteristics, in the same industry, a
fair conclusion is possible.

(B) Return on Equity


In the real sense, equity shareholders are the real owners of the company.
They assume the risk in the firm. Preference shareholders enjoy fixed rate of
dividend and preference for payment of dividend, before dividend is distributed to
equity shareholders. Similarly, in the event of the liquidation of the company,
preference share capital has to be repaid first, before refunding to equity
shareholders. Net profits after tax, after dividend is paid to preference shareholders,
entirely belong to the equity shareholders. Equity shareholders would be interested
to know what their real return is on the funds invested. This ratio is calculated as:

Equity shareholders funds are equity share capital, accumulated reserves


(both general reserves & capital reserves), share premium and balance in profit &
loss account less accumulated losses, if any. Preference shareholders are not to be
included as the dividend due to them has already been deducted from profits after
tax.
Importance:

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

to maximize the owners welfare.


This ratio is more meaningful to equity shareholders as they are interested to
know their return. Interpretation of this ratio is similar to return on investments.
Higher the ratio, better it is to equity shareholders.

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