Q. 3. Explain Profitability Ratio with examples

Answer

Profitability Ratio

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

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Example:

Cost of goods sold: $3,00,000
Selling exp.: 40,000
Admn. Exp.: 60,000
Total net sales: 6,00,000

Solution

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

= 66.66%

Comments: Two-third of the sales is consumed by operating cost and the balance is to cover up interest change, income tax, divident 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

Example

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

Solution

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

= 20%

(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.

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Formula:

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 Networth

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.

Example

20,000 equity shares of $10 each: 2,00,000
2,000 10% Preference shares of 100 each: 2,00,000
Total: $4,00,000

Reserved and Surplus

Revenue reserves40,000
Capital reserves30,000
Reserves for emergencies30,0001,00,000
Net profit before tax and interest2,00,000
Interest Charges40,000
Tax rate50%

Calculate Return on shareholder’s investment.

Solution

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: Interest40,000
1,60,000
Less: 50% tax80,000
80,000

Return on shareholder’s investment = Net Profit after Tax x 100 / Shareholder’s investment

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= 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.

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