Ratio Analysis – Profitability Ratios

Introduction: Profitability Ratios

The capacity of a business concern to earn profit can be termed as profitability. Thus, profit earning can be ascertained on the basis of the volume of profit margin of any activity and is calculated by subtracting costs from the total Revenue accruing to a firm during a particular period. The overall efficiency or performance of a business can be ascertained with the help of profitability ratios. Generally, a large number of ratios can also be put to implementation for determination of the profitability, as the same is in consonance with the sales or investments.

The important profitability ratios are discussed below:

• Gross Profit Ratio
• Operating Ratio
• Operating Profit Ratio
• Net Profit Ratio
• Return on Investment Ratio
• Return on Capital Employed Ratio
• Earning Per Share Ratio
• Dividend Payout Ratio
• Dividend Yield Ratio
• Price Earning Ratio
• Net Profit to Net worth Ratio

1. Gross Profit Ratio

Gross Profit Ratio is the formative component in relationship between gross profit and net sales. Higher

Gross Profit Ratio is a precursor to the business concern that the firm has higher profitability. It is also

reflective of the standard of performance of firm’s business apropos to its effectiveness.

Advantages

• The relationship between gross profit and net sales is adequately ascertained by it
• It reflects the efficiency and productivity of a firm
• This ratio highlights to the management, that a low gross profit ratio can be a precursor to the adverse purchasing and mark-up policies
• A low gross profit ratio also underlines the incapacitated state of the management to increase sales

2. Operating Ratio:

Operating Ratio measures the relationship between total operating expenses and sales. The total operating

expenses is the sum total of cost of goods sold, office and administrative expenses and selling and

distribution expenses. This ratio equips the firm with the ability to cover total operating expenses.

3. Operating Profit Ratio:

It indicates the operational efficiency of the firm and is a measure of the firm’s ability to cover the total

operating expenses.

4. Net Profit Ratio

This ratio tells us the overall efficiency in operating the business. It is used to measure the relationship

between net profit and sales. It includes non-operating incomes and profits.

Advantages

• This is the best yardstick to gauge profitability and liquidity
• It aids in evaluation of overall operational efficiency of the business concern
• It facilitates better decision making ability
• It leverages the process of determination of the managerial efficiency to utilize a firm’s resources to generate income on its invested capital
• Net profit Ratio is an indispensable tool of investment evaluation

5. Return On Investment Ratio

This ratio measures a return on owner’s or shareholders’ investment. It establishes the relationship

between net profit after interest and taxes and the owner investment.

Advantages

• This ratio indicates the owner’s viewpoint pertaining to the success of the business
• It aids in measuring an income on the shareholders’ or proprietor’s investments
• This ratio equips the management with the important decisions making with respect to the business concern
• It facilitates in efficient handling of owner’s investment

6. Return on Capital Employed Ratio

It measures the relationship between profit and capital employed. Return means profits or net profits.

Capital employed means total investment made in the business.

7. Earning Per Ratio

It measures the earning capacity of the firm from the owners view and helps in determining the price of the

equity share in the market.

Advantages

• It measures the price of shares in the market
• It measures the capacity of the firm to pay dividend to its shareholders
• It is used as yardstick to measure the overall performance of the concern

8. Dividend Payout Ratio

It is the relationship between payment of dividend on equity share capital and the profits available

after meeting tax and preference dividend. Indication of the dividend policy, as incorporated by the top

management is underlined by this ratio. It highlights the utilization of divisible profit to pay dividend or

pertaining to the retention of both.

9. Dividend Yield Ratio

It is the relationship is established between dividend per share and market value per share. This ratio is a

major factor that determines the dividend income from the investor point of view.

10. Price Earning Ratio:

It highlights the earning per share reflected by market share. It establishes the relationship between the

market price of an equity share and the earning per equity share. It helps to find out whether the equity

shares of a company are undervalued or not. It is also useful in financial forecasting.

11. Net Profit to Net Worth Ratio:

It measures the profit return on investment. It indicates the established relationship between net profit and

shareholders net worth.

Advantages

• It determines the incentive to owners.
• It measures the profit as well as net worth.
• It indicates the overall performance & effectiveness of the firm.

Profitability is the very essence of any business. What a pulse to a human being, Profitability is to a business.

It is the first vital sign of a business. Hence, Profitability ratios form an important part of financial analysis of

any firm. In our next post we’ll look at

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