Accounting Ratios Notes5

Study Material & Notes for the Chapter 11

COMPANY - ACCOUNTING RATIOS

V. PROFITABILITY RATIOS

A.  Meaning
  • These ratios are called profitability ratios because it measure the profitability of a business and helps in assessing the overall efficiency of the business. 
  • Profitability ratios examine the earning capacity and current operating performance of the organization which is the outcome of utilization of resources employed in the business. 
  • These ratios are helpful for the management to take remedial measures if there is a declining trend. Higher turnover ratio means better utilisation of assets and signifies improved efficiency and profitability
  • These ratios are expressed as ‘percentage’
B. Type
1. Gross Profit Ratio
2. Operating Profit Ratio
3. Operating Ratio
4. Net Profit Ratio
5. Return on Investment
C. Gross Profit Ratio
a. Meaning
  • Gross profit ratio as a percentage of revenue from operations is computed to have an idea about gross margin
  • It expresses the relationship of gross profit to revenue from operations (net sales). Gross profit ratio shows the margin of profit.
b. Formula
  • It is computed by dividing Gross Profit by Revenue From Operations
  • Gross Profit Ratio = (Gross Profit/Revenue from Operations) X 100  
  • Gross Profit = Revenue from Operations – Cost of Revenue from Operations
  • Cost of Revenue from Operations = Opening Inventory (excluding Stores and Spares and Loose Tools) + Net Purchases + Direct Expenses – Closing Inventory (excluding Stores and Spares and Loose Tools) 
  • Cost of Revenue from Operations = Cost of Materials Consumed + Purchases of Stock-in-Trade + Changes in Inventories of Finished Goods, WIP and Stock-in-Trade + Direct Expenses.
c. Important Considerations
  • The Gross Profit ratio is expressed in percentage form 
  • It indicates gross margin on products sold.
  • It also indicates the margin available to cover operating expenses, non-operating expenses, etc.
  • Change in gross profit ratio may be due to change in selling price or cost of revenue from operations or a combination of both.
  • A higher ratio is always considered a good sign as it means lower cost of goods sold as well as good returns for the owners. 
  • A low ratio may indicate unfavourable purchase and sales policy.
D. Operating Ratio
a. Meaning
  • Operating Ratio is calculated to assess the operational efficiency of the business. 
  • It establishes relationship between cost of operations and revenue from operation (net sales).
b. Formula
  • It is computed by dividing Operating Cost by Revenue from Operations
  • Operating Ratio = (Operating Cost/Revenue from Operations) X 100  
  • Operating Cost = Cost of Revenue from Operations + Operating Expenses
  • Cost of Revenue from Operations = Opening Inventory (excluding Stores and Spares and Loose Tools) + Net Purchases + Direct Expenses – Closing Inventory (excluding Stores and Spares and Loose Tools) 
  • Operating Expenses = Employees benefit expenses + expenses directly related to business (Office & administrative, selling & distribution, depreciation & amortisation)
c. Important Considerations
  • The Operating ratio is expressed in percentage form 
  • This ratio is calculated to assess the operational efficiency of the business. 
  • A lower operating ratio is considered a healthy sign as it means higher margin, and thus, more profit 
  • It is very useful for inter-firm and intra-firm comparisons
E. Operating Profit Ratio
a. Meaning
  • Operating Profit Ratio is calculated to assess the operating margin. 
  • It establishes relationship between operating profit and revenue from operation (net sales).
b. Formula
  • It is computed by dividing Operating Profit by Revenue from Operations
  • Operating Profit Ratio = (Operating Profit/Revenue from Operations) X 100  
  • Operating Profit = Gross Profit + Operating Income – Operating Expenses
  • Operating Profit = Net Profit before tax + Non-operating Expenses – Non-operating Income 
  • Non-operating Expenses = Interest on Long-term Borrowings + Loss on Sale of Fixed Assets + Loss by theft/fire + Charity/Donation 
  • Non-operating Income = Interest received on investments + Profit on Sale of Fixed Assets + Interest/dividend received + Insurance Claim received
c. Important Considerations
  • The Operating Profit ratio is expressed in percentage form 
  • This ratio is calculated to assess the operational efficiency of the business. 
  • Higher the ratio, the better is the profitability of the business
  • It is very useful for inter-firm and intra-firm comparisons
d. Operating Ratio and Operating Profit Ratio
  • Operating Ratio = Operating Cost / Revenue from Operations 
  • Operating Profit Ratio = Operating Profit / Revenue from Operations
  • Operating Cost + Operating Profit = Revenue from Operations
  • Operating Ratio + Operating Profit Ratio = (Operating Cost / Revenue from Operations) + (Operating Profit / Revenue from Operations)
  • Operating Ratio + Operating Profit Ratio = Operating Cost + Operating Profit / Revenue from Operations
  • Operating Ratio + Operating Profit Ratio = Revenue from Operations / Revenue from Operations
  • Operating ratio and Operating profit ratio are complementary to each other and thus, if one each ratio Is deducted from 100, other ratio is obtained. In the form of formula :
  • Operating Profit Ratio + Operating Ratio = 100
  • Operating Profit Ratio = 100 – Operating Ratio
  • Operating Ratio = 100 – Operating Profit Ratio
F. Net Profit Ratio
a. Meaning
  • Net profit ratio is based on all inclusive concept of profit
  • It relates revenue from operations to net profit after operational as well as non-operational expenses and incomes.
  • Net profit ratio determines overall efficiency of the business.
  • It expresses the relationship of Net profit to Revenue from operations (net sales).
b. Formula
  • It is computed by dividing Profit after Tax by Revenue From Operations
  • Net Profit Ratio = (Profit after Tax / Revenue from Operations) X 100  
  • Profit after Tax = Gross Profit + Operating Income + Non-operating Income – Operating Expenses – Non-operating expenses – Tax
c. Important Considerations
  • The Net Profit ratio is expressed in percentage form 
  • It reflects the overall efficiency of the business, assumes great significance from the point of view of investors.
  • A firm with a high net profit ratio is in an advantageous position to survive in case of rising cost of production and falling selling prices. 
  • Where the net profit ratio is low, the firm will find it difficult to withstand these types of adverse conditions.
G. Return on Investment
a. Meaning
  • This ratio indicates how efficiently the management has utilised the funds employed by owners and lenders. 
  • It assesses the overall performance of the enterprise. It measures, how efficiently the resources entrusted to the business are used.
  • It establishes the relationship between Net profit before interest, tax & dividend to Capital Employed (equity & debts).
b. Formula
  • It is computed by dividing Profit before Interest Tax and Dividend by Capital Employed
  • Return on Investments = (Profit before Interest,  tax and Dividend / Capital Employed) X 100  
  • Capital Employed (Liabilities Approach): Share Capital + Reserves and Surplus + Long-term Borrowings + Long-term Provisions
  • Capital Employed (Assets Approach): Non-Current Assets (Tangible Assets + Intangible Assets) + Non-current Investments + Long-term Loans and Advances) + Working Capital.
c. Important Considerations
  • The Return on Investments ratio is expressed in percentage form 
  • The objective of calculating return on investment is to measure the earning power of the net assets of the business.
  • This ratio is very important from Investors’ point of view in assessing whether their investment in the firm generates a reasonable return or not.
  • The higher the Return on Investments, the more efficient the management is considered to be in using the funds employed.
  • For inter-firm comparison, return on capital employed funds is considered a good measure of profitability

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