# Accounting Ratios Notes5

## 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’
##### 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