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Types of Profitability Ratios: 2

Types (With Calculations)
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Read this article to learn about the two types of profitability

ratios.
(a) General Profitability Ratios:
(i) Gross Profit Ratio:

This is the ratio of Gross Profit to Net Sales and expressed as a

percentage. It is also called Turnover Ratio. It reveals the amount
of Gross Profit for each rupee of sale. It is highly significant and
important since the earning capacity of the business can be
ascertained by taking the margin between cost of goods and
sales.

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The higher the ratio, the greater will be the margin, and this is
why it is also called Margin Ratio. Management is always
interested in a high margin in order to cover the operating
expenses and sufficient return on the Proprietor’s Fund. It is very
useful as a test of profitability and management efficiency.

20% to 30% Gross Profit Ratio may be considered normal:

[Net Sales = Gross Sales – Returns Inward – Cash Discount

Allowed]

Interpretation and Significance:

This ratio reveals the efficiency of the firm about the goods
produced. Since gross profit is the difference between selling
price and cost of goods sold—the higher the profit, better will be
the financial performances. There must be adequate amount of
gross profit, otherwise, after deducting operating expenses,
depreciation, other overheads, nothing will remain for declaring
dividend, or Transfer to Reserves etc.

A low gross profit results from the higher amount of cost of

goods sold for defective purchasing procedure of the
management, lowest selling price, over-investment in fixed
assets, etc. Gross Profit Ratio may be compared with other firms
of the same group. If any change is found, the reasons for such
change should be investigated and, accordingly, steps must be
taken to improve the situation.

(ii) Net Profit Ratio:

This is the ratio of Net Profit to Net Sales and is also expressed as
a percentage. It indicates the amount of sales left for
shareholders after all costs and expenses have been met. The
higher the ratio, the greater will be profitability—and the higher
the return to the shareholders. 5% to 10% may be considered the
normal.

It is a very useful tool to control the cost of production as

well as to increase sales:

Interpretation and Significance:

This ratio measures the overall efficiency of the management.

Practically, it measures the firm’s overall profitability. It is the
difference between Gross Profit and operating and non-
operating income minus operating and non-operating expenses
after deduction of tax.

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This ratio is very significant as, if it is found to be very low, many

problems may arise, dividend may not be paid, operating
expenses may not be paid, etc. Moreover, higher profit earning
capacity protects a firm against many financial hindrances (e.g.
adverse economic condition) and, naturally, higher the ratio, the
better will be the profitability.

(iii) Operating Ratio:

This is the ratio of operating expenses or operating cost to sales.

It may be expressed as a percentage and it reveals the amount of
sales required to cover the cost of goods sold plus operating
expenses. The lower the ratio the higher is the profitability and
the better is the management efficiency.

80% to 90% may be considered as normal:

Operating Expenses consist of:

(i) Office and Administrative expenses, and

(ii) Selling and Distribution expenses, and the two components of
this ratio are Operating Expenses and Net Sales.

Interpretation and Significance:

This ratio reveals that 75% of the sales have been utilized for
operating cost and the rest 25% is left for interest, dividend, and
transfer to Reserve, Income Tax etc. The primary purpose of this
ratio is to compare the different cost components in order to
ascertain any change in cost composition, i.e. increase or
decrease and to see which element of cost has increased and
which one decreased.

Moreover, there is no standard or norm about this ratio since it

varies from firm to firm depending on the nature and type of the
firm and its capital structure. For a better performance, a trend
analysis of the ratios for some consecutive years may present
valuable information. If non-operating expenses are considered
by mistake, the same may present wrong information.

(iv) Operating Profit Ratio:

It is a modified version of Net Profit to Sales Ratio. Here, the non-

operating incomes and expenses are to be adjusted (i.e. to be
excluded) with the net profit in order to find out the amount of
operating net profit. It indicates the amount of profit earned for
each rupee of sales after dividing Operating Net Profit by Net
Sales.

It is also expressed as a percentage:

Here, Operating Net Profit = Net Profit – Income from external
securities and others (i.e. non-trading incomes) + Non-operating
expenses (i.e. Interest on Debentures, etc.).

Illustration 1:

X Ltd. presented the following Trading and Profit and Loss

Account for the year ended 31st Dec. 2000:

Compute:

(i) Gross Profit Ratio;

(ii) Net Profit Ratio;

(iii) Operating Ratio;

(iv) Operating Net Profit Ratio.

Solution:
(v) Cash Flow Margin:

This ratio measures the relationship between cash flow from

operating activities and sales, since gross profit or Net profit is
ascertained on the basis of data prepared under accrual basis of
accounting. Many authorities prefer to use cash flow data in
order to avoid the effects of accruals and deferrals system.

We know that a firm requires cash for various modes of

payments. Naturally, earning on the basis of accrual system fails
to provide information relating to cash positions. Thus, cash flow
technique really measures the convertibility of sales into cash.

This ratio is calculated as:

(vi) Margin before Interest and Tax:

This ratio is calculated as:

(vii) Pre-Tax Margin:

This ratio indicates that how much rupee of sales are left after
paying all expenses (including interest but before the payment of
Income-Tax).

This is calculated as:

(viii) Contribution Margin Ratio:

In order to determine the BEP (Break-Even Point) analysis

contribution is very important. Since fixed costs and variable
costs are not separately provided in the Financial Statement, it is
rather very difficult to ascertain contribution directly. Practically,
this ratio supplies the information regarding the relationship
between sales, variable cost and contribution per rupee of sales
against fixed cost and profit.

This ratio is calculated as:

[Contribution = Sales – Variable Cost]

(ix) Expense Ratio:

(a) Fixed Expenses to Total Cost Ratio:

It indicates the idle capacity in the organisation. If this ratio

gradually increases without, however, a corresponding
increase in fixed assets, the matter should be analyzed and
scrutinised carefully:

(b) Material Consumption to Sales Ratio and Wages to Sales

Ratio:

These indicate the percentage of Materials and Wages to Total

Sales.

The higher the ratios, the smaller will be the margin of

profit:

This ratio indicates the relationship between expenses and sales.

This is very significant since some expenses may increase, some
may decrease, and i.e. they are of varying nature. The analyst
can compare the change of each component of expenses to sales
which helps him to take the financial decision after proper
analysis and interpretation. This ratio may be computed in two
ways—sum total of all expenses to net sales, or, each individual
item of expenses to net sales. Naturally, greater the ratio, smaller
will be the margin, and vice versa.

(x) Profit Cover Ratios:

(a) Dividend Coverage Ratio:

(i) Preference Shareholders’ Coverage Ratio:

It indicates the number of times the Preference Dividends are

covered by the Net Profit (i.e., Net Profit after Interest and Tax
but before Equity Dividend). The higher the coverage, the better
will be the financial strength.

It reveals the safety margin available to the Preference

Shareholders:

Pref. Shareholders’ Coverage Ratio:

(ii) Equity Shareholders’ Coverage Ratio:

It indicates the number of times the Equity dividends are

covered by the Net Profit (i.e. Net Profit after Interest, Tax and
Pref. Dividend). The higher the coverage, the better will be the
financial strength and the fairer the return for the shareholder
since maintenance of dividend is assured.

(b) Interest Coverage Ratio:

It indicates the number of times the fixed interest charges

(Debenture Interest, Interest on Loans, etc.) are covered by the
Net Profit (i.e. Net Profit before Interest and Tax). It is calculated
by dividing the Net Profit (before Tax and Interest) by the
amount of fixed interest and charges. The higher the coverage,
the better will be the position of Debenture holders or Loan
Creditors regarding their fixed payment of interest, the greater
will be the profitability, and the better will be the management
efficiency:

(c) Total Coverage Ratio:

It expresses the relationship that exists between the Net Profit

before Interest and Tax on Total Fixed charges (Total Fixed
Charges = Interest on Loan + Pref. Dividend + Repayment of
Capital, etc.). It also indicates the number of times the total fixed
charges are covered by the Net Profit.

Naturally, the higher the coverage, the greater will be the

profitability:

Illustration 2:

From the following particulars submitted by D. Co. Ltd.

compute the following Revenue Statement Ratios:

(a) Dividend Coverage Ratio:

(i) Preference Shareholders’ Coverage Ratio,

(ii) Equity Shareholders’ Coverage Ratio;

(b) Interest Coverage Ratio;

(c) Total Coverage Ratio.

(b) Overall Profitability Ratios:
(i) Return on Capital Employed (ROCE)/Return on Investment
(ROI):
This is the ratio of Net Profit (after Tax) to capital employed. It
shows whether the amount of capital employed has been
effectively used or not. It is an index to the operational efficiency
of the business as well as an indicator of profitability.

Therefore, the higher the ratio, the more efficient use of the
capital employed—the better is the management efficiency and
profitability. Moreover, the capital employed basis provides a
test of profitability related to the sources of long-term funds.

And, needless to mention here, that a proper comparison of this

ratio with similar firms, with the industry average, and over the
time, would provide sufficient insight into how effectively and
efficiently the long-term funds of creditors and owners are used.

The ROCE can be computed in different ways as:

(ii) Return on Equity (ROE):

It is expressed as:

Practically this ratio expresses the return or earnings of an

investor against each rupee of investment.
(iii) Return on Common Equity (ROCE/ROE):

This ratio measures the rate of return to the risk-holders. This

ratio expresses the rate of return to the investors of Equity
Shareholders.

This ratio is calculated as:

(iv) Return on Assets (ROA):

This ratio expresses the rate of return on total assets which are
employed in a firm. It measures the rate of return on assets
which are employed to earn profit.

This ratio is calculated as:

(v) Cash Return on Assets:

Return should be measured as per cash flow from operating

activities as accrual basis of accounting does not supply
information relating to cash generation ability.

This ratio is calculated as:

Illustration 3:

Following is the Profit and Loss Account and the Balance

Sheet of Anindita Ltd.:
(vi) Return on Proprietor’s Fund/Earnings Ratio:
It is the ratio of Net Profit (after tax) to Proprietor’s Fund. It
reveals the rate of the earning capacity of the business. That is
why it is alternatively called Earning Ratio. It also indicates
whether the Proprietor’s Fund has been used properly or not.

The higher the ratio, the greater will be the return for the
owners— and better the profitability:

(vii) Return on Ordinary Shareholders’ Equity (ROE):

This is calculated by dividing the Net Profit (after Tax and Pref.
Dividend) by the Shareholders’ Equity (less Pref. Share Capital).
This ratio is applied for testing profitability.

The higher the ratio, the better is the return for the ordinary
shareholders:

Return on Ordinary

(viii) Net Profit to Fixed Assets Ratio:

This is the ratio of Net Profit to Fixed Assets which indicates

whether or not the fixed assets have been effectively utilised
in the business:

(ix) Net Profit to Total Assets Ratio:

This is the ratio of Net Profit to Total Assets. It also indicates

whether the total assets of the business have been properly used
or not. If not properly used, it proves inefficiency on the part of
the management.

It also helps to measure the profitability of the firm:

(x) Price Earnings Ratio:

It is the ratio which relates to the market price of the shares to

earning per equity share. A high ratio satisfies the investors and
indicates the share prices that are comparatively lower in
relation to recent earning per share.

It is highly significant from the point of view of prospective

investors:

(xi) Earning Price Ratio/Earning Yield:

The yield is expressed in terms of market value per share. This

ratio is calculated by dividing Earning per share by the Market
Price per share.

It is also very useful to prospective investors:

(xii) Earning per Share (EPS):

This is calculated by dividing the net profit (after Tax and Pref.
Dividend) available to the shareholders by the number of
ordinary shares.
It indicates the profit available to the ordinary shareholders
on per share basis:

The ratio should be used carefully as a measure of profitability

since it does not recognize the effect of increase in equity capital
as a result of retention of earnings.

(xiii) Dividend Yield Ratio:

It is calculated by dividing the cash dividend per share by the

market value per share.

It is very important to the new investors:

(xiv) Dividend Pay-Out Ratio/Pay-Out Ratio:

It defines the relationship between the returns belonging to the

ordinary shareholders and the dividend paid to them, or, the
percentage share of Net Profit (after Tax and Pref. Dividend) is
paid to ordinary shareholders as dividend.

It can be calculated as:

(xv) Dividend per Share (DPS):

It is the net distributed profit (Net Profit after Interest and Pref.
Dividend) belonging to the shareholders, divided by the number
of ordinary shares. In other words, it reveals the amount of
dividend paid to the ordinary shareholders on a per share basis.

It cannot be considered as a reliable measure of profitability:

Illustration 4:

Following is the Profit and Loss Account and the Balance

Sheet of Summit Ltd.:

Market price of an Equity Share is Rs. 5.

Ascertain the following Balance Sheet and Revenue

Statement Ratios:
(a) Return on Proprietor’s Fund/Earnings Ratio;

(b) Net Profit to Fixed Assets Ratio;

(c) Net Profit to Total Assets Ratio;

(d) Earnings per Share;

(e) Earning Price/Earning Yield Ratio;

(f) Price-Earnings Ratio;

(g) Dividend per Share;

(h) Dividend Ratio/Dividend Yield Ratio;

(i) Dividend- Payout Ratio.

(xvi) Capital Turnover Ratio:

It is the ratio between Sales or Turnover and Average Capital

Employed
Note:

If the amount of Opening Capital Employed is not given, Closing

Capital Employed should be taken into consideration.

Interpretation and Significance:

Needless to mention here that Capital Turnover Ratio reveals or

measures the efficiency of the firm to utilize the net assets of the
firm while generating sales. Naturally, higher the ratio more will
be the efficiency of the firm. In other words, it may be expressed
as the extent of capital required for each rupee of sale which is a
very important indicator for measuring the relationship between
the two components. Similarly, if the ratio is found to be too high,
this situation is not desirable as it invites over-trading.

At the same time, a low Capital Turnover Ratio reveals under

trading—which is also not desirable since the same indicates that
a part of capital remains idle, i.e. not properly utilized. There is
practically no hard and fast norm of this ratio. But it may be
compared with the industry average.

(xvii) Turnover to Proprietor’s Fund Ratio:

It is the ratio of Turnover or Cost of Goods Sold to Proprietor’s

Fund.

(xviii) Assets to Proprietorship Ratio:

This is the ratio between the Total Assets and Proprietor’s Fund.
(xix) Price-Book Value Ratio:

(xx) Market Price per Share:

An investor, before investing, wants to evaluate the performance

of the firm, taking the information either from external sources
or from the annual reports. Usually, shares are quoted in the
stock exchange with their exchange price. These prices affect the
market. The prices of shares which are reported in dailies are
taken as the evaluation of the outsiders about the firm. No doubt
such prices may be considered dependable since these are
excluded from personal bias—even though the same is not free
from criticism.

Speculators or some brokers always want to manipulate the

price of shares by insider trading. Even then market price is the
best indicator for the evaluation of firm’s performances. In order
to judge the performance of a firm, market price of a share is not
the only source of information in proper way. The other way to
assess is-to compile the internal data which must include the
book-value per share.

(xxi) Book-Value per Share:

It is expressed:

(i) As per Method I:

Practically, Assets backing Method is followed here to find out
the market value of shares.

Illustration 5:

From the following Income Statement of X Ltd. for the year

ended 31.12.2007 and its Balance Sheet as on that date and
other particulars, calculate:

(i) EPS;

(ii) Dividend yield;

(iii) Earning yield;

(iv) P/E ratio; and

(v) P/B ratio:

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