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Profitability ratios are the tools for financial analysis which communicate about the final goal of a business. lenders etc. They are quite useful tools to understand the efficiencies / inefficiencies of a business and thereby assist management and owners to take corrective actions. Net Profit ratio c. Operating ratio e. creditors. they are as important as the profits. Gross Profit ratio b. the final goal is none other than the profits. Since the ratios measure the efficiency of operations of a business with the help of profits. Profits are the life blood of any business without which a business cannot remain a going concern. The stakeholders of a business include owners. the profitability ratios deal with the profits.COST & MANAGEMENT ACCOUNTING Explain the following terms: I) Profitability Ratios:Profitability ratios are the financial ratios which talk about the profitability of a business with respect to its sales or investments. however discussed briefly: a. management. Return on capital employed BGIMS Page 2 . The purpose behind calculating the profitability ratios is to measure the operating efficiency of a business and returns which the business generates. The different stakeholders of a business are interested in the profitability ratios for different purposes. A large number of ratios may be used for measuring profitability. The following ratios are. For all the profit oriented businesses. Since. P/V Ratio d. they are called profitability ratios.

Formula for Gross Profit Margin: Gross profit margin= Gross Profit X 100 Net Sales Gross profit = Net sales – Cost of goods sold ILLUSTRATIONS:From the following detail of a business concern ascertain the gross profit ratio: Particulars Sales Gross profit Solution: 2005 Gross profit ratio = Rs 40. the greater is the profitability of the firm. Gross Profit Ratio:This ratio shows the amount of gross profit made out of the total net sales. A high gross profit ratio is a great satisfaction to the management. Higher the rate of gross profit. the ratio should preferably be found out for each product separately. Gross profit ratio shows the margin of profit. other factors remaining constant. the loss arising in one product may be concealed by the high profit made in another.000 =26 67%.000 X 100 Rs 120. The relation between gross profit and sales is expressed in percentage. Otherwise. It represents the low cost of goods sold. The higher the gross profit ratio. lower the cost of goods sold.COST & MANAGEMENT ACCOUNTING a. 2005 120000 40000 2006 160000 60000 BGIMS Page 3 . Where there are several products.

charges and expenses have been deducted. This ratio is a guide to the efficiency or otherwise of operating the firm. The main objective of calculating this ratio is to determine the overall profitability. It indicates sales margin on sales.000 =37.5% b. Net Profit Ratio:This ratio indicates the portion of the sales that is left to the firm after all costs. It is thus. A ratio of net profit to sales is called Net profit ratio. better it is for the business.000 X 100 Rs 160. extremely useful to the firm as it is an indication of cost control and sales promotion. Calculation of net profit ratio: Net profit Ratio = Net profit X 100 Net sales Net sales = Sales – Sales returns BGIMS Page 4 . Net profit ratio determines overall efficiency of the business. Higher the net profit ratio. It indicates the extent to which management has been effective in reducing the operational expenses.COST & MANAGEMENT ACCOUNTING 2006 Gross profit ratio = Rs 60. This is expressed as a percentage.

000 Net profit ratio = Rs 45.000 Rs 640.000 = 7.000 – Rs 40.000 Rs 40.COST & MANAGEMENT ACCOUNTING ILLUSTRATION: Calculate Net profit ratio from the following: Net profit Sales Sales Return SOLUTION: Net profit Ratio = Net profit X 100 Net sales Net sales = Sales – Sales returns = Rs 640.000 X 100 Rs 600.000 = Rs 600.000 Rs 45.5% BGIMS Page 5 .

000 25.COST & MANAGEMENT ACCOUNTING c.000 35.20. It helps in examining the overall efficiency of the business.000 BGIMS Page 6 . This ratio is also helpful in controlling cash.00.000 1. It measures profitability and soundness of the business. It reveals only overall efficiency. This ratio is expressed as a percentage.000 9. the better is the profitability of the business. Operating Ratio:This is the ratio of the cost of goods sold plus the operating expenses to net sales.000 15. CALCULATION OF RATIO: Operating profit = Operating profit X 100 Net sales Operating Profit = Gross Profit – (Administration expenses + selling expenses) ILLUSTRATION: Calculate operating profit ratio from the following data: Sales Gross profit Administration expenses Selling and distribution expenses Income on investment Loss by fire 3. It establishes relationship between operating profit and net sales. Higher the ratio. Operating profit is an indicator of operational efficiencies.

000) = 1.000 = 20% Note: Operating profit = Gross profit – (Administration expenses + Selling expenses) = 1.000 – 60.000 BGIMS Page 7 .000 + 25. 20.000 = 60. 00.COST & MANAGEMENT ACCOUNTING SOLUTION: Operating profit = Operating profit X 100 Net sales =Rs60. 000 X 100 Rs 3.000 – (35. 20.

tax and dividend should be added back to calculate the net profit before interest. selling and distribution expenses Rs 5000. Return on investment ratio (ROI):ROI is the basic profitability ratio. Interest on longterm debt Rs 7500 tax Rs 8750. the amount of interest. tax and dividend.COST & MANAGEMENT ACCOUNTING d. BGIMS Page 8 . office and administrative expenses Rs 2500. It is expressed as a percentage on investment.000. The term investment here refers to long-term funds invested in business. tax and dividend) and capital employed. tax and dividend is given. Gross profit Rs 32. There were no long term investments.500. ILLUSTRATION: From the following data. Where Capital employed = Equity share capital + preference share capital+ Reserve and surplus + long term liabilities– fictitious assets – Non trading investment Or Capital employed = (Fixed asset – depreciation) + (Current Asset– Current liabilities) Or Capital employed = (Fixed Assets – Depreciation) + (Working capital) This ratio is also known as Return on capital employed ratio.000 current assets Rs 50.000. tax and dividend X 100 Capital employed Note: If net profit after interest. it tells what is the earning capacity of the net assets of the business. Higher the ratio the more efficient is the management and utilization of capital employed. Significance: ROI ratio judges the overall performance of the concern. It is calculated as under ROI = Net profit before interest. It measures how efficiently the sources of the business are being used. This ratio establishes relationship between net profit (before interest. This investment is called capital employed. calculate the return on capital employed: Net fixed assets Rs 100. In other words. current liabilities Rs 25.

500 – Rs 2500 – Rs 5000 = Rs 25000 Capital employed = Net fixed Assets + Current Assets – Current liabilities = Rs 100.000 = 20% BGIMS Page 9 .COST & MANAGEMENT ACCOUNTING Solution: Calculation of return on capital employed: Net profit before interest = Gross profit – office and Administrative and tax expenses – selling and distribution expenses = Rs 32.000 Return on capital employed = Net profit before interest and tax X 100 Capital employed =Rs 25.000 – 25.000 X 100 Rs 125.000 + 50. 25.000 = 1.

then it is known as profit/volume ratio (or P/V ratio). & BGIMS Page 10 . Sound ‘financial health’ of a company’s product is indicated by better P/V ratio. The net profit ratio shows the earnings left for the shareholders as a percentage of net sales. The profit-volume ratio is very useful especially when the business is dealing with a range of products and break even has to be found out for each product to decide upon the selling price and a most suitable product mix. The change in profit due to change in volume is reflected by this is reflected by this ratio. P/V ratio can be referred by other terms like: (a) Marginal income ratio.COST & MANAGEMENT ACCOUNTING e. When the contribution from sales is expressed as a sales value percentage. administration. It measures the overall efficiency of production. it becomes particularly useful. then P/V ratio of 60% will mean that contribution is $ 60. The gross profit ratio shows the margin left after meeting the manufacturing costs and it measures the efficiency of production as well as pricing. financing. One important characteristic of P/V ratio is that at all levels of output it will remain constant because at various levels. variable cost as a proportion of sales remains constant. Profit-Volume ratio:Profit volume ratio is the relation between contribution and sales expressed as a percentage indicating the intrinsic strength of a product which denotes as to what is the contribution from sales revenue of each rupee. it will show how large the contribution will appear. If size of sales is $ 100. The gross profit ratio and the net profit ratio provide a valuable understanding of the cost and profit structure of the firm and enable the financial analyst to identify the sources of business efficiency/inefficiency. The relationship between the contribution & sales is expressed by it. When P/V ratio is considered in conjunction with margin of safety. (b) Contribution to sales ratio. If expressed on equal footing with sales. This ratio is different from gross profit ratio and net profit ratio. pricing and tax management. selling.

Variable cost Sales Or. P/V ratio = Fixed Cost + Profit Sales Return on assets (ROA):This ratio measures the profitability of the total funds of a firm. Return on assets = net profit after taxes plus interest x 100 Total assets BGIMS Page 11 . It measures the relationship between net profits and total assets. P/V ratio may be expressed as: P/V ratio= Contribution Sales = Sales – Variable cost Sales = 1. The objective is to find out how efficiently the total assets have been used by the management.COST & MANAGEMENT ACCOUNTING (c) Variable profit ratio.

COST & MANAGEMENT ACCOUNTING Total assets exclude fictitious assets. Shareholders fall into two groups i. Return on capital employed = Net profit after taxes plus interest x 100 Capital employed CAPITAL EMPLOYED denotes shareholders’ funds and long-term borrowings. Return on shareholders equity:This ratio measures the relationship of profits to owner’s funds. To have a fair representation of the capital employed. average total assets may be used as the denominator.e. It indicates how efficiently the long-term funds of owners and creditors are being used. So the variants of return on shareholders equity are Return on total shareholder’s equity = Net profits after taxes x 100 Total shareholders’ equity . BGIMS Page 12 . Return on capital employed (ROCE):This ratio measures the relationship between net profit and capital employed. average capital employed may be used as the denominator. As the total assets at the beginning of the year and end of the year may not be the same. preference shareholders and equity shareholders.

This ratio is calculated by dividing net profit available to equity shareholders by the number of equity shares.COST & MANAGEMENT ACCOUNTING  TOTAL SHAREHOLDER’S EQUITY includes preference share capital plus equity share capital plus reserves and surplus less accumulated losses and fictitious assets. Earnings per share = net profit after tax – preference dividend Number of equity shares BGIMS Page 13 . To have a fair representation of the total shareholders funds. Earnings per share (EPS)”This ratio measures the profit available to the equity shareholders on a per share basis. average total shareholders funds may be used as the denominator Return on ordinary shareholders equity = net profit after taxes – pref. dividend x 100 Ordinary shareholders equity or net worth ORDINARY SHAREHOLDERS EQUITY OR NET WORTH includes equity share capital plus reserves and surplus minus fictitious assets.

This is a better indicator than the EPS as it shows the amount of dividend received by the ordinary shareholders.COST & MANAGEMENT ACCOUNTING Dividend per share (DPS):This ratio shows the dividend paid to the shareholder on a per share basis. Dividend pay out ratio = total dividend paid to ordinary shareholders x 100 Net profit after tax –preference dividend OR Dividend pay out ratio = Dividend per share x 100 Earnings per share BGIMS Page 14 . while EPS merely shows theoretically how much belongs to the ordinary shareholders Dividend per share = Dividend paid to ordinary shareholders Number of equity shares Dividend payout ratio (D/P):This ratio measures the relationship between the earnings belonging to the ordinary shareholders and the dividend paid to them.

do not indicate a critical problem. This may also indicate problems in working capital management. then the company may not be efficiently using its current assets or its short-term financing facilities. if inventory turns over much more rapidly than the accounts payable become due. This can allow a firm to operate with a low current ratio. then the company may have problems meeting its short-term obligations. If an organization has good long-term prospects. Low values. It is expressed as follows: The current ratio is an indication of a firm's market liquidity and ability to meet creditor's demands. it may be able to borrow against those prospects to meet current obligations. however. sets include those BGIMS Page 15 . Some types of businesses usually operate with a current ratio less than one. Low values for the current or quick ratios (values less than 1) indicate that a firm may have difficulty meeting current obligations. For example. If the current ratio is too high. then the current ratio will be less than one. If a company's current ratio is in this range. Acceptable current ratios vary from industry to industry and are generally between 1.COST & MANAGEMENT ACCOUNTING Price earning ratio (P/E):This ratio is computed by dividing the market price of the shares by the earnings per share.5 and 3 for healthy businesses. then it generally indicates good short-term financial strength. If current liabilities exceed current assets (the current ratio is below 1). It compares a firm's current assets to its current liabilities. Price earning ratio = market price per share Earnings per share CURRENT RATIO The current ratio is a financial ratio that measures whether or not a firm has enough resources to pay its debts over the next 12 months. It measures the expectations of the investors and market appraisal of the performance of the firm.

it may have a very low Quick Ratio and yet be very healthy. but the ratio may also be calculated using market values for both. the better able to meet current obligations using liquid asset) Notice that very often "Acid test" refers to Cash ratio. if the business has negotiated fast payment or cash from customers. Generally. and essential business expenses and Accounts Payable due for immediate payment. the Quick Ratio may look healthy when the business is actually about to run out of cash. if the company's debt and equity are publicly traded. BGIMS Page 16 .COST & MANAGEMENT ACCOUNTING Note that Inventory is excluded from the sum of assets in the Quick Ratio. however this varies widely by industry. or using a combination of book value for debt and market value for equity financially. If a business has large amounts in Accounts Receivable which are due for payment after a long period (say 120 days). the higher the ratio. Closely related to leveraging.e. the greater the company's liquidity (i. the ratio is also known as Risk. Ratios are tests of viability for business entities but do not give a complete picture of the business' health.. The two components are often taken from the firm's balance sheet or statement of financial position (so-called book value). In contrast. Gearing or Leverage. the acid test ratio should be 1:1 or higher. instead of Quick ratio: The debt-to-equity ratio (D/E) is a financial ratio indicating the relative proportion of shareholders' equity and debt used to finance a company's assets. [1] In general. but included in the Current Ratio. and long terms from suppliers.

The combined ratio is calculated by taking the sum of incurred losses and expenses and then dividing them by earned premium.COST & MANAGEMENT ACCOUNTING COMBINED RATIO: A measure of profitability used by an insurance company to indicate how well it is performing in its daily operations. The claims ratio is claims owed as a percentage of revenue earned from premiums. A ratio below 100% indicates that the company is making underwriting profit while a ratio above 100% means that it is paying out more money in claims that it is receiving from premiums. The combined ratio is comprised of the claims ratio and the expense ratio. BGIMS Page 17 . The expense ratio is operating costs as a percentage of revenue earned from premiums.