MAHARASHTRA NATIONAL LAW UNIVERSITY

MUMBAI

SEMESTER VIII

CORPORATE FINANCE

TOPIC: PROFITABILITY RATIOS ANALYSIS

FIRST DRAFT

SUBMITTED BY SUBMITTED TO FACULTY OF

Vidit Harsulkar Corporate Finance

2015 021
INTRODUCTION

To be successful and remain in business, both profitability and growth are important and
necessary for a company to survive and remain attractive to investors and analysts.
Profitability is, of course, critical to a company's long term survivability. Profit, for any
company, is the primary goal, and with a company that does not initially have investors or
financing, profit may be the corporation’s only capital. Without sufficient capital or the
financial resources used to sustain and run a company, business failure is imminent. The
bottom line is that no business can survive for a significant amount of time without making a
profit. One of the most frequently used tools of financial ratio analysis is profitability ratios,
which are used to determine the company's bottom line and its return to its investors.
Profitability measures are important to company managers and owners alike. If a small
business has outside investors who have put their own money into the company, the primary
owner certainly has to show profitability to those equity investors. Profitability ratios show a
company's overall efficiency and performance. Profitability ratios are divided into two types:
margins and returns. Ratios that show margins represent the firm's ability to translate sales
dollars into profits at various stages of measurement. Ratios that show returns represent the
firm's ability to measure the overall efficiency of the firm in generating returns for its
shareholders

Meaning of Accounting Ratios Accounting ratios are an important tool of financial

statements analysis. A ratio is a mathematical number calculated as a reference to relationship
of two or more numbers and can be expressed as a fraction, proportion, percentage and a
number of times. When the number is calculated by referring to two accounting numbers
derived from the financial statements, it is termed as accounting ratio. Objectives of Ratio
Analysis Ratio analysis is indispensable part of interpretation of results revealed by the
financial statements. It provides users with crucial financial information and points out the
areas which require investigation. Ratio analysis is a technique which involves regrouping of
data by application of arithmetical relationships, though its interpretation is a complex matter.
It requires a fine understanding of the way and the rules used for preparing financial
statements. Once done effectively, it provides a lot of information which helps the analyst:

1. To know the areas of the business which need more attention

2. To know about the potential areas which can be improved with the effort in the desired
direction
3. To provide a deeper analysis of the profitability, liquidity, solvency and efficiency levels in
the business

4. To provide information for making cross-sectional analysis by comparing the performance

with the best industry standards

5. To provide information derived from financial statements useful for making projections
and estimates for the future.
SCOPE OF THE STUDY

The scope of the study is identified after and during the study is conducted. The main scope
of the study is to check the management of working capital (current assets and current
liabilities) of 2 companies in a sector. The study will look to analyse the liquidity position
and working capital management of a limited sample consisting of only 2 companies. The
study of working capital is based on only one tool i.e. Ratio Analysis. Further the study is
based on last years Annual Reports of the companies taken into consideration. As only One
sector will be studied, the findings could only be generalized to the sector’s firms.

FORMULATION OF PROBLEM

Study of the working capital management is very crucial for all the firms. Unless the
working capital is planned, managed and monitored effectively, company cannot earn
profits and increase its turnover, Also, it helps in removing bottlenecks. This study
aims to bridge the gap and highlights the current status of working capital management of top
2 companies in a sector in India.

METHODOLOGY

The researcher will try to come up a research study which is conclusive in nature as it would
try to give the status of working capital management of companies in India. It will try to
describe whether the companies are maintaining an aggressive or flexible working capital
policy.

TOOLS USED FOR DATA ANALYSES

Ratios:-

1. Gross Profit Ratio Quick Ratio

2. Net Profit Ratio
3. Return on Investment
4. Earnings per Share
5. Operating Ratio
6. Operating Profit Ratio
TYPES OF ACCOUNTING RATIOS

PROFITABILITY RATIOS

Profitability Ratios measure the degree of operating success of a company in an accounting

period. The only reason why investors are interested in a company is that they think they will
earn a reasonable return in the form of capital gain and dividend on their investment. Failure
to earn adequate rate of profit over a period will also drain the company's cash and impair its
liquidity. The profitability of a firm can be measured by its profitability ratios. In other words
Profitability ratios are designed to provide answers to questions like

i. Is the profit of the firm adequate?

ii. What rate of return does it represent?
iii. What is the rate of profit for various divisions and segments of the firm?
iv. What are the earnings per share?
v. What was the amount paid in dividends?

The profitability ratios, also known as performance ratios, assesses the firm`s ability to earn
profits on sales, assets and equity. These are critical to determining the attractiveness of
investing in company shares, and investors use these ratios widely. We will examine five
important profitability ratios namely –

1. Gross profit margin

2. Operating profit margin

3. Net profit margin

4. Return on assets

5. Return on equity.

1. Gross Profit Ratio

Gross Profit is the result of the relationship between prices, sales volume and costs. The gross
margin represents the limit beyond which fall in sales prices are outside the tolerance limit. A
firm should have a reasonable gross margin to ensure adequate coverage of direct expenses
associated with the Business.

2. Net Profit Ratio

Net profit is the excess of revenue after deducting all expenses both direct and indirect
expenses from it. It is an indicator of the overall profitability situation of the business. Ahigh
net profit Ratio is indicative of efficiency of the business.

3. Return on Investment

The strategic aim of a business enterprise is to earn a return on capital. Thus this ratio
measures the rate of return on the capital invested. Return on Investment analysis provides a
strong incentive for optimum utilization of assets in the company in order to ensure
maximum return on the invested capital.

4. Earnings per Share

The basic aim of financial management is to maximize the wealth of the shareholders. This
ratio measures the earning available to each shareholder holding a single share. This ratio is
of primary importance to the shareholders as it is an indicator of how long it will take to get
their money back.

5. Operating Ratio

Operating ratio is a ratio of all the operating expenses to the sales. A comparison of the
operating ratio would indicate whether the cost content is high or low in sales. The major
components of cost are- Material, labour and overheads.

6. Operating Profit Ratio

Operating Profit is the excess of total revenue over all operating expenses of a firm.
Operating Profit is a measure of the operating efficiency of the firm. It is arrived at by
subtracting operating ratio from 100.