Profitability Ratio

Profitability refers to the financial performance of the business.

Accounting Ratios that measure profitability are known as Profitability
Ratios. We express these ratios in ‘Percentage’.

Types of Profitability Ratio

Profitability Ratios are of five types. These are:

 Gross Profit Ratio

 Operating Ratio/ operating cost ratio
 Operating Profit Ratio
 Net Profit Ratio
 Return on Investment
Gross Profit Ratio

Gross Profit Ratio establishes the relationship between gross profit and
Revenue from Operations, i.e. Net Sales of an enterprise. Thus,

Gross Profit Ratio = (Gross Profit/Revenue from Operations) x 100

Revenue from operations means revenue earned by the enterprise from

its operating activities. It includes Net Sales and commission, etc., in
the case of non-finance companies and interest earned, dividend, profit
on the sale of securities, etc., in the case of finance companies.

Gross Profit = Revenue from Operations – Cost of Revenue from

Operations
(Cost of operations is also called as Cost of Goods Sold)

Cost of Revenue from Operations = Opening Inventory + Net

Purchases + Direct Expenses – Closing Inventories.

Or

= Revenue from Operations – Gross Profit

Objective:

The main objective of computing Gross Profit Ratio is to determine the

efficiency of the business. We can also compare this ratio with the ratio
of earlier years or with that of other firms to compare and to assess the
efficiency of the business. Therefore, Higher Gross Profit Ratio is better
as it leaves a higher margin to meet operating expenses and the creation
of reserves.

Operating Ratio

It establishes the relationship between operating costs and Revenue

from Operations.

Operating cost includes Cost of Revenue from Operations and

Operating Expenses. These are those costs which are incurred for
operating activities of the business.

Operating Ratio = (Cost of Revenue from Operations + Operating

Expenses/Revenue from Operations) x 100

Or
=(Operating cost/Revenue from Operations) x 100

Operating Expenses = Employees Benefit Expenses + Depreciation

and Amortization Expenses + Other Expenses (Other than Non-
operating Expenses)

Or

= Office Expenses + Selling and Distribution Expenses + Employees

Benefit Expenses + Depreciation and Amortization Expenses.

We should keep in mind that Operating Profit Ratio and Operating

Ratio are complementary to each other and thus if we deduct one of the
two ratios from 100, another ratio will obtain.

Operating Ratio + Operating Profit Ratio = 100

Objective:

The objective of computing Operating Ratio is to assess the operational

efficiency of the business.

Lower Operating Ratio is better because it leaves a higher profit margin

to meet non-operating expenses, to pay the dividend, etc. A rise in the
Operating Ratio indicates a decline in efficiency.

Operating Profit Ratio

Operating Profit Ratio measures the relationship between Operating

Profit and Revenue from Operations, i.e. Net Sales.
We compute Operating Profit Ratio by dividing operating profit by
revenue from operations (Net Sales) and is express in Percentage.

Operating Profit Ratio = (Operating Profit/Revenue from Operations)

x 100

Operating Profit = Gross Profit + Other Operating Income – Other

Operating Expenses

Or,

= Net Profit (Before Tax) + Non-operating Expenses – Non-operating

Incomes

Or,

= Revenue from Operations – Operating Cost

Objective:

The objective of computing Operating Profit Ratio is to determine the

operational efficiency of the business. An increase in the ratio over the
previous period shows improvement in the operational efficiency of the
business enterprise.

Net Profit Ratio

Net Profit Ratio measures the relationship between Net Profit and Net
Sales. It shows the percentage of Net Profit earned on Revenue from
Operations.

Net Profit Ratio = (Net Profit/Net Sales) x 100

Net Profit = Revenue from Operations – Cost of Revenue from
Operations – Operating Expenses – Non-operating Expenses + Non-
operating Incomes – Tax

Objective:

Net Profit Ratio indicates the overall efficiency of the business.

Higher the Net Profit Ratio, better is the business. An increase in the
ratio over the previous year shows improvement in operational
efficiency.

Return on Investment

Return on Investment or Return on Capital Employed shows the

relationship of profit (profit before interest and tax) with capital
employed. The result of operations of a business is either profit or loss.

The funds or sources used in the business to earn profit/loss are

proprietors’ (shareholders’) funds and loans.

Return on Investment = (Net Profit before Interest, Tax and

Dividend/Capital Employed) x 100

We compute Capital Employed by Liabilities Approach or by Assets

Approach. We should keep in mind, whichever approach we will
follow; the amount of capital employed will be the same.

Liabilities Approach:
Capital Employed = Shareholder’ Fund + Non-current Liabilities.

Capital employed= share capital+reserve+retained earnings+long term

loan+debenture & bond capital

(In case, Surplus balance is there in Statement of Profit and Loss, we

will deduct the amount of surplus to calculate the Shareholder’ Fund)

Assets Approach:

Capital Employed = Non-current Assets + Working Capital.

Capital employed= non current asset+(current asset-current liabilities)

Capital employed=(non current asset+ current asset)- current liabilities

Capital employed= total assets- current liabilities

Where,

Non-current Assets = Fixed assets + Non-current Trade Investments +

Long-term Loans and Advances.

Working Capital = Current Assets – Current Liabilities

 1. Cash sales=200000

Credit sales=500000

Sales return = 50000

Opening stock=20000

Closing stock=30000

Purchases=300000

Wage=20000

Carriage on purchases= 10000

Calculate gross profit ratio?

Net sales=(200000+500000)-50000=650000

Gross profit= net sales- cost of goods sold

COGS=opening stock + net purchases+ other direct expenses-closing

stock

=650000-(20000+300000+20000+10000-30000)

=650000-320000

=330000
GP Ratio=(330000/650000)100

=50.76%

2. Total sales=700000

Total purchases=400000

Opening stock=50000

Closing stock=30000

Sales return=10000

Purchase return=5000

Freight=15000

Wage=12000

Import duty=10000

Calculate GP ratio?

Net sales= 690000

Cogs=452000

GP=238000

GP Ratio=(238000/690000)*100
 =34.49%

3. COGS=500000

Office expenses= 100000

Selling charges= 60000

Distribution charges=100000

Net Sales=900000

Find out operating ratio?

Operating cost =500000+100000+60000+100000

=760000

Operating ratio=(760000/900000)*100

=84.44%

4. Opening stock=20000 total purchases=600000

Closing stock=10000 total sales= 1000000

Sales return = 5000 purchase return=6000

Legal fees=6000 audit fees=10000

Pachaging cost=4000 carriage inward-=4000

 Import duty=1000 export duty=2000

Sales man salary= 10000 insurance of godown= 5000

Calculate GP Ratio, operating ratio and operating profit ratio?

5. Net sales= 400000

Cost of goods sold= 300000

Office & administrative expenses=20000

Selling & distribution expenses= 15000

Find out operating profit ratio? Ans=16.25%

6. Opening stock 60000 purchases=275000 closing stock=

75000sales = 400000 wage= 25000 administrative expenses=
45000 selling expenses= 10000 office expenses= 5000non
operating income= 10000 non operating expenses= 15000

Find out GP Ratio, operating ratio, operating profit ratio and net
profit ratio.

GP Ratio=28.75%

Operating ratio=86.25%

Operating profit ratio= 13.75%

Net profit ratio=12.5%