Profitability Ratios

Profit is the difference between revenues & expenses over a period of time.
Profit is the ultimate output of the company & it will have no future if it fails to
make sufficient profits.
Profitability Ratios reveal the total effect of the business transactions on the
profit position of the enterprise & indicate how far the enterprise has been
successful in its aim.
1) Profit Ratios Related to Sales
2) Profitability in Relation to Investment
1. Profit Ratios Related to Sales
These are the ratios, which are based on the premise that a firm should earn
sufficient profit on each rupee of sales, the difference ratios under this head are:
i. Profit Margin Ratio
Measures the relationship between profit & sales. The ratios under this category
are:
o Gross Profit Ratio
o Net Profit Ratio
ii. Expenses Ratio
Expenses refer to operating expenses of a firm exclusive of financial expenses
like interest, taxes & dividends & extra ordinary losses due to theft of goods, goods
loosed by fire etc. Different expense ratios are
o Operating Expenses Ratio
o Cost of Goods Sold Ratio
o Specific Expenses Ratio
2. Profitability Ratios Related to Investments

This is based on the exim that a firm should earn reasonable

profits on the capital invested. The different ratios under this
category are
o Return on Assets
o Return on Capital Employed
o Return on Share holders Equity Funds
o Return on Equity Capital Ratio
o Earning Per Share
o Dividend Per Share
o Dividend Payout Ratio
o Earnings & Dividend Yield
o Price-Earning Ratio
1. Gross Profit Ratio
This is the relationship between gross profit & sales
Expression:

Gross Profit * 100

Sales

Interpretation
A high Ratio of G/P to sales is a sign of good management,
as it implies that the cost of production of the firm is relatively
low. It may also be indicative of higher sales price without a
corresponding increase in the CGS.
2. Net Profit Ratio
This is the ratio between net profit & sales.
Expression:

Net Profit * 100

Sales
Interpretation
A high Ratio indicates that profitability of the concern is good & vice versa
in adverse cases.

3. Operating Expenses Ratio

This is the ratio of operating expenses to sales.
Expression:

Operating Expenses * 100

Sales

Operating Expenses

CGS + other operating expenses

Interpretation
A low Ratio is an indication of operating efficiency of the
business.
4. Cost of Goods Sold Ratio
This is the ratio of CGS to sales
Expression:

Cost of Gods Sold

Sales

Cost of Goods Sold =Operating Stock+ Purchase Closing Stock.

5. Specified Expenses Ratio
This is the ratio of specified expenses & sales

i. Factory Expenses Ratio =

Factory Expenses * 100

Net Sales
=
Wages, Power etc.

Factory Expenses

ii. Administrative Expenses Ratio = Administrative Expenses

* 100
Net Sales
Administrative

Expenses

Salaries,

Office

Rent,

Printing,

Stationary
iii. Selling & Distribution Expenses Ratio
= Selling & Distribution Expenses * 100
Net Sales
Selling & Distribution Expenses = Advertisement, Cash discounts
allowed,

carriage outward etc

Interpretation
A low expense ratio is an indication of the economy & efficiency of
operations. A high ratio is the indication of inefficiency.

6.Return on Assets
This is the ratio of net profit to total assets
Expression:

Net Profit after Tax * 100

Total Assets

Interpretation:

A return of 10% is considered as ideal ratio. As such, if the actual ratio is

equal or more than 10%, it indicates the higher productivity of the total resources/
assets & vice versa in adverse cases.
7. Return on Capital Employed
This is the ratio of return on capital employed & capital employed
Return on Capital Employed
Total Capital Employed

EBIT/ Net Profit after Tax

=Net Fixed Assets + Trade Investment +

W.C.
Expression:

Net Profit after Tax

* 100

Total Capital Employed

Interpretation
Ideal ratio is about 15%. Actual Ratio equal or more than 15% is the
indication of higher productivity of capital employed & vice versa.
8. Return on Shareholders Equity
This is the ratio of net profit to net worth.
Expression:

Net Profit after Tax (between dividend) * 100

Net worth

Net worth =

share capital + share premium + reserves &

surplus Accumulated loss.

Interpretation:
Ideal ratio is 13%. If actual ratio is equal or more than 13%, it indicates good
return on shareholders fund & vice versa.

9. Return on Equity Capital Ratio

This is the ratio of net profit to equity capital
Expression:
Net Profit available for Equity Share Holders

* 100

Equity Shareholders Fund lonely Equity Capital

Net Profit

Profit after Tax & Dividend

Equity SH Fund = Equity Share Capital + Accumulated Reserves &

Surplus losses & Fictitious Assets
Interpretation:
There is no ideal ratio. The actual net profit to equity capital
ratio is compared with those of others similar concerns & the
productivity of equity capital is determined.
10. Interpreted Earning Per Share
This is the ratio of Net Profit available for Equity
Shareholders i.e., Net Profit after tax & dividend to the no of
Equity Shares or common shares outstanding.
Expression:
100

Profit after Tax & Dividend

No of common shares outstanding

Interpretation

The more the EPS, the better is performance & future

prospectus of the company & vice versa.

11. Dividend Per Share

This is the ratio of earnings paid to share holders to number
common shares outstanding.
Expression:

Earnings paid to Share Holders

Number of Common Shares Outstanding

Interpretation:
A higher ratio attracts investors in shares & vice versa.

12. Dividend Payout Ratio

This is the ratio of Dividend Share to EPS.
Expression:

Dividend Per Share

EPS

Interpretation:
A high ratio indicates high dividends & low retained profits &
vice versa.

13. Earnings & Dividend Yield

i. Dividend Yield =

Dividend Per Share * 100

Market Price of Share

Interpretation:
If the dividend yield of the company is more than the other company, it is an
indication to the investor that it is worth investing on shares of the company & vice
versa.
ii. Price Earning Ratio
This is the ratio of market price per share to earning per share
Expression:

Market Price of Share

EPS

Interpretation:
The higher the price, the better are the chances of appreciation in the market
price of shares.