29 General and Overall Profitability Ratios

Deepika Gautam

LEARNING OBJECTIVES:

The objective of this module is to learn about various profitability ratios, including what they mean, their formulas and examples illustrating them. The formulas can be used to judge a company’s performance and to compare its performance against other similarly-situated companies. Profitability ratios are the financial ratios which talk about the profitability of a business in relation to its sales or investments. The ratios are called profitability ratios because it measures the efficiency of operations of a business with thehelp of profits. These ratios are quite useful tools to understand the efficiencies and inefficiencies of a business which helps the management and owners to take right decisions.

CONCEPT OF PROFITABILITY RATIOS:

The primary objective of any business undertaking is to earn the profit. The organization is considered to be business only if the main motive is to earn profit and profit only because if the main motive is not to earn the profit then that is called non trading organization, the motive of which is to serve the society i.e. Charity. A business needs profit not only to start but also for expansion, promotion and diversification. The investors want an adequate return on their investment; workers want higher wages, creditor want higher security for their interest and loan so on. A business enterprise can discharge its obligations to the various segments of the society only through earning of profits. Profits are thus, a useful measure of overall efficiency of a business. Profits to the management are important as the test of efficiency and a control device; to owners, a measure of worth of their investment; to the creditors, the margin of safety, a source of fringe benefits; to government, a tax measurement tool and the basis of legislative action; to customer a hint to demand for better quality product; to an enterprise, less cumbersome source of finance for growth and existence and finally to the country, profits are an index of economic progress. Profitability ratios are calculated to measure the overall efficiency of the business. Generally, profitability ratios are calculated either in relation to sales or in relation to investment. Profitability ratios are the tools for financial analysis which communicate about the final goal of a business. For all the profit oriented businesses, the final goal is none other than the profits. Profits are the life blood of any business without which a business cannot remain a going concern. Since, the profitability ratios deal with the profits, they are as important as the profits.

Definitions:

1. “Profit is the engine that drives the business enterprise”

Lord Keynes

2. A type of measurement that help to determine the ability of a company to generate earnings in comparison to its costs and expenses over a certain time period. The company with a higher profitability ratio than their competitors is considered to be doing well.

Investor words

A. GENERAL PROFITABILITY RATIOS

The following ratios are considered as general profitability ratios:

(i) Gross Profit Ratio

(ii) Net Profit Ratio

(iii) Operating Ratio

(iv) Operating Profit Ratio

(v) Expenses Ratio

Let us discuss each one in detail:

(i) Gross Profit Ratio: It is usually represented as a percentage and it measure the relationship of gross profit to net sales. It can be calculated by dividing the gross profit by sales.

Gross Profit Ratio= Gross Profit/Net Sales*100 Gross Profit= Sales-Cost of Goods Sold

Cost of Goods Sold= Opening Stock+ Purchases+ Direct Expenses- Closing stock

The two basic component of the gross profit ratio are sales and cost of goods sold since gross profit is simply the excess of net sales over cost of goods sold. Net sales can be calculated by deducting sales return or return inward out of sales.

Ratio of cost of Goods Sold to Sales= 100- Gross Profit Ratio

Interpretation of Gross Profit Ratio:

The Gross Profit ratio indicates the extent to which selling prices of goods per unit may decline without resulting in losses on operations of a firm. It reflects the efficiency of the concern with which it produces its product. Generally it is considered that:

Higher the Gross profit, better the results

As such there is no Rule of Thumb for gross profit ratio and it may vary from business to business but the gross profit should be adequate to cover the operating cost and to provide for fixed cost (The cost which remains fixed irrespective of the level of production). A low gross profit ratio generally indicates high cost of goods sold due to unfavorable purchasing policies, less sales of the product, lower selling prices, excessive competition, and over-investment in fixed assets.

A comparison of gross profit ratio over time or for different firms in the same industry is a good measure of profitability. But any significances change in the ratio should be properly investigated because an increase in the Gross Profit Ratio occurs not only by a change in economic factors like increases in selling prices but also due to certain misleading factors like overvaluation of the closing inventories or undervaluation of the opening inventories, etc, yet the Gross profit ratio is one of the very important ratios for measure profitability of a firm.

Example: Calculate, Gross Profit Ratio:

Total Sales= 6,20,000

Sales Return= 20,000

Cost of Goods Sold= 2,00,000

Solution:

Gross Profit Ratio= Gross Profit/Net Sales* 100

Net Sales= 6,20,000- 20,000= 6,00,000

Gross Profit= Sales- Cost of Goods Sold

Gross Profit= 6,00,000-2,00,000=4,00,000

Gross Profit Ratio= 4,00,000/6,00,000*100= 66.67%

(ii) Net Profit Ratio:

This ratio measures the overall profitability of the firm. It indicates the efficiency of the management in manufacturing, selling, administrative and other activities of the firm. By establishes a relationship between net profit (after taxes) and sales. Net Profit Ratio can be calculated in either of the way depends upon the information available:

(a) Net Profit Ratio (b) Net Profit ratio = Net Profit after tax/Net Sales*100 = Net Operating Profit/Net Sales*100

The two basic elements of this ratio are net profits and sales. The net profits are obtained after deducting all the non-operating expenses, income-tax, non-operating incomes & expenses and from the net profits for calculation. Thus, incomes such as interest on investment outside the business, profit on sale of fixed assets, etc, are also excluded. The ratio is very useful as if the profit is not sufficient, the firm shall not be able to achieve a satisfactory return on its investment (ROI). This ratio also indicates the firm‟s capacity to face adverse economic conditions such as price competition, low demand etc. and guides the management to cope with same.

Higher the Net Profit Ratio, Better the Profitability of the concern.

But while interpreting the ratio, it should be kept in mind that the performance of profits must also be seen in relation to investments or capital of the firm and not in relation to sales.

Example:

Given Net profit=43,200

Sales=4,00,000

Return Inwards=40,000

Calculate Net profit Ratio.

Solution:

Net Profit Ratio = Net Profit/Net Sales*100

Sales= 4,00,000-40,000= 3,60,000

Net Profit Ratio = 43,200/3,60,000*100 = 12%

(iii) Operating Ratio: Operating profit establish the relationship between cost of goods sold and other operating expenses on the one hand and the sales on the other hand. In simple words, it measures the cost of operations sales per rupee. The ratio is calculated by divided operating costs with net sales and it is generally represented as percentage.

Operating Ratio= Operating Cost/Net Sales*100

Operating Cost= Cost of Goods Sold + Operating expenses /Net Sales*100

The two basic component of this ratio are operating cost and net sales. Operating cost can be calculated by adding operating expenses to the cost of goods. Basically operating expenses consist of:

(a) Administrative expenses, office expenses (Salaries, rent, electricity, stationary etc.)

(b) Selling and Distribution expenses (Salesman salary, commission, advertisement, transportation, storage etc.

Interpretation of Operating Ratio:

This ratio indicates the percentage of net sales that is consumed by operating cost. It is a fact that higher, the operating ratio, the less favorable it is, because, it would have a small margin to cover interest, income-tax, dividend and reserves. As such there is no rule of thumb for this ratio as it may differ from firm to firm depending upon the nature of its business and its capital structure. However 75 to 85 percent may be considered to be a good ratio in case of a manufacturing undertaking. To get a better idea of the ratio, either a trend should be found by calculating operating ratio for a number of years or comparison of the firm should be made with another in a similar business or in the same industry.

Example:

Find out operating ratio:

Cost of goods sold =4,40,000

Selling Expenses = 50,000

Office Expenses =10,000

Net Sales

= 5,00,000

Solution:

Operating Ratio = Cost of goods Sold + Operating Expenses/Net Sales * 100

Operating Cost= 3,40,000 + 50,000 +10,000 = 4,00,000

Operating Ratio = 4,00,000/5,00,00 *100 = 80%

The above calculated ratio indicates that 80% of the sales have been consumed by operating cost, i.e., cost of goods sold and operating expenses and only 20% (100-80%) is left to cover interest charge, income tax payment, dividend and retention of profits as reserves.

(iv) Operating Profit Ratio: This ratio is calculated by dividing operating profit by sales. Operating profit is calculated as:

Operating Profit = Net Sales- Operating Cost

Or = Net sales – (Cost of goods sold + Administrative expenses, selling expenses) Or= Operating Profit/Sales * 100

This ratio can also be calculated as: Operating Profit Ratio = 100- Operating Ratio

Example:

Given: Cost of Goods Sold= 40,000

Administrative Expenses = 3,500

Selling Expenses	=4,500
Net Sales	= 1,00,000

Solution:

Operating Profit Ratio = Operating Profit/ Net Sales * 100

Operating Profit = Sales – (Administrative Expenses + Selling Expenses)

Operating Profit = 1,00,000 – (40,000 +3,500 +4,500)

Operating Profit = 100,000-48,000 = 52,000

Operating Profit Ratio = 52,000/1,00,000 *100

=52%

Alternatively:

Operating profit ratio = 100- Operating Ratio

Operating Ratio = 40,000 + 3,500 + 4,500/ 1,00,000 * 100

Operating Ratio = 48,000/1,00,000 *100

Operating Ratio= 48%

Therefore;

Operating profit ratio = 100 – 48 = 52%.

(v) Expenses Ratio: The relationship of various expenses to net sales is indicating by Expenses ratio. The operating ratio reveals the average total variations in expenses. But some of the expenses may be increasing while some may be falling. Hence, expenses ratios are calculated by dividing each item of expenses or groups of expenses with the net sales to analyze the causes of variation of the operating ratio. This ratio can be calculated for each individual item of expenses or a group of a items of a particular type of expenses like cost of sales ratio, administrative expenses ratio, selling expenses ratio, material consumed ratio, etc.

“The lower the ratio, the greater is the profitability and higher the ratio, lower is the profitability”.

While interpreting the ratio, it must be remembered that for a fixed expenses like rent, salaries etc. the ratio will fall if the sales increases and for a variable expenses, the ratio in proportion to sales shall remain nearly the same.

Particular Expense Ratio = Particular Expenses /Net Sales * 100

Specific expense ratio may be calculated as follows:

(a) Cost of Goods Sold ratio = Cost of Goods Sold/ sales *100

(b) Administrative & office Expense Ratio = Administrative & Office Expenses/Sales * 100

(d) Non-Operating Expenses Ratio = Non-Operating Expenses/Sales * 100

Example: From the following extracts calculate these Ratios:

(a) Administrative Expenses Ratio

(b) Selling & distribution Expenses Ratio

Sales =	5,60,000
Gross Profit =	2,01,000
Selling Expenses =	89,000

Administrative Expenses = 20,000

Net profit = 80,000

Solution:

(a) Administrative Expenses Ratio = Administrative Expenses/Net Sales * 100 Administrative Expenses Ratio = 20,000/5,60,000*100 = 3.57%

(b) Selling & distribution Expenses Ratio = Selling & distribution Expenses/Net Sales*100

Selling & distribution Expenses Ratio = 89,000/5,60,000*100 = 15.89%

Cost of Goods Sold = 5,60,000 – 2,01,000 = 3,59,000

(vi) Cash Profit Ratio:

The net profits of a company are also affected by the amount and the method of depreciation adopted by the concern as there are number of methods of charging depreciation like straight line method, written down value method, machine hour method, annuity method etc. and each method has different impact on income statement. Further, depreciation being a non cash expenses, it is being used to calculate cash profit ratio. This ratio measure the relationship between cash generated from operations and the net sale.

Cash Profit Ratio = Cash Profit/ Net Sale * 100

Cash Profit = Net profit + Depreciation.

B. OVERALL PROFITABILITY RATIOS

Profits are the measure of overall efficiency of a business. The higher the profit, the more efficient is the business considered. Changes in total profits may although indicate changes in efficiency but they will not indicate true state of efficiency of the business or profitability unless profits are related with the size of investments. Thus overall profitability or efficiency of a business can be measured in terms of profits related to investments made in the business and further investments, depends upon the goodwill of the concern. (Goodwill is generally considered as a good reputation of the firm) It is generally accepted rule that more the goodwill of a particular concern the larger the size of investment of that concern, so it can be consider that investment size is somehow concerned with the goodwill (directly or indirectly).

Following are the important overall profitability ratios or measure of Return on Investments:

(i) RETURN ON SHAREHOLDER’S INVESTMENT OR NET WORTH:

This ratio is popularly known as ROI or return on shareholder funds. The investors are interested on the return which they will get on their investment. This ratio indicates the relationship between net profits and in this net profit is considered after interest and tax. This ratio is generally calculated as a percentage by multiplying with 100.

Return on Shareholders‟ Investment = Net Profit (after interest and tax)/Shareholders‟

Funds *100

The two main components of this ratio are net profits and shareholders‟ funds. Shareholders‟ funds include equity share capital, preference share capital, free reserves, such as share premium, revenue reserve, capital reserve, retained earnings and less

accumulated losses, if any. Net profit can be visualized from the owners point of view. Shareholders‟ Investment = Equity Share capital + Preference Share Capital + Reserves & surpluses – Accumulated profits

Net profit = Net profit after payment of interest and tax.

Interpretation of ROI:

This ratio is one of the most important ratios used for measuring the overall efficiency of a firm. This ratio indicates how efficiently a firm may able to achieve its primary objective i.e maximum profit with minimum cost. In other words the main objective of any firm is not only to earn maximum profit but the wealth maximization. This ratio is of great importance to the present and prospective shareholders as well as the management of the company. This ratio reveals how well the resources of a firm are being used, higher the ratio, better are the results. The return on shareholders‟ investment should be compared with the return of other similar firms in the same industry because of internal as well as external equity concept. The inter-firm comparison of this ratio determines whether the investments in the firm are attractive or not as the investors would like to invest only where the return is higher. In the same way trend ratios can also be calculated for a number of years to get an idea of the prosperity, growth of deterioration in the company‟s profitability and efficiency.

(ii) RETURN ON EQUITY CAPITAL:

Generally shareholders are the real owners of the company as they have voting right in the company and they assume the greatest risk in the company. There are two types of shareholders preference and equity. Preference shareholders have a great preference over ordinary shareholder in the payment of dividend as well as capital. These shareholders get a fixed rate of dividend irrespective of the quantum of the profit.

Example: 5% Preference Shares (It indicates that these shareholders are entitled to get 5 % rate of dividend)

Whereas there is no as such rate is fixed in case of equity shareholder.

The rate of dividend varies with the availability of profits in case of ordinary share only. Thus, ordinary shareholders are more interested in the profitability of a company and the performance of a company should be judged on the basis of return on equity capital of the company. Return on equity capital which is the relationship between profits of a company and its equity capital, can be calculated as follows:

Return on Equity Capital = Net Profit after tax – Preference Dividend/ Equity share capital (paid up)

Example:

Following information is given for a company whose accounting year ends on 31st march, 2015

20,000 equity shares of Rs 10 each Rs 8 paid	1,60,000
11%, 5,000 preference share of Rs 20 each	1,00,000
Profit before tax	70,000
Rate of Tax	50%

Solution:

Return on Equity capital = Net Profit after tax – Preference Dividend/ Equity share

capital (paid up)
Profits available for equity shareholders:
Profits	=	70,000
Less: 50% tax	=	(35,000)
Profit after tax	=	35000
Less preference divided		=(11000)
(1,00,000 @ 11%)
Net profit available		=24,000

Return on Equity capital = 24,000/70,000 * 100 = 34.29%

(iii) EARNINGS PER SHARE:

In simple words earning per share means the return earned by the company for each share. It is a small variation of return on equity capital and is calculated by dividing the net profit after taxes and preference dividend by the total number of equity shares.

E.P.S = Net Profit after tax – Preference Dividend/ No of Equity share

It is one of the good measures of profitability and when compared with E.P.S of similar other company, it gives a view of the comparative earnings or earnings power of a firm. E.P.S. calculated for a number of years indicates whether or not earnings capacity of the company has increased.

(iv) RETURN ON CAPITAL EMPLOYED:

Return on capital employed indicates the relationship between profits and the capital employed. It is the primary ratio and is most widely used to measure the overall profitability and efficiency of a business. This ratio helps in providing fair remuneration to various factors of production (Land, Labor, Material and Cost). Management aims to make optimum use of available resources so that the return on capital employed can be increased.

The term capital employed refers to the total of investments made in a business and may vary from company to company.

(a) Gross Capital Employed: The total of current assets as well as fixed assets.

(b) Net Capital Employed: Current liabilities are usually excluded from total assets (Total Assets – Current Liabilities).

The profits for the purpose of Calculating return on capital should be computed according to the concept of „capital employed‟ used. The profits taken must be profits earned on the capital employed in the business.

Return on capital employed = Adjusted Net Profits/Net capital employed * 100.

(v) CAPITAL TURNOVER RATIO: This ratio depicts the relationship between cost of goods sold and the actual capital employed. This ratio is calculated to measure the efficiency or effectiveness with which a firm utilizes its resources or the capital employed.

Capital Turnover Ratio = Cost of Goods Sold or Sales/ Capital Employed

SUMMARY:

All these ratios are more meaningful to the equity shareholders who are interested to know profits earned by the company as the rate of dividend depends upon the profits earned by the company and to the investors who are likely to invest in a concern and for those who have already invested because the ultimate aim of every investor is the maximum return of their investment that is why the main aim of all the concern is not only to increase the profit but to maximize the shareholders wealth which ultimately helps them to attract new investors and therefore positive impact on goodwill. While applying various formulas to compute the efficiency of the firm certain points should be remembered like; Net profit should be taken before the payment of tax because tax is paid after the profits have been earned and has no relation to the earning capacity of a business. It not only measures the overall efficiency of the firm but also helps in evaluating the performance of various departments. The borrowing policy of the enterprise may be properly formulated and the rate of borrowings should always be less than the return on capital employed.

you can view video on General and Overall Profitability Ratios

Few Suggested Readings to learn more:

Gupta, K. Shashi (2004), “Accounting for Managers”. New Delhi- 110 002: Kalyani Publishers.
Jaiswal. Pawan & Singh. P Nidhi (2007) “Business Finance” Goel Printers Allahabad.
Narayanaswamy, R,(2005) “Financial Accounting”. Prentice-Hall of India Private Limited, New Delhi.
Sahni, N.K & Gupta Meenu (2011), Financial Management. New Delhi- 110 002: Kalyani Publishers..

Points to Ponder

Ø Profits are the measure of efficiency of a business.
Ø A comparison of various profit ratios over time or for different firms in the same industry is a good measure.
Ø Profitability Ratios is considered to be yardstick of efficiency.
Ø Investors remain interested in the rate of dividend.
Ø The rate of dividend depends upon the profits earned by the company.
Ø Company should focus on wealth maximization.
Ø As the return on capital employed is the prime ratio which measure the efficiency of the business.
Ø The higher returns will enable payments to workers.
Ø All the profitability ratios help in devising future business policies for expansion or diversification.
Ø The various profitability ratios have direct relationship with each other.