CHAPTER - 3 PROFITABILITY RA R ATIOS 3.1. INTRODUCTION: Profitability ratios are to measure the operating efficiency of the company. Besides management, lenders and owners of the company are interested in the analysis of the profitability of the firm. If profits are adequate, there would be no difficulty for lenders, normally, to get payment of interest and repayment of principal. Owners want to get required rate of return on investment. 3.2. TYPES OF PROFITABILITY RATIOS: RATIOS: Generally, two maor types of profitability profitabilit y ratios are calculated: 1. Profitability ratios based on sales 2. Profitability ratios based on investment
3.2.1. PROFITABILITY RATIOS BASED ON SALES !. ". $. '.
Gross Gross profit profit margin margin or ratio ratio #et #et prof profit it marg margin in or or ratio ratio Operat Operating ing e%pens e%penses es &atio &atio Oper Operat atin ing g profit profit mar margi gin n
1. Gross Profit Rtio (he first ratio in relation to sales is gross profit ratio or gross margin ratio. (he ratio can be calculated by
I!"ort#$%: (he ratio reflects the efficiency with which a firm produces)sells its different products. *igh gross profit ratio is a sign of good management. &easons could be: •
*igh sales price, cost of goods remaining constant
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+ower cost of goods sold, sales price remaining constant
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combination of factors in sales price and costs of different products, widening the margin
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n increase in proportion of volume of sales of those products that carry a higher margin and
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Overvaluation of closing stoc- due to misleading factors.
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&easons for fall in gross profit ratio: &easons may be:
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Purchase of raw materials, at unfavourable rates
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Over investment and) or inefficient utilisation of plant and machinery, resulting in higher cost of production
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%cessive competition, compelling to sell at reduced prices
2. N%t Profit Rtio #et profit is obtained, after deducting operating e%penses, interest and ta%es from gross profit. (he net profit ratio is calculated by
#et profit includes non/operating income so the later may be deducted to arrive at profitability arising from operations.
I!"ort#$%: #et Profit ratio indicates the o&%r'' %ffi$i%#$( of t)% !#*%!%#t i# !#+f$t+ri#*, administering and selling the products. #et profit has a direct relationship with the return on investment. If net profit is high, with no change in investment, return on investment would be high. If there is fall in profits, return on investment would also go down. 0or a meaningful understanding, both the ratios 1 gross profit ratio and net profit ratio 1 have to be interpreted together. If gross margin increases but net margin declines, this indicates operating e%penses have gone up. 0urther analysis has to be made which operating e%pense has contributed to the declining position for control. &everse situation is also possible with gross margin declining, and net margin going up. (his could be due to increase of cost of production, without any change in selling price, and operating e%penses reducing more to compensate the change. 3.
O"%rti#* E,"%#s%s Rtios (o identify the cause of fall or rise in net profit, each operating e%pense ratio is
to be calculated. 2hile some of the e%penses may be increasing and other may be declining. (o -now the behaviour of specific items of e%penses, the ratio of each individual operating e%pense to net sales should be calculated. Operating e%pense ratio 3 Operating e%penses 4 !55 #et sales Operating e%penses includes cost of goods produced)sold, general and administrative e%penses, selling and distributive e%penses (he various variants of e%penses are:
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O"%rti#* "rofit !r*i# rtio: Operating profit margin)ratio establishes the relationship between operating
profit and net sales. It is calculated by
Operating profit)Operating margin 3 Operating Profit 4 !55 #et sales Operating profit is the difference between net sales and total operating expenses. (Operating profit = Net sales – cost of goods sold – administrative expenses – selling and distribution expenses.)
3.2.2. PROFITABILITY RATIOS BASED ON IN/EST0ENT: quity shareholders are the owners of the company. Profits belong to the owners of the firm who have invested their funds, in anticipation of return. If preference shares e%ist, then profits, after ta% and dividend due to preference shareholders, are to be considered for calculation of the return to equity shareholders. It is not important, whether the profits are distributed to the equity shareholders or left in the firm as retained earnings. (he profitability of a firm can be analy6ed from the point of view of owners in different perspectives, as follows: 78 &eturn on Investment 7B8 &eturn on quity
A R%t+r# o# I#&%st!%#t 1. R%t+r# o# Tot' Ass%ts: 9(otal assets is the total amount appearing on the assets side of the balance sheet. *owever, in calculating total assets, fictitious assets li-e preliminary e%penses, accumulated losses and discount on issue of shares are to be e%cluded. *owever, intangible assets li-e goodwill, patents and trademar-s are to be included. &eason is these intangible assets contribute for the development of sales and business, while the fictitious assets do not add anything for the growth in business. 2hen return on investment is calculated on total assets, it is called &O(. (otal assets are related to operating profit. Operating profit is BI(, in the absence of other income. BI( is arrived at by adding financial charges 7interest etc.8 and ta% to net operating profit. By this, we are separating financing effect from the operating effect. (he formula is
2. R%t+r# o# C"it' E!"'o(%: nother way to calculate return on investment is through capital employed or net assets. ;apital employed can be calculated in two ways: ;apital mployed 3 #et 2orth < +ong/term Borrowings O& 3 #et 0i%ed ssets < ;urrent ssets = ;urrent +iabilities &eturn on net assets is called &O#. s net assets are equal to capital employed, the terms &O# and &O; indicate the same. (his ratio indicates the overall efficiency of business, before ta%. (he formula for calculation is
I!"ort#$%: • •
&OI 7&O( and &O#8 measure the overall efficiency of business. (he owners are interested in -nowing the profitability of the firm, in relation to the total assets and amount invested in the firm. higher percentage of return on capital employed will satisfy the owners that their funds are profitably
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utili6ed. It indicates the efficiency of the management of various departments as funds
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are -ept at its disposal for ma-ing investment in assets Inter/firm comparison would be useful. Both the ratios of a particular firm should be compared with the industry average or its immediate competitor to understand the efficiency of the management in managing the assets, profitably. >o, a higher rate of return on capital employed, without comparison, does not imply that the firm is managed, efficiently. Once a comparison is made with other firms, having similar characteristics, in the same industry, a fair conclusion is possible.
B R%t+r# o# E4+it( In the real sense, equity shareholders are the real owners of the company. (hey assume the ris- in the firm. Preference shareholders enoy fi%ed rate of dividend and preference for payment of dividend, before dividend is distributed to equity shareholders. >imilarly, in the event of the liquidation of the company, preference share capital has to be repaid first, before refunding to equity shareholders. #et profits after ta%, after dividend is paid to preference shareholders, entirely belong to the equity shareholders. quity shareholders would be interested to -now what their real return is on the funds invested. (his ratio is calculated as:
quity shareholders funds are equity share capital, accumulated reserves 7both general reserves ? capital reserves8, share premium and balance in profit ? loss account less accumulated losses, if any. Preference shareholders are not to be included as the dividend due to them has already been deducted from profits after ta%. I!"ort#$%: • •
&O indicates how well the firm has used the resources of owners. arning a satisfactory return is the most desirable obective of a business. (his ratio is of greatest interest to the management as it is their responsibility
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to ma%imi6e the owners welfare. (his ratio is more meaningful to equity shareholders as they are interested to -now their return. Interpretation of this ratio is similar to return on investments. *igher the ratio, better it is to equity shareholders.
