The purpose of calculating these ratios is to assess the adequacy of the profits earned by the company and also to estimate the trend of profitability over a period of time. Profitability of a company is the net result of numerous policies and decision. These ratios show the combined effect of capital budgeting,liquidity management, asset management on operating results. Profitability, ratios are measured with reference to sales, capital employed, total assets,shareholders funds, etc. The major profitability ratios are as follows:
(a) Return on Capital Employed (ROCE) or Return on Investment (ROI);
(b) Earning Per Share (EPS);
(c) Cash Earning Per Share (Cash EPS);
(d) Gross Profit Margin ;
(e) Net Profit Margin;
(f) Cash Profit Ratio;
(g) Return on Assets;
(h) Return on Net Worth (or Return on Shareholders Equity);
(i) Operating Ratios.
(a) Return on Investment: The aim of any business enterprise is to earn a return on capital employed. ROI is determined by dividing the net profit or income by the capital employed or investment made to achieve the profit.
ROI =(Net Profit/Capital employed)× 100
ROI consists of two components (i) Profit Margins (ii) Investment Turnover.
ROI =(Net Profit/Sales)×(Sales/Investment in assets)
(Profit Margin) (Investment Turnover)
ROI can be improved by increasing the profit margin and investment turnover or both. The capital employed is found out by adding the debt and equity components of the balance sheet viz., Share Capital (paid up),Reserves and Surplus and Loans (secured and unsecured), from this total subtract if any, (i) Capital Work in Progress (ii) Investment Outside the Business Activities (iii) Preliminary Expenses (iv) Debit Balance of P&L A/c.
ROI is a measure regarding optimal utilisation of the assets of the company. This measure helps in selecting and disposing of assets as well as in selecting various investment proposals.
(b) Earnings Per Share (EPS): One of the objectives of the firm/company is wealth/value maximisation, of the stake of various stakeholders. The value is maximised when the market price of equity shares increases. The market price of equity shares is a function of the present and future earning potential of the firm. An appropriate and operationally feasible way to measure value maximisation is to measure Earning Per Share (EPS).The EPS is one of the important measures of economic performance of an economic entity. A higher EPS among the comparable firms means better capital productivity.
EPS = Net profit after tax and preference dividend/No. of equity shares
(i) EPS when debt and equity is used:
(EBIT − 1)/ (1 − T )N
(ii) EPS when debt equity and preference shares are used:
((EBIT − 1) (1 − T ) − D p)/N
where EBIT = Earning before Interest and Taxes
I = Interest
T = Rate of Corporate Tax
D p = Preference Dividend
N = Number of Equity Shares
(c) Cash Earning Per Share: The cash earning per share is calculated by dividing the Net Profit + Depreciation by number of Equity Shares.
Cash EPS =Net profit + Depreciation/ No. of equity shares
(d) Gross Profit Margin: The gross profit margin is calculated as follows:
=(Sales − cost of goods sold/Sales)× 100
or
=
(Gross profit/Sales)× 100
The gross profit measures, the excess of sales proceed over their cost before taking into consideration administration, selling, distribution and financing charges. This ratio measures, the efficiency of the company’s operation. Under normal circumstances the gross profit margin should remain unchanged over a period of time irrespective of the level of production and sales, since it is based on the assumption that all cost deducted when computing gross profit are directly variable with sales.
Variation in gross profit margin may be due to the following reasons:
(i) price cuts;
(ii) cost increases;
(iii) change in product mix;
(iv) under or over valuation of stocks.
(e) Net Profit Margin: This profit is calculated as follows:
(Net profit before interest and tax/Sales)× 100
This ratio reflects net profit margin on the total sales after deducting all expenses but before deducting the interest and corporate tax. The non- operating incomes and expenses are ignored in computation of net profit before tax, depreciation and interest. This ratio is used to compare performance with that of the previous year as well as with the competitors.
(f) Cash Profit Ratio: This ratio is computed as follows:
(Cash profit/Sales)× 100
where Cash profit= Net profit + Depreciation
This ratio measures the cash generated by the company as a result of the operations expressed in terms of sales. In situations where the profit fluctuates from year to year, due to changes in tax rates and depreciation rates and policies, this ratio is a reliable indicator of performance. This ratio is not affected by the method of depreciation used to charge depreciation.
(g) Return on Assets: This ratio is calculated as follows:
(Net profit after tax/Total assets) × 100
This ratio establishes the relationships of profits with the total assets of the organisation. This ratio indicates the efficiency of utilisation of assets in generating revenue.
(h) Return on Shareholders Funds or Return on Net Worth:
(Net profit after interest and tax/Net worth)× 100
Where Net Worth= Equity capital + reserves and surplus. This ratio expresses the net profit in terms of the equity shareholder funds.
(i) Operating Ratios
The ratio of all operating expenses (i.e., materials used, labour, factory overheads, administration and selling expenses), to sales is the operating ratio over a period of time would reveal the behaviour of the particular cost.The operating ratios are classified as follows:
(i) Material Cost Ratio =(Materials consumed/Sales)× 100
(ii) Labour Cost Ratio = (Labour cost/Sales)× 100
(iii) Factory Overhead Ratio =(Factory expenses/Sales) × 100
(iv) Administrative Expense Ratio =(Administra tive expenses/Sales)× 100
(a) Return on Capital Employed (ROCE) or Return on Investment (ROI);
(b) Earning Per Share (EPS);
(c) Cash Earning Per Share (Cash EPS);
(d) Gross Profit Margin ;
(e) Net Profit Margin;
(f) Cash Profit Ratio;
(g) Return on Assets;
(h) Return on Net Worth (or Return on Shareholders Equity);
(i) Operating Ratios.
(a) Return on Investment: The aim of any business enterprise is to earn a return on capital employed. ROI is determined by dividing the net profit or income by the capital employed or investment made to achieve the profit.
ROI =(Net Profit/Capital employed)× 100
ROI consists of two components (i) Profit Margins (ii) Investment Turnover.
ROI =(Net Profit/Sales)×(Sales/Investment in assets)
(Profit Margin) (Investment Turnover)
ROI can be improved by increasing the profit margin and investment turnover or both. The capital employed is found out by adding the debt and equity components of the balance sheet viz., Share Capital (paid up),Reserves and Surplus and Loans (secured and unsecured), from this total subtract if any, (i) Capital Work in Progress (ii) Investment Outside the Business Activities (iii) Preliminary Expenses (iv) Debit Balance of P&L A/c.
ROI is a measure regarding optimal utilisation of the assets of the company. This measure helps in selecting and disposing of assets as well as in selecting various investment proposals.
(b) Earnings Per Share (EPS): One of the objectives of the firm/company is wealth/value maximisation, of the stake of various stakeholders. The value is maximised when the market price of equity shares increases. The market price of equity shares is a function of the present and future earning potential of the firm. An appropriate and operationally feasible way to measure value maximisation is to measure Earning Per Share (EPS).The EPS is one of the important measures of economic performance of an economic entity. A higher EPS among the comparable firms means better capital productivity.
EPS = Net profit after tax and preference dividend/No. of equity shares
(i) EPS when debt and equity is used:
(EBIT − 1)/ (1 − T )N
(ii) EPS when debt equity and preference shares are used:
((EBIT − 1) (1 − T ) − D p)/N
where EBIT = Earning before Interest and Taxes
I = Interest
T = Rate of Corporate Tax
D p = Preference Dividend
N = Number of Equity Shares
(c) Cash Earning Per Share: The cash earning per share is calculated by dividing the Net Profit + Depreciation by number of Equity Shares.
Cash EPS =Net profit + Depreciation/ No. of equity shares
(d) Gross Profit Margin: The gross profit margin is calculated as follows:
=(Sales − cost of goods sold/Sales)× 100
or
=
(Gross profit/Sales)× 100
The gross profit measures, the excess of sales proceed over their cost before taking into consideration administration, selling, distribution and financing charges. This ratio measures, the efficiency of the company’s operation. Under normal circumstances the gross profit margin should remain unchanged over a period of time irrespective of the level of production and sales, since it is based on the assumption that all cost deducted when computing gross profit are directly variable with sales.
Variation in gross profit margin may be due to the following reasons:
(i) price cuts;
(ii) cost increases;
(iii) change in product mix;
(iv) under or over valuation of stocks.
(e) Net Profit Margin: This profit is calculated as follows:
(Net profit before interest and tax/Sales)× 100
This ratio reflects net profit margin on the total sales after deducting all expenses but before deducting the interest and corporate tax. The non- operating incomes and expenses are ignored in computation of net profit before tax, depreciation and interest. This ratio is used to compare performance with that of the previous year as well as with the competitors.
(f) Cash Profit Ratio: This ratio is computed as follows:
(Cash profit/Sales)× 100
where Cash profit= Net profit + Depreciation
This ratio measures the cash generated by the company as a result of the operations expressed in terms of sales. In situations where the profit fluctuates from year to year, due to changes in tax rates and depreciation rates and policies, this ratio is a reliable indicator of performance. This ratio is not affected by the method of depreciation used to charge depreciation.
(g) Return on Assets: This ratio is calculated as follows:
(Net profit after tax/Total assets) × 100
This ratio establishes the relationships of profits with the total assets of the organisation. This ratio indicates the efficiency of utilisation of assets in generating revenue.
(h) Return on Shareholders Funds or Return on Net Worth:
(Net profit after interest and tax/Net worth)× 100
Where Net Worth= Equity capital + reserves and surplus. This ratio expresses the net profit in terms of the equity shareholder funds.
(i) Operating Ratios
The ratio of all operating expenses (i.e., materials used, labour, factory overheads, administration and selling expenses), to sales is the operating ratio over a period of time would reveal the behaviour of the particular cost.The operating ratios are classified as follows:
(i) Material Cost Ratio =(Materials consumed/Sales)× 100
(ii) Labour Cost Ratio = (Labour cost/Sales)× 100
(iii) Factory Overhead Ratio =(Factory expenses/Sales) × 100
(iv) Administrative Expense Ratio =(Administra tive expenses/Sales)× 100
(v) Selling and Distribution = (Selling and distributi on experience/Sales)×100
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