Profitability Ratios
Profitability Ratios
Profitability ratios are essential tools for management to continuously evaluate a company's ability to generate earnings relative to its expenses and other relevant costs. These ratios are crucial for assessing financial performance and making informed business decisions. They compare figures from both the income statement and the balance sheet to provide insights into the company's profitability.
1) Gross Profit Ratio
Definition: This ratio compares a company's gross profit to its net sales, indicating the basic profitability of the firm. It shows the margin in the selling price before the company incurs losses from operations.
Formula:
Where:
- Gross Profit = Sales – Cost of Sales
- Net Revenue from Operations = Net Sales = Sales – Sales Returns
Significance:
- A higher gross profit ratio indicates a higher margin between sales and cost of goods sold, suggesting better profitability.
- Useful for assessing the basic profitability and pricing strategy of the company.
2) Operating Ratio
Definition: This ratio measures the relationship between the cost of operating activities and net sales. It considers the cost of goods sold and operating expenses as a percentage of net sales.
Formula:
Where:
- COGS = Cost of Goods Sold
- Operating Expenses = Administration and office expenses, selling and distribution costs, salaries, depreciation, etc.
Significance:
- Helps ascertain the efficiency and profitability of the organization.
- No standard ratio; trend analysis over time is crucial.
3) Net Profit Ratio
Definition: This ratio includes the total revenue of the firm, both operating and non-operating income, and compares it to net profit. It indicates the overall profitability of the firm.
Formula:
Where:
- Net Profit = Net Profit after Tax (NPAT)
Significance:
- Reflects the portion of net revenue available to proprietors.
- Important for assessing the overall efficiency and profitability of the business.
- Key ratio for investors and financiers.
4) Return on Capital Employed (ROCE)
Definition: This ratio measures the overall efficiency of the utilization of the firm’s funds, showing the relationship between total profit earned and total capital employed.
Formula:
Where:
- PBIT = Profit Before Income and Tax
Significance:
- Indicates how well the company is using its capital to generate profits.
- Useful for assessing the productivity and efficiency of capital employed.
5) Earnings Per Share (EPS)
Definition: This ratio represents the profit of a company in the context of one share, showing earnings available to equity shareholders.
Formula:
Where:
- Profit available to Equity Shareholders = NPAT – Preference Dividend
Significance:
- Important for shareholders to decide whether to hold or sell shares.
- Indicates potential dividends and bonus issues.
- Reflects the profitability attributable to each share of equity.