Long Answer Question
What are important profitability ratios? How are these worked out?
rofitability ratios are calculated on the basis of profit earned by a business. This ratio gives a percentage measure to assess the financial viability, profitability and operational efficiency of the business. The various important Profitability Ratios are as follows:
1. Gross Profit Ratio
2. Operating Ratio
3. Operating Profit Ratio
4. Net Profit Ratio
5. Return on Investment or Capital Employed
6. Earnings per Share Ratio
7. Dividend Payout Ratio
8. Price Earnings Ratio
1. Gross Profit Ratio- It shows the relationship between Gross Profit and Net Sales. It depicts the trading efficiency of a business. A higher Gross Profit Ratio implies a better position of a business, whereas a low Gross Profit Ratio implies an inefficient unfavourable sales policy.
`"Gross Profit Ratio"= "Gross Profit"/"Net sales"xx" 100`
`" Gross profit"= " Net Sales" - "Cost of Goods Sold"`
`" Cost of Goods Sold" ="Sales" - "Gross profit"`
3. Operating Profit Ratio- It shows the relationship between the Operating Profit and Net Sales. It helps in assessing the operational efficiency and the performance of the business.
`" Operating Profit Ratio"= "Operating Profit"/"Sales"xx"100`
`"Operating Profit Ratio" = 100 - "Operating Ratio"`
`"Operating Profit" " Sales" - "Opeartion Cost"`
4. Net Profit Ratio- It shows the relationship between net profit and sales. Higher ratio is better for firm. It depicts the overall efficiency of a business and acts as an important tool to the investors for analysing and measuring the viability and performance of the business.
`" Net Profit Ratio" = "Net Profit"/ "Net Sales"xx"100`
`"or. Net Profit Ratio" = "Profit Before Tax"/" Net Sales"xx"100`
`"or. Net Profit Ratio" = "Profit After Tax"/" Net Sales"xx"100`
`"Net Sales" =" Total Sales" - "Sales Return"`
5. Return on Investment or Capital Employed- It shows the relationship between the profit earned and the capital employed to earn that profit. It is calculated as:
`"Return on Investment or Capital Employed" = "Profit Before Interest and Tax"/" Capital Employed"xx"100`
`"Capital Employed" ="Fixed Assets" + "Current Assets - Current Liablities"`
`"or. Capital Employed" = " Share capital" +"Reserve and Surplus" +"Long Term Funds" - "Fictitious assets"`
This ratio depicts the efficiency with which the business has utilised the capital invested by the investors. It is an important yardstick to assess the profit earning capacity of the business.
6. Earning per Shares- It shows the relationship between the amount of profit available to distribute as dividend among the equity shareholders and number of equity shares.
`"Earning per share" = " Profit available for equity shareholders"/"Number of equity shares"`
`"Profit available for equity shareholders" = "Net Profit after Tax" - "Preference share Dividend"`
7. Dividend Payout Ratio- It shows the relationship between the dividend per share and earnings per share. This ratio depicts the amount of earnings that is distributed in the form of dividend among the shareholders. A high Dividend Payout Ratio implies a better position and goodwill of the business for the shareholders.
`"Dividend Payout Ratio"= "Dividend per share"/"Earning per share"`
`"Dividend per share" = "Dividend paid"/"No. of shares"`
8. Price Earning Ratio- It shows the relationship between the market price of a share and the earnings per share. This ratio is the most common tool that is used in the stock markets. This ratio depicts the degree of reliance and trust that the shareholders have on the business. This ratio reflects the expectation of the shareholders regarding the rise in the future prices of the company’s shares. A higher Price Earning Ratio definitely enables a company to enjoy favourable position in the market.
`"Profit Earning Ratio" = "Market Price of a share"/"Earnings per share"`