Q.What are various Profitability ratios? How are they worked out?
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Start your 14-day free trial to unlock the full solution →Option 1: Profitability ratios (Gross Profit, Net Profit, Operating, Return on Investment ratios, etc.) measure how efficiently a firm earns profit relative to sales or capital employed. Option 2: The Quick Ratio is a stricter, more reliable liquidity measure than the Current Ratio because it excludes inventory and prepaid expenses, which are the least liquid current assets.
Option 1 — Various Profitability Ratios and how they are worked out
Profitability ratios measure the overall efficiency of the business in earning profit, usually expressed in relation to sales (revenue from operations) or to the capital employed. The main profitability ratios are:
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Gross Profit Ratio = (Gross Profit ÷ Revenue from Operations) × 100
Shows the margin available after deducting the direct cost of goods sold.
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Operating Ratio = [(Cost of Revenue from Operations + Operating Expenses) ÷ Revenue from Operations] × 100
Shows the proportion of revenue absorbed by the cost of operations; a lower ratio indicates better operating efficiency.
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Operating Profit Ratio = (Operating Profit ÷ Revenue from Operations) × 100, or simply 100 − Operating Ratio
Shows operating profitability, excluding non-operating items.
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Net Profit Ratio = (Net Profit ÷ Revenue from Operations) × 100
Shows overall profitability after all expenses, including non-operating items, interest and tax.
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Return on Investment (Return on Capital Employed) = (Net Profit before Interest and Tax ÷ Capital Employed) × 100
Measures the overall earning efficiency of the capital invested in the business (both owners' funds and borrowed funds).
Each ratio is worked out by taking the relevant profit figure (gross profit, operating profit, or net profit, as derived from the Statement of Profit and Loss) as the numerator, and the relevant base (revenue from operations, or capital employed from the Balance Sheet) as the denominator, and expressing the result as a percentage.
Option 2 — "Quick ratio is a preferred measure of overall liquidity" — Explanation
The Quick Ratio (or Acid Test Ratio) is calculated as:
Quick Ratio = Quick Assets ÷ Current Liabilities
where Quick Assets = Current Assets − Inventory − Prepaid Expenses (i.e., current assets excluding the least liquid items).
This statement is considered true because:
- Inventory is excluded: Inventory is the least liquid of all current assets — it must first be sold, and then the resulting debt (if sold on credit) must be collected, before it becomes cash. Including it (as the Current Ratio does) can overstate a firm's real short-term liquidity, especially if the inventory is slow-moving or obsolete.
- Prepaid expenses are excluded: These represent services already paid for in advance (e.g. prepaid insurance); they cannot be converted into cash to meet current liabilities, so including them (again, as the Current Ratio does) overstates liquidity. …
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