Accountancy · Ch 8 — Accounting Ratios
Profitability Ratios
Profitability Ratios
Profitability ratios measure the earning capacity of a business. The profit earned is the outcome of how efficiently the resources of the business are used. These ratios are calculated from the figures in the Statement of Profit and Loss (the income statement). The ten ratios listed in the textbook are covered below.
1. Gross Profit Ratio
This ratio shows the relationship between Gross Profit and Revenue from Operations (Net Sales). It tells us the percentage of revenue left after covering the direct costs of goods sold.
Formula:
Gross Profit Ratio = (Gross Profit / Revenue from Operations) × 100
Where:
- Gross Profit = Revenue from Operations – Cost of Revenue from Operations
- Revenue from Operations = Net Sales (Gross Sales minus Sales Returns)
A higher ratio is generally better, as it indicates efficient production or purchasing and good pricing power. A falling ratio may signal rising costs of raw materials or lower selling prices.
2. Operating Ratio
This ratio measures the proportion of revenue that is consumed by operating expenses. It shows the operational efficiency of the business.
Formula:
Operating Ratio = (Cost of Revenue from Operations + Operating Expenses) / Revenue from Operations × 100
Where:
- Operating Expenses include: Office and Administrative Expenses, Selling and Distribution Expenses, Depreciation, and Employee Benefit Expenses.
- Non-operating expenses (like interest, loss on sale of asset) and Non-operating incomes (like profit on sale of asset, dividend income) are excluded.
A lower operating ratio is better, as it leaves a larger margin for non-operating items and profit.
3. Operating Profit Ratio
This ratio shows the profit earned from core business operations, expressed as a percentage of revenue.
Formula:
Operating Profit Ratio = (Operating Profit / Revenue from Operations) × 100
Where:
- Operating Profit = Revenue from Operations – Operating Cost
- Alternatively: Operating Profit = Net Profit (before tax) + Non-operating Expenses – Non-operating Incomes
Relationship: Operating Profit Ratio = 100 – Operating Ratio. This is because the sum of operating ratio and operating profit ratio equals 100% of revenue from operations.
4. Net Profit Ratio
This ratio measures the overall profitability of the business after all expenses (including non-operating items) have been deducted.
Formula:
Net Profit Ratio = (Net Profit / Revenue from Operations) × 100
Where:
- Net Profit is the profit after tax (as shown in the Statement of Profit and Loss).
A higher ratio indicates better overall efficiency and profitability.
5. Return on Investment (ROI) or Return on Capital Employed (ROCE)
This ratio measures the return earned on the total capital employed in the business. It is a key indicator of how efficiently the business uses its long-term funds.
Formula:
ROI = (Net Profit before Interest, Tax, and Dividend / Capital Employed) × 100
Where:
- Capital Employed = Shareholders’ Funds + Long-term Borrowings
- Alternatively: Capital Employed = Non-current Assets + Working Capital (Current Assets – Current Liabilities)
- Net Profit before Interest, Tax, and Dividend is used because the return is on all capital providers (both owners and lenders).
A higher ROI is desirable, as it shows the business is generating good returns on the funds invested.
6. Return on Net Worth (RONW)
This ratio measures the return earned on the shareholders’ funds (equity and preference share capital plus reserves and surplus).
Formula:
RONW = (Net Profit after Tax / Shareholders’ Funds) × 100
Where:
- Shareholders’ Funds = Equity Share Capital + Preference Share Capital + Reserves and Surplus – Accumulated Losses (if any).
This ratio is of particular interest to equity shareholders as it shows the return on their investment.
7. Earnings per Share (EPS)
This ratio calculates the profit attributable to each equity share.
Formula:
EPS = (Net Profit after Tax – Preference Dividend) / Number of Equity Shares
Where:
- Preference dividend is deducted because EPS relates only to equity shareholders.
- The number of equity shares is the total number of shares outstanding.
A higher EPS is generally seen as a positive sign.
8. Book Value per Share
This ratio shows the net asset value per equity share as per the balance sheet.
Formula:
Book Value per Share = (Equity Shareholders’ Funds) / Number of Equity Shares
Where:
- Equity Shareholders’ Funds = Equity Share Capital + Reserves and Surplus – Accumulated Losses.
This value is not the same as the market price of the share.