Q.What are various profitability ratios? How are these worked out?

Profitability Ratios

Profitability ratios measure a business's ability to generate earnings relative to its revenue, assets, equity, or other financial metrics. They are classified into two broad categories:

1. General Profitability Ratios (based on sales)

2. Overall Profitability Ratios (based on investments)

Profitability ratios are the most closely watched indicators of a company's financial health. They tell you whether the business is actually making money — not just selling goods, but selling them at a high enough margin, controlling costs, and using its resources efficiently. For any commerce student, these ratios are the bridge between raw accounting data and real business judgment.

The core idea is simple: every profitability ratio compares some measure of profit (gross, operating, net) with a base figure (revenue, capital employed, equity). The "why" behind each ratio is what matters — what aspect of performance it isolates.

The Main Profitability Ratios

1. Gross Profit Ratio

This ratio tells you the basic trading margin — how much profit the company makes on its core buying-and-selling activity before any other expenses are deducted.

Net Revenue from Operations means gross sales minus sales returns. A high ratio means the company either marks up its goods well or controls its cost of goods sold tightly. A falling ratio over time is a red flag — it could mean rising input costs, discounting pressure, or a shift in product mix.

2. Net Profit Ratio

This is the bottom-line margin — what percentage of revenue actually stays with the company after all expenses, interest, and taxes.

Net Profit here is the profit after tax (PAT). This ratio is the ultimate test of overall cost control. If the gross profit ratio is healthy but the net profit ratio is thin, the problem lies in operating expenses, interest, or tax.

3. Operating Ratio

This ratio flips the perspective — instead of showing profit, it shows the proportion of revenue consumed by operating costs.

Operating expenses include selling, administrative, and general expenses — but not interest, tax, or non-operating items like loss on sale of an asset. A lower operating ratio is better. If it exceeds 100%, the company is making an operating loss.

4. Operating Profit Ratio

This is the complement of the operating ratio. It shows the profit earned from regular business operations, before interest and tax.

Operating Profit = Net Profit (before interest and tax) + Non-operating Expenses – Non-operating Incomes. Alternatively, it's Revenue – Cost of Goods Sold – Operating Expenses. This ratio isolates how well the core business is performing, ignoring financing decisions and one-off items.

5. Return on Investment (ROI) or Return on Capital Employed (ROCE)

This ratio measures how efficiently the company uses its long-term funds to generate profit. It's the favourite of investors and lenders.

Capital Employed = Shareholders' Funds + Long-term Borrowings. Or, alternatively, it's Total Assets – Current Liabilities. The numerator uses profit before interest and tax because the return is being measured on total capital — both equity and debt. A high ROI means the company is generating strong returns from the money invested in it.

6. Return on Equity (ROE)

This ratio tells the equity shareholders what return they are earning on their investment.

Shareholders' Funds = Equity Share Capital + Reserves and Surplus – Accumulated Losses. Preference dividend is deducted because that profit belongs to preference shareholders, not equity holders. ROE is the ultimate test for equity investors — it shows how effectively their money is being deployed.

How These Are Worked Out — A Step-by-Step Example

Suppose a company has the following figures for the year: