Profitability Ratios
The main aim of all business enterprises is to earn profit. Moreover, earning profit is considered essential for business prosperity.
Profit is like the engine that drives the business forward. It is also the key to examining the efficiency of the company.
Profits are always measured in terms of sales or investment. These ratios are expressed in terms of percentage and always on sales.
The following important formulae should be understood:
Gross Profit Ratio
This ratio measures the relationship of gross profit to net sales. In general, this percentage is calculated on sales.
The formula for the gross profit ratio is as follows:
GP ratio = (Sales - Cost of goods sold) x 100 / Net sales
Example
Consider the following information and calculate the gross profit ratio:
- Net sales: $320,000
- Sales return: $20,000
- Cost of goods sold: $200,000
Solution
At the outset, we need to calculate net sales. This is calculated as follows:
Net sales = $320,000 - 20,000 = $300,000
To calculate the gross profit ratio, the following working is used:
GP = Net sales - Cost of goods sold
= 300,000 - 200,000 = $100,000
GP ratio = (GP x 100) / Net sales = (100,000 x 100) / 300,000
GP ratio = 33.33%
Operating Ratio
The operating ratio is useful to identify the relationship between the cost of goods sold and other operating expenses, on the one hand, and sales on the other hand. Here, operating cost is divided by net sales. In other words:
Operating ratio = (Operating cost x 100) / Net sales
Operating Cost = (Cost of goods sold + Operating exp.) x 100 / Net sales
Example
Consider the following:
- Cost of goods sold: $300,000
- Selling exp.: $40,000
- Administrative. exp.: $60,000
- Total net sales: $600,000
Solution
Operating ratio = (Operating cost x 100) / Net sales $300,000 + 40,000 + 60,000 = 400,000 = 400,000 x 100 / 600,000 = 66.66%
Comment: Two-third of the sales are consumed by operating costs. The balance is to cover up the interest charges, income tax, dividends, and retention of profits.
Operating Profit Ratio
This ratio reflects how much of sales is consumed by operating costs. A higher operating ratio is always harmful because a small margin is left for interest, income tax, dividends, and reserves. It is a test of a company’s operating efficiency.
The operating profit ratio is calculated as follows:
Operating profit = Net sales - Operating cost or Net sales - Cost of goods sold + Operating cost
Therefore:
Net operating profit = Net profit + Non-operating exp. - Net operating income - Operating profit ratio
= 100 - Operating ratio
Example
From the following information, calculate the operating profit ratio:
- Cost of goods sold: $400,000
- Administrative exp.: $30,000
- Selling exp.: $50,000
- Net sales: $600,000
Solution
Operating profit ratio = (Operating profit x 100) / Net sales = 600,000 - (400,000 + 30,000 + 50,000) = $120,000 Operating profit ratio = 120,000 x 100 / 600,000 = 20%
Expense Ratio
Various expenses are related to total net sales. The lower the expense ratio, the greater the profitability, whereas the higher the ratio, the lower the profitability. The expense ratio is calculated as follows:
Expense ratio = (Specific expenses x 100) / Net sales
Net Profit Ratio
The net profit ratio is calculated as follows:
Net profit ratio = (Net profit x 100) / Net sales
While calculating net profit, there are two schools of thought.
- Net profit after tax
- Net profit before tax
This ratio is very useful from the perspective of shareholders.
Return on Shareholders' Investment or Net Worth
This ratio is popularly known as return on investment (ROI). It indicates the relationship between net profit after interest and tax and the proprietor’s funds.
To calculate ROI, use the following formula:
ROI = Net profit (after tax and interest) x 100 / shareholders’ funds
Here, net profit is defined as follows:
Net profit = Out of Profit - Interest and income
Also, to calculate shareholders’ funds, use the following formula:
Shareholders’ funds = Equity + Preference share capital, share premium, Retained earnings + surpluses, general reserves
Example
Consider the following information:
- 20,000 equity shares at $10 each: $200,000
- 2,000 10% preference shares at $100 each: $200,000
- Total: $400,000
Reserved and Surplus
| Revenue reserves | 40,000 | |
| Capital reserves | 30,000 | |
| Reserves for emergencies | 30,000 | 100,000 |
| Net profit before tax and interest | 200,000 | |
| Interest charges | 40,000 | |
| Tax rate | 50% |
Required: Calculate the return on shareholders’ investment.
Solution
Shareholder’s investment Share capital $200,000 + 200,000 + 100,000 = $500,000
| Net profit before interest and tax | 200,000 |
| Less: Interest | 40,000 |
| 160,000 | |
| Less: 50% tax | 80,000 |
| 80,000 |
Return on shareholders’ investment = Net profit after tax x 100 / Shareholders’ investment
= 80,000 x 100 / 5,00,000 = 16%
Comment: ROI is useful when measuring a company’s profitability, and so shareholders and management are interested in it. The greater the ratio, the higher the level of efficiency that the company has used shareholders’ funds.
Explain Profitability Ratio With Examples FAQs
Return on assets (ROA) reflects how efficient a company is in using its assets to generate profits. It helps an investor understand the profitability of the enterprise with reference to its total assets. Higher ROA usually indicates greater efficiency.
Operating profit ratio, also known as operating margin ratio, refers to the amount of money earned by a company through its operations expressed in percentage terms. It shows how much it costs for a company to make one dollar of revenue. This metric is especially useful when comparing profitability among different companies or industries with varying cost structures.
Revenue ratio, also known as sales to total assets ratio, refers to the amount of money earned by a company through its operations expressed in percentage terms. This metric is especially useful when comparing profitability among different companies or industries with varying cost structures. The higher the ratio, the better for the business.
Return on sales (ROS) is a profitability ratio which reflects how efficient an organization is in utilizing its total assets to generate revenues. Since ROS also takes into account the total assets, it provides a more complete picture of the company's overall efficiency.
Return on equity ratio is a profitability ratio which reflects how profitable companies are in relation to their shareholders' investment. It shows how much money returns to the owners for each dollar invested by them, which enables investors to determine whether it would be worthwhile investing more funding into the company.
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.
To learn more about True, visit his personal website, view his author profile on Amazon, or check out his speaker profile on the CFA Institute website.