The ultimate aim for an entity at the end of the day is profit maximization. It is the goal that the whole organization works towards. And at the end of the financial year, we prepare final accounts that measure the profit for the year. But how to do we evaluate a company’s ability to earn such profit? We calculate the profitability ratios to asses the situation. Let us take a more detailed look.

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## Profitability Ratios

The management of a company cannot wait for the year to end to analyze their financial performance and their profits. This must be done year round. These profitability ratios help the management determine an entity’s ability to use its assets and create earnings. The most useful comparisons for these ratios is to the performance of the previous years.

Profitability ratios are both revenue statement ratios and balance sheet ratios. They compare the revenue of a firm to different types of expense accounts within the Profit and Loss Statement. And then some profitability ratios also compare revenue to aspects of the balance sheet such as assets and equity.

There are a variety of profitability ratios calculated with the help of the Income Statement and the Balance Sheet. Here we will be focusing on the most important ones that are used regularly to analyze the profitability of various entities.

*Gross Profit Ratio*

This ratio simply compares the gross profit of a company to its net sales. Both of these figures are obtained from the Income Statement. The ratio is also known as Margin ratio or the Rate of Gross Profit. The ratio is represented as a percentage of sales.

This ratio basically signifies the basic profitability of the firm. This is why it is one of the most important profitability ratios. It shows the margin in the selling price before the company will incur losses from operations. The formula is

Gross Profit Ratio = \(\frac{\text{Gross Profits}}{\text{Net Revenue from Operations}}\) × 100

Net Revenue from Operations = Net Sales = Sales – Sale Returns

Gross Profit = Sales – Cost of Sales

**Browse more Topics under Accounting Ratios**

- Meaning, Objectives, Advantages and Limitations of Ratio Analysis
- Types of Ratios
- Liquidity Ratios
- Activity (or turnover) Ratios
- Solvency Ratios

*Operating Ratio*

The second one of the profitability ratios is the operating ratio. This ratio measures the equation between the cost of operating activities and the net sales, or revenue from operations. This ratio expresses the cost of goods sold as a percentage of the net sales.

Operating ratio also takes into account operating expenses such as administration and office expenses, selling and distribution costs, salaries paid, depreciation expenses etc. Also, it ignores the non-operating incomes such as interests, commisions, dividends etc.

Operating Ratio = \(\frac{\text{COGS + Operating Expenses}}{\text{Net Revenue from Operations}}\) × 100

This ratio can actually help ascertain the efficiency of the organization along with its profitability. There is no standard ratio, but a trend analysis must be done on year on year basis to check the progress of the firm.

*Net Profit Ratio*

Unlike the operating ratio, the net profit ratio includes the total revenue of the firm. It takes into account both the operating income as well as the non-operating income. Then it compares net profit to these incomes. This ratio too is represented as a percentage. The formula for Net Profit ratio is,

Net Profit Ratio = \(\frac{\text{Net Profit}}{\text{Net Revenue}}\) × 100

Net Profit = Net Profit after Tax (NPAT)

this ratio helps measure the overall profitability of the firm. It indicates the portion of the net revenue that is available to the proprietors. It also reflects on the efficiency of the business and is a very important ratio for investors and financiers.

*Return on Capital Employed *

This ratio is one of the important ones of the profitability ratios. It measures the overall efficiency of the utilization of the firm’s funds. The ratio explores the relationship between the total income/profit earned by a firm and the total capital employed by the firm, or the total investment made. The formula is as follows,

Return on Capital Employed = \(\frac{\text{PBIT}}{\text{Capital Employed}}\) × 100

PBIT = Profit Before Income and Tax

This ratio measures the efficiency with which the capital is being utilized and it indicates the productivity of the capital employed. It is a good tool to measure the overall profitability of the firm as well.

This ratio represents the profit or the earnings of a company in the context of one share. It represents the earnings of a firm whether or not dividends were actually declared on such shares. The formula for this ratio is

Earnings Per Share (EPS) = \(\frac{\text{Profit available to Equity Shareholders}}{\text{Number of equity Shareholders}}\) × 100

Profit available to Equity Shareholders = NPAT – Preference Dividend

This is an important ratio for the shareholders, it helps them decide whether to hold onto the shares or sell them. It also is a good indicator of the dividends to be declared and/or bonus issues.

## Solved Example for You

Q: Firm ABC and Co. have a Gross Profit ratio of 20%. It has credit revenue of 10,00,000 and cash revenue is 20% of the total revenue. The indirect expenses of ABC & Co. added up to 1,50,000. Please find the Net Profit ratio for the firm.

Sol:

Credit revenue = 10,00,000 = 80% of Total Revenue

Cash Revenue = 1000000 × 20/80 = 2,50,000

Total Revenue = 12,50,000

Gross Profit ratio = 20% of Total Revenue = 2,50,000

Net Profit = Gross Profit – Indirect expenses = 250000 – 150000 = 1,00,000

Net Profit Ratio = \(\frac{\text{Net Profit}}{\text{Net Revenue}}\) × 100 = \(\frac{100000}{1250000}\) × 100 = 8%