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What is Profitability ratio?

Profitability ratio: This ratio helps to know the profit earned in relation to capital employed in a company.

Gross Profit ratio: This ratio shows how much profit earn on sales. Higher the ratio better for the company.

Gross profit %= (Cost of goods sold / Net sales) * 100

Operating ratio: It shows how much cost of goods sold and operating expenses are absorbed by sales. Lower the ratio better for the company.

Operating profit % = (Cost of goods sold + operating expenses / net sales ) * 100

Net Profit ratio: It shows the overall profit earned by company through sales. Higher the ratio in comparison to previous year better for the company.

Net Profit % = (Net Profit / Net Sales) * 100

Operating profit ratio: It ignored non-operating income and expenses. The total of operating profit and operating ratio are 100.

Operating Profit % = (Operating Profit / Net Sales) * 100

Operating Profit = Gross profit – operating expenses

Net profit = gross profit – all operating expenses + all non operating expenses

Example: Find out the gross profit, net profit and operating profit ratio from the following information:

Sales
Rs. 3, 60,800
Sales return
Rs. 40, 000
Cost of sales
30% on sales
Selling and distribution expenses
22, 000
Depreciation
8, 000
Interest
16, 000
Office expense
10, 000
Loss on sale of asset
4, 000
Rent received
1, 200
Dividend received
5, 000

Solution: Net sales = Rs. ( 3, 60,800 – 40, 000) = Rs. 3, 20,800
Cost of goods sold = Rs. (3, 60,800*0.30) = Rs. 1, 08,240
Operating expenses = Selling and distribution expenses + Depreciation + Interest + Office expense
= 22, 000 + 8, 000 + 16, 000 + 10, 000
=Rs. 56, 000
Gross profit ratio = 1, 08,240 / 3, 20,800 = 0.337 or 33.7%
Operating ratio = (1, 08,240 + 56, 000) / 3, 20,800 = 0.51 or 51.19%
Gross profit = sales – cost of goods sold
= Rs. (3, 20,800 – 1, 08,240)
= Rs. 2, 12,560
Net profit = Rs. (2, 12,560 – 56, 000 – 4, 000 + 6, 200) = Rs. 1, 58,760
Operating profit = Rs. ( 2, 12,560 – 56, 000) = Rs. 1, 56,560
Net Profit ratio = 1, 58,760 / 3, 20,800 = 0.494 or 49.48%
OR
Operating profit ratio = 1, 56,560 / 3, 20,800 = 0.488 or 48.8%

Return on Investment(ROI): It is also known as Yield on Capital. It tells that how much profit is earned in relation of capital invested in a company.

ROI = Profit before interest tax and dividend paid to preference shareholders / Capital Employed

Capital Employed = Share capital + Preference share + Profit & Loss a/c balance + Long term loan – Fictitious asset – non-operating expenses
OR
Capital employed = fixed assets + working capital

Example: Find out the profit available for equity shareholders:

Equity capital
Rs. 3, 00,000
Preference share capital
Rs. 1, 20,000
Debenture
Rs. 2, 30,000
Profit before interest and tax
Rs. 4, 62,000
Interst
-----
Tax
Rs. 1, 60,000

Solution:

Particulars
Amount (Rs.)
Profit before interest and tax
4,62,000
Less: Interest
-----
Less: tax
1, 60,000
Profit available for shareholders
3, 02,000

Earning per share (EPS): It tells how much company can pay to each shareholders from available profit. It helps to determine the market value of company’s share. Higher the ratio better for the shareholders and for company.

Earning Per Share = (Net income – dividend paid to preference shareholders) / Number of equity shares

Dividend Per Share: With the help of this ratio company or shareholders can find out the dividend receive by each shareholders.

Dividend Per Share = Profit distributed as dividend / Number of equity shares

Price earning ratio: It is a ratio with the help of which shareholders can determine how much they get after investing in market share of company to get such earnings on per share.

Price Earnings ratio = Market price of company’s share / Earnings per share

Example: XYZ Company issues 30, 000 shares @ Rs. 50 each. Mohan wants to invest in this company but he does not know that it is a good decision or not. Find out with the help of following information:

Net income
Rs. 4, 10,000
Dividend on prefernce share
Rs. 28, 700
Market price
180

Solution:  
Earnings Per Share = 4, 10,000 / 30,000
= 13.66
Dividend per share = (4, 10,000 – 28, 700) / 30, 000
= 12.71
Price Earning ratio = 80 / 13.66
= 5.85
The market price is 5 times more than EPS. There is a little  gap between EPS and Dividend per share which shows that investing in a company is a good decision.


                                                      





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