Introduction to Profitability Ratios
Profitability ratios are financial tools that help assess how well a business performs financially at the end of an accounting period. These ratios reveal how effectively a company turns its operations into profits.
Now, that we have learned what is Profitability Ratio, let’s explore the different types of profitability ratios!
Types of Profitability Ratios
Let’s see all the profitability ratio types according to the latest CBSE Class 12 Accountancy Syllabus and the different Profitability Ratio Formulas.
Gross Profit Ratio
Operating Ratio
Operating Profit Ratio
Net Profit Ratio
Return on Investment (ROI)
Return on Net Worth
Earnings per share
Book Value per share
Dividend Payout Ratio
Price Earning Ratio
Gross Profit Ratio
The gross profit ratio measures the relationship between gross profit and net sales revenue. When expressed as a percentage, it is also referred to as the Gross Profit Margin.
Formula:
Gross Profit Ratio = Gross Profit / Net Revenue from Operations × 100
A fluctuating gross profit ratio may indicate poor product quality or ineffective management practices.
Operating Ratio
The operating ratio is used to determine the cost of operations as a percentage of the revenue earned from operations.
Formula:
Operating Ratio = (Cost of Revenue from Operations + Operating Expenses) / Net Revenue from Operations × 100
Operating Profit Ratio
This ratio shows the relationship between operating profit and net revenue from operations. It reflects how effectively the company generates profit from its core activities.
Formula:
Operating Profit Ratio = (Operating Profit / Revenue from Operations) × 100
Or
Operating Profit Ratio = 100 − Operating Ratio
Net Profit Ratio
The net profit ratio indicates the relationship between net profit after tax and net sales. When expressed as a percentage, it is also called the Net Profit Margin.
Formula:
Net Profit Ratio = Net Profit After Tax / Net Sales
Or
Net Profit Ratio = (Net Profit / Revenue from Operations) × 100
This ratio helps investors assess whether the company can generate profit from sales and manage operating and overhead costs effectively.
Return on Capital Employed (ROCE) or Return on Investment (ROI)
ROCE or ROI measures how efficiently a company generates profits from its capital. This ratio is often used by investors when evaluating companies for investment.
Formula:
ROCE or ROI = (EBIT / Capital Employed) × 100
Where:
EBIT = Earnings Before Interest and Taxes
Capital Employed = Total Assets – Current Liabilities
Return on Net Worth
Also called Return on Shareholders’ Funds, this ratio shows if shareholders’ investments are generating profitable returns. A return lower than the ROI suggests inefficient utilisation of funds.
Formula:
Return on Shareholders’ Funds = (Profit After Tax / Shareholders’ Funds) × 100
Earnings Per Share (EPS)
EPS indicates how much profit a company earns per outstanding share. It is calculated by dividing the net profit by the number of outstanding shares.
Formula:
Earnings Per Share = Net Profit / Total Number of Outstanding Shares
A higher EPS indicates better profitability.
Book Value Per Share
Book value per share represents the equity available to common shareholders, divided by the number of outstanding shares.
Formula:
Book Value Per Share = (Shareholders’ Equity − Preferred Equity) / Total Outstanding Common Shares
Where:
Equity Funds = Shareholders' Funds – Preference Share Capital
Dividend Payout Ratio (DPR)
This ratio shows how much of the net income is distributed to shareholders as dividends.
Formula:
Dividend Payout Ratio = Dividends Per Share / Earnings Per Share
Price-to-Earnings (P/E) Ratio
The P/E ratio compares the stock price of a company to its earnings per share. This ratio helps investors determine whether a company's stock is overvalued or undervalued.
Formula:
P/E Ratio = Market Value Per Share / Earnings Per Share
This ratio is crucial for evaluating the future profitability of a company’s shares.
Profitability Ratio Analysis
Profitability ratio analysis helps measure how well a company is earning profits from its business. It shows how efficiently a company uses its resources to generate income. These ratios are useful for business owners, investors, and other stakeholders to understand the financial health of the company.
Why is Profitability Ratio Analysis Important?
Investors use these ratios to decide if they should invest in the company.
It tells how well a company is managing its costs and making profits.
You can see if the company's profits are improving or declining over time.
These ratios help compare one company’s performance with others in the same industry.
Benefits of Profitability Ratio Analysis
This helps investors know if a company is a good option to invest in.
Shows areas where the business can reduce costs or increase profits.
Helps monitor how the company is performing over time.
Helps compare the company’s performance with others in the market.
Limitations of Profitability Ratio Analysis
It focuses only on internal performance and ignores external market factors.
Wrong or outdated data can lead to incorrect results.
Profitability ratios may vary for businesses in different industries, making it harder to compare.
Conclusion
Profitability ratio analysis is a simple and effective way to check how well a company is doing in terms of making money. It is an essential tool for understanding a company’s financial position and planning for its growth.
FAQs on Profitability Ratios
1. Give a Profitability Ratio Example.
Vedantu has provided the different Probability Ratios along with examples in this article. Read ahead to know more.
2. How to calculate Profitability Ratio?
Vedantu has provided all the formulas in this article.
3. What are the Profitability Ratio Measures?
Investors: This helps them evaluate whether the company is a good investment opportunity.
Management: Assists in identifying strengths and areas for improvement in operations.
Competitors: Useful for benchmarking against industry peers.
Sustainability: This shows if the company can sustain operations and grow over time.
By using profitability ratios, businesses and stakeholders can gain valuable insights into financial performance and make informed decisions.
4. How is operating profit ratio different from net profit ratio?
Operating profit ratio focuses only on the profit from a company’s core operations, excluding non-operating items, while the net profit ratio includes all costs and revenues, including taxes and interest.
5. What is a good profitability ratio?
A "good" profitability ratio depends on the industry and company size. Generally, higher profitability ratios indicate better financial performance, but ratios should be compared with industry standards for context.
6. How do profitability ratios help investors?
Profitability ratios help investors evaluate how well a company can generate profit from its sales, assets, and equity, which can inform their investment decisions.
7. What does a high operating profit ratio indicate?
A high operating profit ratio suggests that a company is efficiently managing its operating expenses and generating good profits from its core business activities.
8. How does a fluctuating profitability ratio affect a company?
A fluctuating profitability ratio can indicate inconsistent performance, possibly due to changes in production costs, pricing strategies, or overall business efficiency.
9. What is the significance of Return on Capital Employed (ROCE)?
ROCE measures how well a company uses its capital to generate profit. A higher ROCE indicates better efficiency in utilising capital.
10. How can profitability ratios be improved?
Companies can improve profitability ratios by reducing costs, increasing sales, optimising operations, and managing expenses effectively.
