Explain profitability ratios with suitable illustration
Definition of 'Profitability Ratios'
A class of
financial metrics that are used to assess a business's ability to generate
earnings as compared to its expenses and other relevant costs incurred during a
specific period of time. For most of these ratios, having a higher value
relative to a competitor's ratio or the same ratio from a previous period is
indicative that the company is doing well.
Profitability
ratios are used to assess a business' ability to generate earnings as compared
to expenses over a specified time period. These tutorials define the ratios and
walk you through the calculations, including where on the financial statements
the numbers can be found.
Profitability Ratio Analysis & Example
List of profitability ratios and formulas:
1) Gross Profit ratio = (Gross profit / Net sales) * 100 %
2) Net Profit ratio = (Net profit / Net sales) * 100 %
3) Operating profit margin = Operating income / Net sales
4) Return on Capital Employed = (Profit before interest / Capital employed) * 100 %
5) Return on Equity (ROE) = Net income / Average shareholders equity
6) Return on Assets (ROA) = Net income / Total assets
7) Cash flow return on investment (CFROI) = Cash flow / Market recapitalisation
8) Risk adjusted return on capital (RAROC) = Expected return / Economic capital
9) Return on net assets = Net income / Net assets
Example:
Calculate the profitability ratios, given the following figures:
Stock at the start of the year: $10,000
Stock at the end of the year: $6,000
Sales: $18,000
Sales returns: $3,000
Purchases: $2,000
Overhead expenses: $3,000
Capital at start of year: $17,000
Capital at end of year: $15,000
Solution:
Net sales = $18,000 - $3,000 = $15,000
Cost of sales = Stock at start + Purchases - Stock at end = 10,000 + 2,000 - 6,000 = $6,000
Gross profit = Net sales - Cost of sales = $15,000 - $6,000 = $9,000
Gross profit ratio = (9,000 / 15,000 ) * 100% = 60 %
Net profit = Gross profit - overhead expenses = 9,000 - 3,000 = $6,000
Net profit ratio = (6,000 / 15,000 ) * 100% = 40 %
Average capital employed = 1/2 (Capital at start + Capital at end) = 1/2 (17,000+15,000) = $16,000
ROCE = (6,000 / 16,000) * 100% = 37.5%
1) Gross Profit ratio = (Gross profit / Net sales) * 100 %
2) Net Profit ratio = (Net profit / Net sales) * 100 %
3) Operating profit margin = Operating income / Net sales
4) Return on Capital Employed = (Profit before interest / Capital employed) * 100 %
5) Return on Equity (ROE) = Net income / Average shareholders equity
6) Return on Assets (ROA) = Net income / Total assets
7) Cash flow return on investment (CFROI) = Cash flow / Market recapitalisation
8) Risk adjusted return on capital (RAROC) = Expected return / Economic capital
9) Return on net assets = Net income / Net assets
Example:
Calculate the profitability ratios, given the following figures:
Stock at the start of the year: $10,000
Stock at the end of the year: $6,000
Sales: $18,000
Sales returns: $3,000
Purchases: $2,000
Overhead expenses: $3,000
Capital at start of year: $17,000
Capital at end of year: $15,000
Solution:
Net sales = $18,000 - $3,000 = $15,000
Cost of sales = Stock at start + Purchases - Stock at end = 10,000 + 2,000 - 6,000 = $6,000
Gross profit = Net sales - Cost of sales = $15,000 - $6,000 = $9,000
Gross profit ratio = (9,000 / 15,000 ) * 100% = 60 %
Net profit = Gross profit - overhead expenses = 9,000 - 3,000 = $6,000
Net profit ratio = (6,000 / 15,000 ) * 100% = 40 %
Average capital employed = 1/2 (Capital at start + Capital at end) = 1/2 (17,000+15,000) = $16,000
ROCE = (6,000 / 16,000) * 100% = 37.5%
