Profitability Ratios

Profitability ratios are a type of accounting ratio that helps in determining the financial performance of business at the end of an accounting period. Profitability ratios show how well a company is able to make profits from its operations.

Let us now discuss the types of profitability ratios.

Types of Profitability Ratios

The following types of profitability ratios are discussed for the students of Class 12 Accountancy as per the new syllabus prescribed by CBSE:

  1. Gross Profit Ratio
  2. Operating Ratio
  3. Operating Profit Ratio
  4. Net Profit Ratio
  5. Return on Investment (ROI)
  6. Return on Net Worth
  7. Earnings per share
  8. Book Value per share
  9. Dividend Payout Ratio
  10. Price Earning Ratio

Gross Profit Ratio

 Gross Profit Ratio is a profitability ratio that measures the relationship between the gross profit and net sales revenue. When it is expressed as a percentage, it is also known as the Gross Profit Margin.

Formula for Gross Profit ratio is

Gross Profit Ratio = Gross Profit/Net Revenue of Operations × 100 

A fluctuating gross profit ratio is indicative of inferior product or management practices.

Operating Ratio

 Operating ratio is calculated to determine the cost of operation in relation to the revenue earned from the operations.

The formula for operating ratio is as follows

Operating Ratio      =       (Cost of Revenue from Operations + Operating Expenses)/

Net Revenue from Operations ×100

Operating Profit Ratio

 Operating profit ratio is a type of profitability ratio that is used for determining the operating profit and net revenue generated from the operations. It is expressed as a percentage.

The formula for calculating operating profit ratio is:

Operating Profit Ratio = Operating Profit/ Revenue from Operations × 100 

Or  Operating Profit Ratio = 100 – Operating ratio 

Net Profit Ratio

 Net profit ratio is an important profitability ratio that shows the relationship between net sales and net profit after tax. When expressed as percentage, it is known as net profit margin.

Formula for net profit ratio is

Net Profit Ratio = Net Profit after tax ÷ Net sales

Or

Net Profit Ratio = Net profit/Revenue from Operations × 100

It helps investors in determining whether the company’s management is able to generate profit from the sales and how well the operating costs and costs related to overhead are contained.

Also read: Net Profit Ratio

Return on Capital Employed (ROCE) or Return on Investment (ROI)

 Return on capital employed (ROCE) or Return on Investment is a profitability ratio that measures how well a company is able to generate profits from its capital. It is an important ratio that is mostly used by investors while screening for companies to invest.

The formula for calculating Return on Capital Employed is :

ROCE or ROI = EBIT ÷ Capital Employed × 100

Where EBIT = Earnings before interest and taxes or Profit before interest and taxes

Capital Employed = Total Assets – Current Liabilities

Return on Net Worth

 This is also known as Return on Shareholders funds and is used for determining whether the investment done by the shareholders are able to generate profitable returns or not. 

It should always be higher than the return on investment which otherwise would indicate that the company funds are not utilised properly.

The formula for Return on Net Worth is calculated as :

Return on Shareholders’ Fund =  Profit after Tax / Shareholders’ Funds × 100

Or Return on Net Worth = Profit after Tax / Shareholders’ Funds × 100

Earnings Per Share (EPS)

 Earnings per share or EPS is a profitability ratio that measures the extent to which a company earns profit. It is calculated by dividing the net profit earned by outstanding shares.

The formula for calculating EPS is:

Earnings per share = Net Profit ÷ Total no. of shares outstanding

Having higher EPS translates into more profitability for the company.

Book Value Per Share

Book value per share is referred to as the equity that is available to the the common shareholders divided by the number of outstanding shares

Equity can be calculated by:

Equity funds = Shareholders funds – Preference share capital

The formula for calculating book value per share is:

Book Value per Share = (Shareholders’ Equity – Preferred Equity) / Total Outstanding Common Shares.

Dividend Payout Ratio

Dividend payout ratio calculates the amount paid to shareholders as dividends in relation to the amount of net income generated by the business.

It can be calculated as follows:

Dividend Payout Ratio (DPR) : Dividends per share / Earnings per share

Price Earning Ratio

This is also known as P/E Ratio. It establishes a relationship between the stock (share) price of a company and the earnings per share. It is very helpful for investors as they will be more interested in knowing the profitability of the shares of the company and how much profitable it will be in future.

P/E ratio is calculated as follows:

P/E Ratio = Market value per share ÷ Earnings per share

It shows if the company’s stock is overvalued or undervalued.

This concludes the article on the topic of Profitability Ratios, which is an important topic for students of Class 12 Commerce. For more such interesting articles, stay tuned to BYJU’S.

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