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:
- 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
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 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
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.
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.