Profitability Ratio: Meaning, Formulas, and Types with Objectives (2024)

Profitability Ratio

Profitability refers to the financial performance of the business. Accounting Ratios that measure profitability are known as Profitability Ratios. We express these ratios in ‘Percentage’.

Types of Profitability Ratio

Profitability Ratios are of five types. These are:

• Gross Profit Ratio
• Operating Ratio
• Operating Profit Ratio
• Net Profit Ratio
• Return on Investment

Gross Profit Ratio

Gross Profit Ratio establishes the relationship between gross profit and Revenue from Operations, i.e. Net Sales of an enterprise. Thus,

Gross Profit Ratio = (Gross Profit/Revenue from Operations) x 100

Revenue from operations means revenue earned by the enterprise from its operating activities. It includes Net Sales and commission, etc., in the case of non-finance companies and interest earned, dividend, profit on the sale of securities, etc., in the case of finance companies.

Gross Profit = Revenue from Operations – Cost of Revenue from Operations

(Cost of operations is also called as Cost of Goods Sold)

Cost of Revenue from Operations = Opening Inventory + Net Purchases + Direct Expenses – Closing Inventories.

Or

= Revenue from Operations – Gross Profit

Objective:

The main objective of computing Gross Profit Ratio is to determine the efficiency of the business. We can also compare this ratio with the ratio of earlier years or with that of other firms to compare and to assess the efficiency of the business. Therefore, Higher Gross Profit Ratio is better as it leaves a higher margin to meet operating expenses and the creation of reserves.

Learn more about Solvency Ratio here in detail.

Operating Ratio

It establishes the relationship between operating costs and Revenue from Operations.

Operating cost includes Cost of Revenue from Operations and Operating Expenses. These are those costs which are incurred for operating activities of the business.

Operating Ratio = (Cost of Revenue from Operations + Operating Expenses/Revenue from Operations) x 100

Or

=(Operating cost/Revenue from Operations) x 100

Operating Expenses = Employees Benefit Expenses + Depreciation and Amortization Expenses + Other Expenses (Other than Non-operating Expenses)

Or

= Office Expenses + Selling and Distribution Expenses + Employees Benefit Expenses + Depreciation and Amortization Expenses.

We should keep in mind that Operating Profit Ratio and Operating Ratio are complementary to each other and thus if we deduct one of the two ratios from 100, another ratio will obtain.

Operating Ratio + Operating Profit Ratio = 100

Objective:

The objective of computing Operating Ratio is to assess the operational efficiency of the business.

Lower Operating Ratio is better because it leaves a higher profit margin to meet non-operating expenses, to pay the dividend, etc. A rise in the Operating Ratio indicates a decline in efficiency.

Operating Profit Ratio

Operating Profit Ratio measures the relationship between Operating Profit and Revenue from Operations, i.e. Net Sales.

We compute Operating Profit Ratio by dividing operating profit by revenue from operations (Net Sales) and is express in Percentage.

Operating Profit Ratio = (Operating Profit/Revenue from Operations) x 100

Operating Profit = Gross Profit + Other Operating Income – Other Operating Expenses

Or,

= Net Profit (Before Tax) + Non-operating Expenses – Non-operating Incomes

Or,

= Revenue from Operations – Operating Cost

Objective:

The objective of computing Operating Profit Ratio is to determine the operational efficiency of the business. An increase in the ratio over the previous period shows improvement in the operational efficiency of the business enterprise.

Net Profit Ratio

Net Profit Ratio measures the relationship between Net Profit and Net Sales. It shows the percentage of Net Profit earned on Revenue from Operations.

Net Profit Ratio = (Net Profit/Net Sales) x 100

Net Profit = Revenue from Operations – Cost of Revenue from Operations – Operating Expenses – Non-operating Expenses + Non-operating Incomes – Tax

Objective:

Net Profit Ratio indicates the overall efficiency of the business.

Higher the Net Profit Ratio, better is the business. An increase in the ratio over the previous year shows improvement in operational efficiency.

Return on Investment

Return on Investment or Return on Capital Employed shows the relationship of profit (profit before interest and tax) with capital employed. The result of operations of a business is either profit or loss.

The funds or sources used in the business to earn profit/loss are proprietors’ (shareholders’) funds and loans.

Return on Investment = (Net Profit before Interest, Tax and Dividend/Capital Employed) x 100

We compute Capital Employed by Liabilities Approach or by Assets Approach. We should keep in mind, whichever approach we will follow; the amount of capital employed will be the same.

Liabilities Approach:

Capital Employed = Shareholder’ Fund + Non-current Liabilities.

(In case, Surplus balance is there in Statement of Profit and Loss, we will deduct the amount of surplus to calculate the Shareholder’ Fund)

Assets Approach:

Capital Employed = Non-current Assets + Working Capital.

Where,

Non-current Assets = Fixed assets + Non-current Trade Investments + Long-term Loans and Advances.

Working Capital = Current Assets – Current Liabilities

Solved Example onProfitability Ratio

Revenue from Operations ₹ 8,00,000; Gross Profit Ratio 25%; Operating Ratio 90%; Non-operating Expenses ₹ 4,000; Non-operating Income ₹ 44,000.

Calculate Net Profit Ratio.

Ans:

Net Profit Ratio = \(\frac{Net Profit}{Net Sales}\) x 100

= \(\frac{120000}{800000}\) x 100

= 15%

Working notes:

Operating Profit Ratio = 100 – Operating Ratio

= 100 – 90 = 10%

Operating Ratio = ₹ 8,00,000 x 10% = ₹ 80,000.

Net Profit = Operating Profit + Non-operating Incomes – Non-operating Expenses

= ₹ 80,000 + ₹ 44,000 – ₹ 4,000 = ₹ 1,20,000.