Profitability Ratios Definition – formula and Use of Profitability Ratios

Accounting ratios are very useful tool to provide information about the financial soundness, strength, position and status of an organization.

Functional Classification of Accounting Ratios: The classification of ratios according to the purpose of its computation is known as functional classification. On this basis ratios are classified as follows:

  • Profitability Ratios
  • Turnover Ratio or Activity Ratio
  • Financial Ratio or Solvency Ratio.
  • Market Test Ratios 

In this blog, we are going to discuss about the Profitability ratios, their formulas & use.

Profitability Ratios measures the overall efficiency of the organization. Profitability Ratio determined on the basis of investment and sales.

The income as compared to capital employed indicated the profitability of the firm.

Main Profitability Ratio = Operating profit /Operating Capital Employed * 100

 

Profitability in relation to investments

1. Return on Investment: It defines the earning of the company as compared to its investment.

           Return on Investment  =  Net Operating Profit /Capital Employed * 100

  • Operating profit means profit before interest & tax
  • Capital Employed = Share Capital + Reserve and surplus + long term loans – Non operating assets – fictitious assets

2.  Return on Shareholders’ Fund: It determines the profitability of the company from the shareholders’ point of view.

      Return on Shareholders’ Fund= Net Profit after interest and tax / Shareholders’ Fund * 100

3. Return on Assets: In this ratio profitability is measured in terms of the relationship between net profits and assets.

       Return on Assets  =  Net profit after tax /Total assets * 100

 

Profitability in relation to sales

1.Gross profit Ratio: It defines the relationship of gross profit to net sales. This ratio determines the general profitability.

                 Gross profit Ratio = Gross profit/Net sales * 100

2.Net Profit Ratio: It represents the net margin earned in a sale of Rs 100.

                Net Profit Ratio = Operating profit /sales * 100

3.Operating Ratio: It is the ratio of operating expenses (materials used, labour, factory overheads, office and selling expenses) to sales. This ratio indicate whether the cost is high or low in comparison to sales

  • Material cost ratio = Material consumed /sales * 100
  • Labour Cost ratio =  Labour cost /sales * 100
  • Administrative expenses ratio = Administrative expenses / Sales * 100