Desarrollo moral y ético

PROFITABILITY RATIOS

A company should earn profits to Survive and Grow over a long period of time.

A company should earn profits to Survive and Grow over a long period of time.

Profits are essential, but it would be wrong to assume that every action initiated Profits are essential, but it would be wrong to assume that every action initiated by management of a company should be aimed at maximizing profits, irrespective by management of a company should be aimed at maximizing profits, irrespective of social consequences.

of social consequences.

Profit is the difference between revenues and expenses over a period of time Profit is the difference between revenues and expenses over a period of time (usually a year).

(usually a year). Profit is the Profit is the ultimate “Output” oultimate “Output” of a company, f a company, and it will hand it will have noave no future if it fails

future if it fails to make suto make sufficient profits. fficient profits. Therefore, the financial Therefore, the financial manager shouldmanager should con

contintinuouuously evalusly evaluate to ate to the effithe efficieciency of ncy of the comthe companpany y in term of in term of proprofitfits. s. TheThe pr

profofititababiliility ty raratitios os are are cacalclcululatated ed to to memeasasurure e ththe e opoperaeratiting ng efeffificicienency cy of of ththee comp

company. any. BesidBesides manages management of the compaement of the company, creditny, creditors and owners are alsoors and owners are also int

intereerestested in d in the prothe profitfitabilability of the firm. ity of the firm. CreCreditditors wanors want to t to get intget intereerest andst and repayment of princip

repayment of principle regularly. le regularly. Owners want Owners want to get a to get a required rate of returequired rate of return onrn on their investment.

their investment. This is possible This is possible only when the coonly when the company earns enoumpany earns enough profits.gh profits.

Generally two major types of profitability ratios are calculated.

Generally two major types of profitability ratios are calculated.

PROFITABILITY IN RELATION TO SALES PROFITABILITY IN RELATION TO SALES



 PROFITABILITY IN RELATION TO INVESTMENTPROFITABILITY IN RELATION TO INVESTMENT

PROFITABILITY RATIOS IN RELATION TO SALES PROFITABILITY RATIOS IN RELATION TO SALES 1

1.. GGRROOSSS S PPRROOFFIIT T MMAARRGGIINN 2

2.. CCAASSH H MMAARRGGIINN 3

3.. OOPPEERRAATTIINNG G MMAARRGGIINN

4

4.. NNEET T PPRROOFFIIT T RRAATTIIOO

GROSS PROFIT MARGIN:

GROSS PROFIT MARGIN:

Gro

Gross ss proprofit fit marmargingin rereflflecects ts ththe e efeffificicienency cy wiwith th whwhicich h ththe e mamananagegemementnt produces each

produces each unit of unit of product. product. This ratio This ratio indicates the indicates the average spread average spread betweenbetween the cost of goo

the cost of goods sold and the ds sold and the sales revenue. sales revenue. When we subtract tWhen we subtract the gross profithe gross profit margin from 100%, we obtain the ratio of Cost of goods to Sales.

margin from 100%, we obtain the ratio of Cost of goods to Sales.

Both this shows profits relative to sales after the deduction of production costs, Both this shows profits relative to sales after the deduction of production costs, and indic

and indicates the relatates the relation betwion between Produeen Production costction costs and Selling pris and Selling price. ce. A highA high gross profit margin relative to the industry average implies that the firm is able gross profit margin relative to the industry average implies that the firm is able to produce at relatively lower cost.

to produce at relatively lower cost.

A high gross p

A high gross profit margin ratio is a rofit margin ratio is a sign of good sign of good management. management. A gross marginA gross margin ratio may increase due to any of the following factors.

ratio may increase due to any of the following factors.

Higher sales prices, cost of

Higher sales prices, cost of goods sold remaining constant,goods sold remaining constant, i.

i. LowLower cost of gooer cost of goods sold, sads sold, sales priceles prices remas remaining consining constanttant,, ii.

ii. A combinatA combination of vion of variations in ariations in sales prices sales prices and costand costs, the mas, the margin widening, argin widening, andnd iii.

iii. IncrIncreaseases in the propores in the proportionationate volumte volume of higher mae of higher margin itemrgin items.s.

  T

  The he ananalalysysis is of of ththesese e fafactctorors s wiwill ll rereveveal al to to ththe e mamananagegemement nt ththat at hohow w aa depressed gross profit margin can be improved.

depressed gross profit margin can be improved.

A low gross profit margin may reflect higher cost of goods sold due to the firms`

A low gross profit margin may reflect higher cost of goods sold due to the firms`

inability to purchase raw materials at favorable terms, inefficient utilization of  inability to purchase raw materials at favorable terms, inefficient utilization of  plant and machinery,

plant and machinery, resulting in higher coresulting in higher cost of productionst of production. . The ratio will also The ratio will also bebe low due to fall in prices in the market, or market reduction in selling price by the low due to fall in prices in the market, or market reduction in selling price by the firm in an attempt to obtain large sales volume, the cost of goods sold remaining firm in an attempt to obtain large sales volume, the cost of goods sold remaining unchanged.

unchanged. The financial mThe financial manager must be anager must be able to detect able to detect the causes othe causes of a fallingf a falling gross margin and initiate action to improve the situation.

gross margin and initiate action to improve the situation.

Sales – Cost of goods sold Sales – Cost of goods sold

(or) Gross profit (or) Gross profit GROSS PROFIT MARGIN RATIO =

GROSS PROFIT MARGIN RATIO =

Sales Sales

NET PROFIT MARGIN RATIO:

NET PROFIT MARGIN RATIO:

Ne

Net t prprofofit it is is obobtatainined ed whwhen en opopereratatioion n exexpepensnseses, , inintetererest st anand d tataxexes s araree subtracted from the gross profit.

subtracted from the gross profit.

If the non-operating income figure is substantial, it may be excluded from PAT If the non-operating income figure is substantial, it may be excluded from PAT to see profitab

to see profitability arising directly from sales. ility arising directly from sales. Net profit margin ratio Net profit margin ratio establishes aestablishes a relationship between net profit and sales and indicated management’s efficiency relationship between net profit and sales and indicated management’s efficiency in manufacturing, a

in manufacturing, administering and dministering and selling the prodselling the products. ucts. This ratio is This ratio is the overallthe overall measu

measure of the firmsre of the firms` ability to tu` ability to turn each rupern each rupee sales inte sales into net profio net profit. t. If the netIf the net ma

margrgin in is is ininadadeqequauatete, , ththe e fifirm rm wiwill ll fafail il to to acachihieveve e sasatitisfsfacactotory ry reretuturn rn onon shareholder`s funds.

shareholder`s funds.

  Th

  This is ratratio io alsalso o indindicaicates tes the the firfirms` ms` capcapacitacity y to to witwithsthstand and advadverserse e ecoeconomnomicic conditions. A firm with a high net margin ratio would be in an advantageous conditions. A firm with a high net margin ratio would be in an advantageous position to survive in the face of falling selling prices, rising costs of production or position to survive in the face of falling selling prices, rising costs of production or declining demand for

declining demand for the product. the product. It would really bIt would really be difficult for a low e difficult for a low net marginnet margin firm to withst

firm to withstand thesand these adversite adversities. ies. SimilSimilarly, a firm higher net profarly, a firm higher net profit margin canit margin can make better use of favorable condition, such as rising selling prices; fall in costs of  make better use of favorable condition, such as rising selling prices; fall in costs of  pro

producductiotion or n or incincreareasinsing demang demand for the produd for the product. ct. SucSuch a h a firfirm will be m will be ablable toe to accelerate its profits at a faster rate than a firm with a low

accelerate its profits at a faster rate than a firm with a low net profit margin will.net profit margin will.

An analyst will be able to interpret the firm’s profitability more meaningfully if  An analyst will be able to interpret the firm’s profitability more meaningfully if  he

he/s/she he evevalaluauatetes s boboth th ththe e ratratioios-s-grgrososs s mamargrgin in anand d nenet t mamargrginin-jo-joinintltly. y. ToTo illustrate, if the gross profit margin has increased over years, but the net profit illustrate, if the gross profit margin has increased over years, but the net profit margin has either remained constant or declined, or has not increased as fast as margin has either remained constant or declined, or has not increased as fast as the gross margin, this implies that the operating expenses relative to sales have the gross margin, this implies that the operating expenses relative to sales have been incre

been increasingasing. . The increThe increasing expasing expenses shenses should be identiould be identified and contfied and controlledrolled..

Gross profit margin may decline due to fall in sales price or increase in the cost of  Gross profit margin may decline due to fall in sales price or increase in the cost of  production.

production.

Profit after tax Profit after tax NET

NET PROFIT PROFIT MARGIN MARGIN RATIO RATIO = = SalesSales

CASH MARGIN RATIO:

CASH MARGIN RATIO:

Cash profit exclud

Cash profit excludes depreciation. es depreciation. It means Net It means Net profit after interests profit after interests and taxesand taxes but before d

but before depreciation. epreciation. This ratio inThis ratio indicates the dicates the relationship between relationship between the profit,the profit, which accru

which accrues in cash and sales. es in cash and sales. GreatGreater percenter percentage indicatage indicates better posies better positiontion and Vice-Versa as it shows the correct profit earned by the firm.

and Vice-Versa as it shows the correct profit earned by the firm.

 This ratio is expressed as cash profit to sales.

 This ratio is expressed as cash profit to sales.

Cash profit Cash profit CASH

CASH MARGIN MARGIN RATIO RATIO = = X X 100100 Sales

Sales

OPERATING MARGIN RATIO:

OPERATING MARGIN RATIO:

Operating margin ratio is also

Operating margin ratio is also known as Operatinknown as Operating Net profit ratio. g Net profit ratio. It is the ratioIt is the ratio of operati

of operating profit to salesng profit to sales. . This ratiThis ratio establio establishes the relatshes the relationsionship betweehip between then the total cost incurred

total cost incurred and sales. and sales. Operating profit is Operating profit is the Net profit after the Net profit after depreciationdepreciation but Before Interests

but Before Interests and Taxes. and Taxes. The purpose of coThe purpose of computing this ratio mputing this ratio is to find outis to find out the overall operational eff

the overall operational efficiency of the buiciency of the business concern. siness concern. It measures It measures the constthe const of operations per rupee of sales.

of operations per rupee of sales.

 This ratio is expressed as operating profit to sales.

 This ratio is expressed as operating profit to sales.

Operating profit Operating profit OPERATING

OPERATING MARGIN MARGIN RATIO RATIO = = X X 100100 Sales

Sales

PROFITABILITY RATIOS IN RELATION TO INVESTMENT PROFITABILITY RATIOS IN RELATION TO INVESTMENT

1

1.. RREETTUURRN N OON N IINNVVEESSTTMMEENNTT 2

2.. RREETTUURRN N OON N NNEET T WWOORRTTHH 3

3.. RREETTUURRN N OON N CCAAPPIITTAALL 4

4.. RREETTUURRN N OON N GGRROOSSS S BBLLOOCCK  K  

RETURN ON INVESTMENT:

RETURN ON INVESTMENT:

 The term inve

 The term investmenstment refers to Total Asst refers to Total Assets. ets. The fundThe funds employes employed in Net assetsd in Net assets are known as Capit

are known as Capital Employal Employed. ed. Net assetNet assets equal net fixed assets equal net fixed assets plus currents plus current

ass

assets minus Currets minus Current liabilent liabilitiities es excexcludluding Bank ing Bank loaloans. ns. AltAlternernatiativelvely, y, CapCapitaitall employed in equal to Net worth plus total debt.

employed in equal to Net worth plus total debt.

 The conventional approach of calculating return on investment (ROI) is to divide  The conventional approach of calculating return on investment (ROI) is to divide PA

PAT T by by InInveveststmmenent. t. InInveveststmement nt rereppreressenents ts popoool l oof f fufunnds ds susupppplilied ed byby shareholders and lenders, while PAT represents residual income of shareholders;

shareholders and lenders, while PAT represents residual income of shareholders;

therefore, it is conceptu

therefore, it is conceptually unsound to ally unsound to use PAT in the cuse PAT in the calculation of ROI. alculation of ROI. Also, asAlso, as dis

discuscussed earlsed earlier, PAT is ier, PAT is affaffectected by ed by capcapitaital l strstructuctureure. . It is, therefIt is, therefore moreore more ap

apprpropopririatate e to to ususe e onone e of of ththe e fofollllowowining g memeasasurures es of of ROROI I fofor r cocompmpararining g ththee operating efficiency of firms.

operating efficiency of firms.

EBIT (1-T) EBIT (1-T) ROI

ROI = = ROTA ROTA ==

Total Assets Total Assets

EBIT (1-T) EBIT (1-T) ROI

ROI = = RONA RONA ==

NET Assets NET Assets

Where ROTA and RONA respectively Return on Total assets and Return on Net Where ROTA and RONA respectively Return on Total assets and Return on Net assets.RONA is equivalent of Return on

assets.RONA is equivalent of Return on Capital Employed.Capital Employed.

RETURN ON NET WORTH:

RETURN ON NET WORTH:

NET Worth is also kno

NET Worth is also known propriwn proprietors Net Capietors Net Capital Emplotal Employed. yed. The ReturThe Return shouldn should be calculated with reference to profits belonging to shareholders, and therefore, be calculated with reference to profits belonging to shareholders, and therefore, profi

profit shall be Net proft shall be Net profit after interit after interest and taxest and tax. . The profThe profit for this purpit for this purpose willose will include even no

include even non-trading profit. n-trading profit. This is This is given as fogiven as follows:llows:

Net profit after interest & tax Net profit after interest & tax RETURN

RETURN ON ON NET NET WORTH WORTH = = X X 100100 Shareholders funds

Shareholders funds

RETURN ON CAPITAL:

RETURN ON CAPITAL:

 The ROCE is t

 The ROCE is the second type he second type of ROI. of ROI. The term capital emThe term capital employed refers to long-ployed refers to long-term funds supplied by t

term funds supplied by the creditors and owners ohe creditors and owners of the fund. f the fund. It can be compuIt can be computedted in two ways.

in two ways. First, it is equal to non-currFirst, it is equal to non-current liabilient liabilities (longties (long-term liabil-term liabilities) pluities) pluss owner

owner’s equity. ’s equity. AlternAlternativelatively, it is y, it is equivequivalent to Net Workinalent to Net Working Capital plus Fixeg Capital plus Fixedd

Ass

Assetsets. . ThuThus, the s, the CapCapitaital l EmpEmployloyed provied provides a des a basbasis to is to testest t the profthe profitaitabilbilityity related to the so

related to the sources of long-term urces of long-term funds. funds. A comparison of A comparison of this ratio with this ratio with similarsimilar firms, with the industry average and overtime would provide sufficient insight firms, with the industry average and overtime would provide sufficient insight into how efficiency the long-term funds of owners and creditors are being used.

into how efficiency the long-term funds of owners and creditors are being used.

 The higher the ratio, the more efficient is the use of Capital Employed.

 The higher the ratio, the more efficient is the use of Capital Employed.

NET PROFIT AFTER TAX/EBIT NET PROFIT AFTER TAX/EBIT ROCE

ROCE = = X X 100100

Average Total Capital

Average Total Capital EmployeeEmployee

RETURN ON GROSS BLOCK:

RETURN ON GROSS BLOCK:

 This ratio establishes a relationship between net profit and gross fixed assets.

 This ratio establishes a relationship between net profit and gross fixed assets.

  Th

  This ratio emphis ratio emphasiasizes the profzes the profit on it on invinvestestmenment in t in FixFixed Asseted Assets. s. ThiThis s ratratio isio is expressed as follows:

expressed as follows:

Net profit Net profit RETURN

RETURN ON ON GROSS GROSS BLOCK BLOCK = = X X 100100 Gross Block 

Gross Block 

NET PRO

NET PROFIT is profiFIT is profit t befbefore Tax. ore Tax. GroGross Blocss Block k meameans Grosns Gross fixed asses fixed assets i.e.ts i.e.,,

NET PROFIT is profiFIT is profit t befbefore Tax. ore Tax. GroGross Blocss Block k meameans Grosns Gross fixed asses fixed assets i.e.ts i.e.,,

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