Write a note on three Important Profitability Ratios

Profitability ratios reflect the overall performance of the business. Profit must be compared with other information to evaluate the firm’s profitability. There are 2 types of profitability ratios –

Profit margin ratios, which indicate the relationship between profit and sales. The important profit margin ratios are: -

ü Gross profit margin ratio

ü Net profit margin ratio

Rate of return ratios, which examine the relationship between profit and investment. The important rate of return ratios are: -

ü Return on total assets

ü Earning power

ü Return on equity

Gross profit margin ratio:

This ratio computes the margin earned by the firm after incurring manufacturing costs. It measures the efficiency of the production process and pricing policy of the firm. It is calculated as –

Gross Profit x 100 %
Net sales

Where

Gross profit is the difference between Net Sales and Cost of Goods Sold

The cost of goods sold takes into account costs of labour, material and manufacturing overheads.

Net profit margin ratio :

The net profit margin ratio gives the earnings available for shareholders as a percentage of net sales. It is calculated as –

Net profit x 100 %
Net sales

It measures the overall efficiency of the firm in relation to production, administration, selling, financing, pricing and tax management.

The gross and net profit margin ratios taken together provide an understanding of the firm’s cost and profit structure. It also helps identify the sources of the firm’s efficiency or inefficiency.

Return on total assets :

This ratio measures the degree to which capital is efficiently employed by the firm. It is calculated as –

Net Income (profit)

Average Total Assets

Earning power:

Earning power is a measure of operating profitability. It is calculated as –

Earnings Before Interest And Tax
Average Total Assets

It measures the business performance, which is not affected by interest charges and tax payments and thus focuses on operating performance.

Return on equity:

The return on equity measures the earnings from shareholders’ investment and is calculated as –

Equity Earning
Average Net Worth

Equity earnings refers to profit after tax less preference dividends.

Average net worth refers to (paid-up capital+ reserves and surplus).

Also known as the return on net worth, this measure is an important indicator of profitability. It indicates the productivity of the owners’ capital employed. The return on equity is influenced by the firm’s earning power, debt-equity ratio, average cost of debt to the firm and the tax rate.