Classification of various profitability ratios:

1. Gross Profit Ratio (June 03)
2. Net Profit Ratio
3. Operating Profit Ratio
4. Operating Ratio
5. Return on Investment or Return on Capital Employed
6. Return on Equity (Dec. 99, Jan. 01, Dec. 01)
7. Earning Per Share

Meaning, Objective and Method of Calculation:

1. Gross Profit Ratio: Gross Profit Ratio shows the relationship between Gross Profit of the concern and its Net Sales. Gross Profit Ratio can be calculated in the following manner:




Gross Profit Ratio		Gross Profit
	=		x	100
		Net Sales

Where Gross Profit = Net Sales – Cost of Goods Sold
Cost of Goods Sold = Opening Stock + Net Purchases + Direct Expenses – Closing Stock
And Net Sales = Total Sales – Sales Return

Objective and Significance: Gross Profit Ratio provides guidelines to the concern whether it is earning sufficient profit to cover administration and marketing expenses and is able to cover its fixed expenses. The gross profit ratio of current year is compared to previous years’ ratios or it is compared with the ratios of the other concerns. The minor change in the ratio from year to year may be ignored but in case there is big change, it must be investigated. This investigation will be helpful to know about any departure from the standard mark-up and would indicate losses on account of theft, damage, bad stock system, bad sales policies and other such reasons.

However it is desirable that this ratio must be high and steady because any fall in it would put the management in difficulty in the realisation of fixed expenses of the business.

2. Net Profit Ratio: Net Profit Ratio shows the relationship between Net Profit of the concern and Its Net Sales. Net Profit Ratio can be calculated in the following manner:
   
   

Net Profit Ratio		Net Profit
	=		x	100
		Net Sales

Where Net Profit = Gross Profit – Selling and Distribution Expenses – Office and Administration Expenses – Financial Expenses – Non Operating Expenses + Non Operating Incomes.
And Net Sales = Total Sales – Sales Return

Objective and Significance: In order to work out overall efficiency of the concern Net Profit ratio is calculated. This ratio is helpful to determine the operational ability of the concern. While comparing the ratio to previous years’ ratios, the increment shows the efficiency of the concern.

3. Operating Profit Ratio: Operating Profit means profit earned by the concern from its business operation and not from the other sources. While calculating the net profit of the concern all incomes either they are not part of the business operation like Rent from tenants, Interest on Investment etc. are added and all non-operating expenses are deducted. So, while calculating operating profit these all are ignored and the concern comes to know about its business income from its business operations.

Operating Profit Ratio shows the relationship between Operating Profit and Net Sales. Operating Profit Ratio can be calculated in the following manner: -

Operating Profit Ratio		Operating Profit
	=		x	100
		Net Sales

Where Operating Profit = Gross Profit – Operating Expenses
Or Operating Profit = Net Profit + Non Operating Expenses – Non Operating Incomes
And Net Sales = Total Sales – Sales Return

Objective and Significance: Operating Profit Ratio indicates the earning capacity of the concern on the basis of its business operations and not from earning from the other sources. It shows whether the business is able to stand in the market or not.

4. Operating Ratio: Operating Ratio matches the operating cost to the net sales of the business. Operating Cost means Cost of goods sold plus Operating Expenses.




Operating Ratio		Operating Cost
	=		x	100
		Net Sales

Where Operating Cost = Cost of goods sold + Operating Expenses
Cost of Goods Sold = Opening Stock + Net Purchases + Direct Expenses – Closing Stock
Operating Expenses = Selling and Distribution Expenses, Office and Administration Expenses, Repair and Maintenance.

Objective and Significance: Operating Ratio is calculated in order to calculate the operating efficiency of the concern. As this ratio indicates about the percentage of operating cost to the net sales, so it is better for a concern to have this ratio in less percentage. The less percentage of cost means higher margin to earn profit.

5. Return on Investment or Return on Capital Employed: This ratio shows the relationship between the profit earned before interest and tax and the capital employed to earn such profit.




Return on Capital Employed		Net Profit before Interest, Tax and Dividend
	=		x	100
		Capital Employed

Where Capital Employed = Share Capital (Equity + Preference) + Reserves and Surplus + Long-term Loans – Fictitious Assets
Or Capital Employed = Fixed Assets + Current Assets – Current Liabilities

Objective and Significance: Return on capital employed measures the profit, which a firm earns on investing a unit of capital. The profit being the net result of all operations, the return on capital expresses all efficiencies and inefficiencies of a business. This ratio has a great importance to the shareholders and investors and also to management. To shareholders it indicates how much their capital is earning and to the management as to how efficiently it has been working. This ratio influences the market price of the shares. The higher the ratio, the better it is.

6. Return on Equity: Return on equity is also known as return on shareholders’ investment. The ratio establishes relationship between profit available to equity shareholders with equity shareholders’ funds.




Return on Equity		Net Profit after Interest, Tax and Preference Dividend
	=		x	100
		Equity Shareholders’ Funds

Where Equity Shareholders’ Funds = Equity Share Capital + Reserves and Surplus – Fictitious Assets

Objective and Significance:

• Return on Equity judges the profitability from the point of view of equity shareholders.
• This ratio has great interest to equity shareholders.
• The return on equity measures the profitability of equity funds invested in the firm.
• The investors favour the company with higher ROE.

1. Earning Per Share: Earning per share is calculated by dividing the net profit (after interest, tax and preference dividend) by the number of equity shares.
   
   

   Earning Per Share		Net Profit after Interest, Tax and Preference Dividend
   	=		x	100
   		No. Of Equity Shares