Introduction to Profitability Ratios

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Financial Ratios:
Introduction to
Profitability Ratios

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Importance of Profitability Ratios
• The profitability or financial performance is mainly summarised in the statement of
profit and loss.
• These ratios are calculated to analyse the earnings capacity of the business which is the
outcome of utilization of resources employed in the business.
• There is a close relationship between the profit and the efficiency with which the
resources employed in the business are utilised.
• These ratios are a class of financial metrics that are used to a business’s ability to
generate earnings compared to its expenses.
• For most of these ratios, having a higher value relative to a competitor's ratio or
relative to the same ratio from a previous period indicates that the company is doing
well.

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Profitability Ratio : Gross Profit ratio
Change in gross profit may be due change in selling price or cost of revenue from operations or a
combination of both.
Significance : It indicates gross margin on products sold.
It also indicates the margin available to cover operating expenses, non-operating expenses.
Gross profit ratio as a percentage of revenue from operations is computed to have an idea about gross
margin.
It is computed as follows Gross Profit Ratio = Gross Profit x 100
Net revenue from Operations
Gross profit is a company’s total revenue (Equivalent to total Sales) minus the cost of goods sold.
Gross profit is the profit a company makes after deducting the costs associated with making and selling
its products.

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Profitability Ratio : Net Profit ratio
This number appears on a company’s income statement and is an important measure of how profitable
the company is over a period of time.
Net Income(NI) is a company’s total earning’s(or profit) is calculated by taking revenues and subtracting
the costs of doing business such as depreciation, Interests, taxes and other expenses.
It is computed as follows: Net Profit Ratio = Net Profit x 100
Revenue from Operations
Net profit is also referred to as bottom line, net income or net earnings is a measure of the profitability
of a venture after accounting for all costs.
It is the actual profit without the inclusion of working expenses in the calculation of gross profit.

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Profitability Ratio : Operating ratio
Operating expenses include office expenses,admin expenses, selling expenses, depreciation and
employee benefit expenses.
Costs of operation is determined by excluding non – operating income and expenses.
Also is referred to as Earnings before interest and tax(EBIT) ,operating profit represents the earnings
power of a company with regard to revenues generated from ongoing operations.
Operating Ratio = (Costs of revenue from operations + Operating expenses) x 100
Net revenue from Operations
Operating profit is the profit earned from a firm’s normal core business operations.
This value does not include any profits earned from the firm’s investments, such as earnings from firms in
which the company has partial interests.

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Profitability Ratio : Operating profit ratio
It is very useful for inter-firm as well as intra firm comparisons.
Lower operating ratio is a very healthy sign.
This ratio is computed to express costs of operations excluding financial charges in relation to revenue
from operations.
It helps to analyse the performance of business and throws light on the operational efficiency of
business.
It is calculated as follows: Operating profit ratio = Operating profit x 100
Revenue from Operations
Where operating profit = Revenue from Operations – Operating Costs
Also known as Operating margin is a margin ratio used to measure a company’s pricing strategy and
operating efficiency.
Operating margin is a measurement of what proportion of a company’s revenue is left over after paying
for all variable costs such as wages, raw materials.

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