Profitability Ratio: Types, Formula,Uses

Profitability Ratio

Profitability is the word which indicates the efficiency of the business. Poor operational performance may indicate poor sales and poor sales is the causes of poor profits. A lower profitability may arise due to the lake of control over the expenses.

However, Profitability ratio helps to measure the profitability position of the business concern. This ratio also measures the efficiency of management.

Types of Profitability Ratio

There is four types of profitability ratio which is commonly used to measure the performance of the concern. These are:

  1. Gross Profit Ratio
  2. Net Profit Ratio
  3. Return on Investment Ratio, and
  4. Fixed Charges Cover Ratio
  1. Gross Profit Ratio:

This ratio is calculated by dividing profit before depreciation, taxation and other allocation by the sales during the period. The ratio is expressed as a percentage. This ratio expresses the relationship between gross profit and net sales.

The formula of Gross Profit Ratio is = Gross Profit/ Net Sales x 100

A comparison of the last few years will show the trend in the profitability of the business operations i.e. whether the profitability is increasing, decreasing, or remains constant. The gross profit should be adequate to cover operating expenses and to provide for fixed charges, dividends etc.

2. Net Profit Ratio:

Net Profit Ratio is derived by dividing the net profit after depreciation but before taxation by the net worth of the company. This ratio helps to determine the efficiency of the management of the business. Increase the ratio indicates improvements in operational efficiency. Hence, this is an effective measurement to check the profitability of the business.

An investor has to judge adequacy or otherwise of this ratio by taking into account the cost of capital, the return in the industry as a whole and market conditions such as boom or depression period. However, constant increase is a definite indication of of improving the business.

The formula of this ratio is : Net Profit Ratio = Net Profit after tax/ Net Sales x 100

3. Return on Capital Employed Ratio :

This ratio also called as overall Profitability Ratio. It indicates the percentage of return on the total capital employed in the business.

The formula of this ratio is : ROCE Ratio = Operating profit/ Capital Employed x 100

The term operating profit means Profit before interest and tax. non-Trading income such as interest on Government Securities or Non-Trading losses or expenses such as loss on account of fire etc. will also be excluded.

4. Fixed Charges Cover Ratio:

This Ratio is very important from the view point of the lenders. It indicates whether the business earn sufficient profits to pay the loan installments. The higher the number, the more secured the lender’s amount.

The formula of Fixed Charges Cover Ratio:

Income before interest and tax/Interest Charges x 100

Ratio At a Glance

  • Gross Profit Ratio = Gross Profit/Net sales x 10
  • Net Profit Ratio = Net Profit after tax/ Net sales x 100
  • Return on Investment Ratio = Operating Profit/Capital Employed x 100
  • Fixed Charges Cover Ratio = Income before interest and tax/Interest Charges x 100

Conclusion

Bankers , Financial institutions and other creditors looks at profitability ratios as an indicator whether the company earns substantially to pay their installments. Owners are interested to know the profitability as it indicates the return which they can get on their investments.