Profitability

ratios
Harsh Sanghvi K041
Nikhil Abichandani M001

What does profitability ratio talk about?

1. Talk about the profitability of a business with respect

to its sales or investments.
2. The purpose is to measure the operating efficiency of
a business and returns which the business generates.
3. The ratios are used by three main groups:
managers who employ ratios to help analyze, control,
and thus improve the firm`s operations
credit analysts such as bank loan officers, who analyze
ratios to help ascertain a company`s ability to pay its
debts.
stock analysts who are interested in a company`
efficiency and growth prospects.

Profit margin
There are two types of profit margins:1. Gross profit margin.
2. Net profit margin.
. Gross profit margin
. Gross profit margin measures the percentage of each sales rupee
remaining after the firm has paid for its goods.
(Gross profit Net sales)*100
. Net profit margin
Net profit margin measure the percentage of each sales rupee
remaining after all costs and expenses including interests and
taxes have deducted.
(Earnings after interests and taxes net sales)*100

Profitability ratios related to

investments.
Return on investment (ROI)
ROI measures the overall effectiveness of management in
generating profits with its available assets. There are 3 parts
for Return of investments.
Return on asset.
Return on capital employed.
Return on shareholders equity.

Return on Asset (ROA)

This ratio measures the profitability of the total funds of a
firm. It measures the relationship between net profit and
assets. The objective is to find out how efficiently the total
assets have been used by the management.
ROA shows how efficiently a company can covert the
money used to purchase assets into net income or profits
ROA= (Net profit after taxes plus Average total
assets)*100
It excludes Fictitious assets.

Return on Capital
Employed
This ratio measures the relationship between net profit
and capital employed. It indicates how efficiently the
long term funds of owner and creditors are being used.
The return on capital employed ratio shows how much
profit each Rupee of employed capital generates.
A higher ratio would be more favorable because it means
that more Rupees of profits are generated by each dollar
of capital employed.
ROCE= (Earnings before interests and taxes average
capital employed)*100
Capital employed denotes the shareholders funds.

Return on total
Shareholders equity.
Measure the return on both preference and equity
shareholders in the firm.
Return on equity measures how efficiently a firm can
use the money from shareholders to generate profits and
grow the company.
ROE is a profitability ratio from the investor's point of
viewnot the company
(Net profit after taxes total shareholders equity)*100
Total shareholders equity includes preference share capital
plus equity share capital plus reserve and surplus less
accumulated losses and fictitious assets.

Du Pont Equation
The profit margin times the total assets turnover is called the Du
Pont equation, and it gives the rate of return on assets (ROA): ROA
= Profit margin Total assets turnover.
(Net Income/Revenue) * (Revenue/Assets) = Profit Margin * Asset
Turnover

The rate of return on assets (ROA) must be multiplied by the equity

multiplier, which is the ratio of assets to common equity, to obtain
the rate of return on equity (ROE):

(Net Income/Revenue) * (Revenue/Assets) * (Assets/Equity)

Equity Multiplier

Compute: Gross Profit Margin, Net Profit to sales ratio,

Return on investment ratio, return on capital employed.

Solution:
Gross Profit Margin= Gross Profit/ Net sales
(21750/49000)*100= 44.38%
Net profit Margin= Net profit/ Net sales
(6300/49000)*100= 12.85%
Return on investment = EBIT/Total Assests
(6300+6300+400/35050)= 0.370
ROCE= EBIT/ Capital Employed (TL-CL)
13000/(35050-1250-5000) = 0.451