Overall Profitability Ratios | Explanation | Formulae | Significance

Overall Profitability Ratios

Profit is used as a yardstick to measure the profitability of any business concern. Generally, an analyst calculates overall profitability ratios before giving any recommendation to the interested parties. The followings are the overall profitability ratios.

  1. Return on Shareholders’ Investment or Net Worth Ratio.
  2. Return on Equity Capital.
  3. Earning Per Share.
  4. Return on Capital Employed.
  5. Capital Turnover Ratio.

Return on Shareholders’ Investment or Net Worth Ratio

This ratio is popularly known as ROI i.e. Return on Investment. The following formula is used to calculate Net Worth Ratio.

Return on Shareholders’ Investment Ratio / Net Worth Ratio = Net Profit (after Interest and Tax) / Shareholders’ Funds x 100

Significance of Return on Shareholders’ Investment or Net Worth Ratio

1. This ratio indicates the extent of utilization of resources of the business concern. The high net worth ratio shows the better utilization of resources.

2. The level of this ratio attracts the new investors and retain the existing investors.

3. Trend ratios can also be calculated for a number of years to get an idea of the prosperity, growth or deterioration of the business concern.

Return on Equity Capital Ratio

Equity shareholders are real owners of the company. They are ready to assume any level of risk in the company. Preference shareholders are not owners of the company. But, they have the preference in getting dividend and principal amount over equity shareholders.

The excess of dividend paid to preference shareholders out of total profits is available only to the equity shareholders. Hence, profit is high, the rate of dividend is also high. But, in actual practice, this is not happened. Even though, the equity shareholders are more interested in the profitability of the company.

Formula to find Equity Capital Ratio

The following formula is used to calculate Return on Equity Capital Ratio.

Return on Equity Capital Ratio = (Net Profit After Tax — Preference Dividend) / Paid up Equity Share Capital

Earnings Per Share

The following formula is used to calculate Earnings Per Share.

Earnings Per Share = (Net Profit After Tax — Preference Dividend) / No. of Equity Shares

Return on Capital Employed

This ratio indicates the relationship between profits and capital employed. The term capital employed refers to the total of investments made within the business. There are three types of capital employed. They are

  1. Gross Capital Employed.
  2. Net Capital Employed.
  3. Proprietors’ Net Capital Employed.

The following formulae are used to calculate Return on Capital Employed.

Return on Gross Capital Employed = Adjusted Net Profits / Gross Capital Employed x 100

Here,

Adjusted net Profits = Net Profit + Payment of Tax + Interest on Long term borrowings and short term borrowings — Interest on investments made outside the business — Abnormal, Nonrecurring, Non-operating gains or losses such as profit/loss on sale of fixed assets — Depreciation based on replacement cost if fixed assets are added at replacement cost.

Return on Net Capital Employed = Adjusted Net Profits / Net Capital Employed x 100

Here,

Adjusted net profits = Net Profit + Payment of Tax + Interest on Long Term borrowings — Interest on Short Term borrowings — Interest on investments made outside the business — Abnormal, non-recurring, Non-operating gains or losses such as profit/loss on sale of fixed assets — Depreciation based on replacement cost if fixed assets are added at replacement cost.

1. Gross Capital Employed

The Gross Capital Employed is calculated with the help of following equation.

Gross Capital Employed = Fixed Assets + Current Assets.

Here, Fixed Assets = Fixed Assets at cost or at replacement value — Depreciation + Investments made within business.

The Net Capital Employed is calculated with the help of following equation.

2. Net Capital Employed

The following formula is used to calculate net capital employed.

Net Capital Employed = Total Assets — Current Liabilities

Here, Total Assets = Fixed Assets + Current Assets

3. Proprietors’ Net Capital Employed

The proprietors’ Net Capital Employed is calculated with the help of following equation.

Proprietors’ Net Capital Employed = Fixed Assets + Current Assets— Outside Liabilities (both long term and short term).

Note: While calculating capital employed, Idle Assets, Intangible Assets (Goodwill, Patent etc.), Investments made outside the business, Fictitious Assets (Preliminary expenses, accumulated losses) and obsolete Assets are excluded.

The capital employed can be calculated one more technique which is given below.

Capital Employed = Total of All Liabilities+ Increase in the value of assets on replacement cost — Accumulated Losses — Fictitious Assets — Intangible Assets — Idle and obsolete Assets — Investments made outside the business.

Formula to calculate average capital employed

Average capital employed may be calculated as follows.

Average Capital Employed

= (Opening Capital Employed + Closing Capital Employed) / 2

or

 = Closing Capital Employed — ½ of Profit earned during the year

or

= Opening Capital Employed + ½ of Profit earned during the year

or

= Gross Capital Employed — ½ of Profit earned during the year

or

= Net Capital Employed — ½ of Profit earned during the year.

Significance of Return on Capital Employed

1. This ratio helps the management in evaluating the performance of various departments.

2. Investors/shareholders can justify their investments. Inter firm comparison and Intra firm comparison is possible.

3. The management can frame the financial policy of the business concern. Besides, the rate of interest on additional borrowings may be less than the return on capital employed.

4. The creditors can decide whether the lending is safe and returnable with interest.

5. The future growth, expansion and diversification policy of the business concern may be decided.

Capital Turnover Ratio

This ratio discloses the relationship prevailing between the cost of goods sold or net sales and capital employed. This ratio is calculated to know the extent of utilization of available financial resources within the business concern. The following formula is used to calculate capital turnover ratio.

Capital Turnover Ratio = Cost of Goods Sold or Net Sales / Capital Employed

The earning capacity of the business concern is based on the level of investments made in the fixed assets. Hence, one more ratio i.e. Fixed Assets Turnover Ratio is calculated with the help of following formula.

Fixed Assets Turnover Ratio = Cost of Goods Sold or Net Sales / Fixed Assets

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