General Profitability Ratios
Some profitability ratios are calculated in relation to sales, they are termed as General Profitability Ratios. Such ratios are presented below:
- Gross Profit Ratio.
- Operating Ratio
- Operating Profit Ratio
- Expenses Ratio
- Net Profit Ratio
Gross Profit Ratio
This ratio discloses the relationship prevailing between the gross profit and net sales and expressed in percentage. The following formulae are used to calculate Gross Profit Ratio.
Gross Profit Ratio = (Gross Profit /Net Sales) x 100
Gross Profit Ratio = (Sales — Cost of Goods Sold) / Net Sales x 100
Significance of Gross Profit Ratio
This ratio indicates the efficiency of the business concern with which produces its products. The high gross profit ratio shows the higher efficiency of the business concern and vice versa. A low gross profit ratio results due to the high cost of goods sold. The cost of goods sold may be increased due to unfavorable purchasing policies, low sales, low selling price, stiff competition in the market, poor canvassing, wrong sales promotion policy, over investment in plant and machinery and the like.
The gross profit should cover operating expenses and provide fixed charges, dividends and accumulation of reserve. The term operating expenses includes office and administration expenses and selling and distribution expenses. Sometimes, high gross profit ratio is possible due to over valuation of closing stock and under valuation of opening stock. Hence, there is a need of thorough investigation before interpreting gross profit ratio.
This ratio discloses the relationship prevailing between the operating cost and sales in percentage. It indicates the cost of operations per rupee of sales. The following formulae are used to calculate operating ratio.
Operating Ratio = Operating Cost / Net Sales x 100
Operating Ratio = (Cost of Goods Sold + Operating Expenses) / Net Sales x 100
Operating Expenses = Office and Administrative Expenses + Selling and Distribution Expenses
Significance of Operating Ratio
The level of operating ratio leads to level of profit earned by the company. It means that high operating ratio indicates high amount of expenses. If expenses is high, automatically the profit is less. Operating ratio is considered to be a yardstick to measure operating efficiency of the company. At the same time, an analyst should be very careful while interpreting the operating ratio. The reason is that the low operating ratio does not result in high amount of profit. Sometimes, non-operating expenses form a major portion of total expenses. In such a situation, there is a possibility of low operating ratio and low amount of profit earned by a company.
Operating Profit Ratio
The following formulae are used to calculate operating profit ratio.
Operating Profit Ratio = Operating Profit / Net Sales x 100
Operating Profit = Net Sales — Operating Cost (or) Net Profit+ Non-operating Expenses — Non-operating
Expenses ratios indicate the relationship of various expenses to net sales. The lower the ratio shows the greater profitability and vice versa. The nature of expense is taken into consideration while interpreting the expenses ratio. The nature of expenses is either fixed or variable. In the case of fixed nature of expenses, the ratio will fall if the sales increase. In the case of variable nature of expenses, the ratio in proportion to sales shall remain nearly the same. The various types of expenses ratios are given below.
1. Cost of Goods sold Ratio = Cost of Goods Sold / Net Sales x 100
2. Office and Administrative Expenses Ratio = Office and Administration Expenses / Net Sales x 100
3. Selling and Distribution Expenses Ratio = Selling and Distribution Expenses / Net Sales x 100
4. Non-operating Expenses Ratio = Non-operating Expenses / Net Sales x 100
Net Profit Ratio
This ratio indicates the efficiency of management on Manufacturing, Administrative, Selling and other business activities. The following formulae are used to calculate net profit ratio.
Net Profit Ratio = Net Profit after Tax / Net Sales x 100
Net Profit Ratio = Net Operating Profit / Net Sales x 100
Net Profit Ratio = Net Profit / Net Sales x 100
Note: Income Tax, non-operating incomes and expenses are excluded. Non-operating income includes interest on investments and profit on sale of fixed assets. High net profit ratio shows better profitability of the business concern.
Cash Profit Ratio
This ratio discloses the relationship prevailing between the cash generated from operations and net sales. The following formula is used to calculate the cash profit ratio.
Cash Profit Ratio = Cash Profit / Net Sales x 100
Cash Profit = Net Profit+ Depreciation