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Profitability Ratios

PROFITABILITY RATIOS

The profitability ratio of the firm can be measured by calculating various profitability ratios.  General two groups of profitability ratios are calculated.

  1. Profitability in relation to sales.
  2. Profitability in relation to investments.

operating profit

Profitability in relation to sales

  1. Gross profit margin or ratio
  2. Net profit margin or ratio
  3. Operating profit margin or ratio
  4. Operating Ratio
  5. Expenses Ratio

 1.  GROSS PROFIT MARGIN OR RATIO

It measures the relationship between gross profit and sales.  It is calculated by dividing gross profit by sales.

  • Gross profit margin or ratio =    Gross profit X 100Net sales
  • Gross profit is the difference between sales and cost of goods sold.

2.  NET PROFIT MARGIN OR RATIO

It measures the relationship between net profit and sales of a firm.  It indicates management’s efficiency in manufacturing, administrating, and selling the products.  It is calculated by dividing net profit after tax by sales.

 Net profit margin or ratio =      Earning after tax  X  100 / Net Sales

3.  OPERATING PROFIT MARGIN OR RATIO

It establishes the relationship between total operating expenses and net sales.  It is calculated by dividing operating expenses by the net sales.

  • Operating profit margin or ratio = Operating costs  X  100 / Net sales

(0r)

  • Cost of goods sold + Operating expenses * 100 / Net sales

Operating expenses includes cost of goods produced/sold, general and administrative expenses, selling and distributive expenses.

4.  EXPENSES RATIO

While some of the expenses may be increasing and other may be declining to know the behavior of specific items of expenses the ratio of each individual operating expenses to net sales should be calculated.  The various variants of expenses are

  • Cost of goods sold = Cost of goods sold  X  100 / Net Sales
  • Administrative Expenses Ratio = Administrative Expenses  X  100Net sales
  • Selling and distribution expenses ratio =Selling and distribution expenses  X  100Net sales

 5.  OPERATING PROFIT MARGIN OR RATIO

  • Operating profit margin or ratio establishes the relationship between operating profit and net sales.  It is calculated by dividing operating profit by sales.
  • Operating profit margin or ratio = Operating Profit X 100 / Net sales
  • Operating profit is the difference between net sales and total operating expenses.  (Operating profit = Net sales – cost of goods sold – administrative expenses – selling and distribution expenses.)

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