 ## Types of Profitability Ratios

Subject: Principles of Accounting

#### Overview

Net profit ratio is the link between Sales and Net profit. Return on assets is an excellent measure to check on a company’s overall performance. Net profit after tax (NPAT) is the excess of gross profit and other incomes over the operating & non-operating expenses and losses.

### Profitability Ratios

Profitability ratio is a measure of profitability which helps to measure the performance of company. They are used to assess a company's ability to earn profit or income compared to its expenses or other relevant cost that are incurred during a certain period of time.

1. #### Gross profit ratio

It measures the relationship between net sales and gross profit. It can be calculated as:
• Gross profit ratio = $\frac {Gross profit}{Net sales}$ x 100%

where,

• Gross profit = Net sales – Cost of goods sold
• Cost of goods sold = Opening stock + Net purchase + Direct expenses – Closing stock

Illustration:

The followings are the information of ‘Caret Co’:  Opening stock Rs. 60,000 Closing stock Rs. 40,000 Purchase Rs. 3,20,000 Purchase return Rs. 5,000 Sales Rs. 6,00,000 Manufacturing expenses Rs. 55,000 Sales return Rs. 25,000

Required: Gross profit ratio

Solution:

Here,
Net sales
= Sales – sales return
= 6,00,000 – 25,000
= Rs. 5,75,000

Cost of goods sold
= Opening stock + Net Purchase + Direct expenses – Closing stock
= 60,000 + (3,20,000 – 5,000) + 55,000 – 40,000
= Rs. 3,90,000

Gross profit:
= Net sales – Cost of goods sold
= 5,75,000 – 3,90,000
= Rs. 1,85,000

Hence,

Gross profit ratio
=$\frac {Gross profit}{Net sales}$ x 100%
=$\frac {1,85,000}{5,75,000}$ x 100%
= 3.22%

1. #### Net profit ratio

Net profit ratio is the link between sales and net profit. This ratio is calculated to ascertain the overall profitability and it can be calculated as:
• Net profit ratio =$\frac {Net profit after tax}{Net sales}$ x 100%

where,

• Net sales = Sales – sales return
• Net profit after tax = Gross profit – Operating expenses – Tax
Or,
• Net profit after tax = (Gross profit – Operating expenses) (1 – Tax rate)

Illustration:

Calculate Gross profit ratio and Net profit ratio Solution:

• Gross profit ratio
=$\frac {Gross profit}{Net sales}$ x 100%
= $\frac {3,50,000}{4,75,000}$ x 100%
= 73.68%

• Net profit ratio
= $\frac {Net profit after tax}{Net sales}$ x 100%
= $\frac {3,51,000}{4,75,000}$ x 100%
= 73.89%

1. #### Return On Assets (ROA)

Return on assets shows the relationship between total assets and profit of a firm on a given date. It is an excellent measure to check on a company’s overall performance. It can be computed as:
• Return on Assets = $\frac {Net profit before interest and tax}{Total assets}$ x 100%

where,

• Net profit before interest and tax = Net profit before payment of interest on long term loans & tax.
• Total assets = Total assets + Fixed assets + Current assets. However, unproductive assets are excluded but investment is included.

Further, Return on Assets can be calculated in other ways too. Such as:

• Return on Assets (ROA) = $\frac {Net profit after tax}{Total assets}$ x 100%
Or,
• Return on Assets (ROA) =$\frac {Net profit after tax + interest}{Total assets}$ x 100%
Or,
• Return on Assets (ROA) = $\frac {Net profit after tax - preference dividend}{Total tangible assets}$ x 100%

Illustration:

Balance Sheet of 'ET Co.' as on 31st Chaitra, 2070 is as follows: Required: Return on Assets

Solution:

Here,

Net profit after tax = Profit for the year = Rs. 7,00,000

Interest
= 10% on debentures
= 10% on Rs. 12,00,000
= Rs. 1,20,000

Total assets
= Net fixed assets + long term investment + current assets
= Rs. (18,00,000 + 10,00,000 + 4,00,000)
= Rs. 32,00,000

Finally,
Return on Assets (ROA)
= $\frac {Net profit after tax}{Total assets}$ x 100%
=$\frac {7,00,000 + 1,20,000}{32,00,000}$ x 100%
= 25.625%

1. #### Return on Shareholders’ Equity

This ratio is the inter relationship between Net profit after tax and Shareholders’ fund. This ratio is to see over the utilization of the funds that are supplied by the shareholders. It is computed as:

• Return on Shareholders’ Equity = $\frac {Net profit after tax + interest}{Shareholders' fund}$ x 100%

where,

• Net profit after tax (NPAT) = the excess of gross profit and other incomes over the operating & non-operating expenses and losses.
• Shareholders’ fund = Equity share capital + Preference share capital + Share premium + Reserve & Surplus + Profit & Loss – Fictitious assets
or,
• Shareholders’ fund = Total assets – Fictitious assets – Total liabilities

Illustration:

Calculate Shareholders’ fund from the followings:

Net profit before interest & tax Rs. 2,00,000
Preliminary expenses Rs. 7,000
Reserve & Surplus Rs. 40,000
Equity share capital Rs. 1,80,000
12% preference share capital Rs. 3,00,000
8% debentures Rs. 1,20,000
Tax on profit 45%

Solution:

Here,

 Net profit before interest & tax Less: Interest (8% on 1,20,000) Net profit before tax Less: tax (45% of 1,90,400) Rs. 2,00,000 9600 1,90,400 85,680 1,04,720

Then,
Shareholders’ fund
= 12% preference share + Equity share + Reserve & Surplus – Preliminary expenses
= 3,00,000 + 1,80,000 + 40,000 – 7,000
= Rs. 5,13,000

Finally,
Return on Shareholders’ Equity
= $\frac {Net profit after tax + interest}{Shareholders' fund}$ x 100%
= $\frac {1,04,720}{5,13,000}$ x 100%
= 20.41%

1. #### Return on Common Shareholders’ Equity or Return on Equity (ROE)

Return on equity is the ratio that expresses the relation between net profit and common shareholders’ equity. This ratio is calculated as:
• ROE = $\frac {Net profit after tax - preference dividend}{Common shareholders' equity}$ x 100%
or,
• ROE = $\frac {Total earning available to equity shareholder}{Equity shareholders' fund}$ x 100%

where,

• Common shareholders’ equity = Equity share capital + Share premium + Reserve & Surplus + Profit & Loss – Fictitious assets

Illustration:

Calculate Return on shareholders’ equity and Return on common shareholders’ equity from the Balance Sheet given below:

 Liabilities Amount (Rs.) Assets Amount (Rs.) Equity share capital Reserve & Surplus 7% Debentures Current liabilities 10% preference share capital Profit & loss a/c 3,00,000 1,40,000 80,000 1,50,000 70,000 1,20,000 Fixed assets (net) Other quick assets Preliminary expenses Term investment Closing stock 5,00,000 2,70,000 15,000 50,000 25,000 8,60,000 8,60,000

• Fixed assets turnover was 2 times during the year.
• Net profit margin before tax was 11% on sales.
• Company’s tax bracket was 50%

Solution:

Here,

Fixed assets turnover
= Sales / Fixed assets
or, 2 = Sales / 5,00,000
or, Sales = Rs. 10,00,000

Common shareholders’ equity
= Equity share + Reserve & surplus + P&L – Preliminary expenses
= Rs. (3,00,000 + 1,40,000 + 1,20,000 – 15,000)
= Rs. 5,45,000

Shareholders’ equity
= Common shareholders’ equity + Preference share
= Rs. (5,45,000 + 70,000)
= Rs. 6,15,000

Net profit after interest & tax
= (Net profit before tax & interest – interest on debentures) (1-t)
= (10% on 10,00,000 – 7% on 80,000)(1 – 0.50)
= Rs. (1,00,000 – 5,600) â‚“ 0.5
= Rs. 47,200

Hence,
Return on Shareholders’ Equity
=$\frac {Net profit after tax + interest}{Shareholders' fund}$ x 100%
= $\frac {47,200}{6,15,000}$ x 100%
= 7.67%

Again,
ROE
=$\frac {Net profit after tax - preference dividend}{Common shareholders' equity}$ x 100%
= $\frac {47,200 - 7,000}{5,45,000}$ x 100%
= 7.38%

1. #### Return on Capital Employed

This ratio depicts the relationship between the permanent capital (capital employed) and net profit after tax. It can be computed as:
• Return on Capital Employed = $\frac {Net profit after tax}{Capital employed}$ x 100%
or,
• Return on Capital Employed =$\frac {Net profit after tax+interest}{Capital employed}$ x 100%

where,

• Capital employed = Equity & preference share capital + reserve + P&L a/c (Cr.) + Share premium + Undistributed profit + Long term debts – Fictitious assets
• Capital employed = Fixed assets + Current assets – Current liabilities

Illustration:

Calculate Return on Capital Employed

 Liabilities Amount (Rs.) Assets Amount (Rs.) Equity share capital Outstanding expenses 11% Debentures General reserve Creditors P&L a/c 6,00,000 40,000 3,60,000 1,10,000 2,15,000 1,40,000 Fixed assets Bank balance Preliminary expenses Investment Debtors Inventories 7,70,000 50,000 25,000 1,00,000 3,20,000 2,00,000 14,65,000 14,65,000

Sales is Rs. 10,00,000
Tax rate is 32%
Net profit before tax is Rs. 3,00,000

Solution:

Here,

Net profit after interest & tax
= (Net profit before tax & interest – interest on debentures) (1-t)
= Rs. (3,00,000 – 39,600)(1 – 0.32)
= Rs. 1,77,072

Capital employed
= Equity share + Reserve + P&L a/c + Debentures – Preliminary expenses
= Rs. (6,00,000 + 1,10,000 + 1,40,000 + 3,60,000 – 25,000)
= Rs. 11,85,000

Therefore,
Return on capital employed:
=$\frac {Net profit after tax+interest}{Capital employed}$ x 100%
= $\frac {1,77,072}{11,85,000}$ x 100%
= 14.94%

References:

Koirala, Madhav et.al., Principles of Accounting -XII, Buddha Prakashan, Kathmandu

Shrestha, Dasharatha et.al., Accountancy -XII, M.K. Prakashan, Kathmandu

Bajracharya, Puskar, Principle of Accounting-XII, Asia Publication Pvt. Ltd., Kathmandu

##### Things to remember
1. Net profit ratio is the link between Sales and Net profit.
2. Return on assets shows the relationship between total assets and profit of a firm, on a given date.
3. Return on equity is the ratio that expresses the relation between net profit and common shareholders’ equity.
4. Return on Shareholders’ Equity is the inter relationship between Net profit after tax and Shareholders’ fund.
• It includes every relationship which established among the people.
• There can be more than one community in a society. Community smaller than society.
• It is a network of social relationships which cannot see or touched.
• common interests and common objectives are not necessary for society.