Ratio Analysis – Part III: Profitability Ratios

What are Profitability Ratios

Profitability is the heartbeat of any business. Whether you're an investor, manager, or student, knowing how efficiently an enterprise converts its efforts into profit is crucial. That's where profitability ratios step in. They help us move beyond surface-level numbers, revealing how well a company turns sales into earnings and utilizes its resources. These ratios bring clarity to questions such as:
Is the company managing costs effectively?
Is it generating adequate returns for its owners?
Let's examine each ratio, its formula, and its meaning.

a. Gross Profit Ratio (GP Ratio)

Formula:

Gross Profit Ratio = (Gross Profit / Net Sales) × 100

Interpretation: This ratio indicates the percentage of sales remaining after accounting for the cost of goods sold (COGS). A higher GP Ratio suggests the firm can cover operating expenses and still have enough for profit.

b. Net Profit Ratio (NP Ratio)

Formula:

Net Profit Ratio = (Net Profit / Net Sales) × 100

Interpretation: This shows the portion of sales converted into net profit after all expenses, including tax and interest. It provides a comprehensive measure of profitability and operational efficiency.

c. Operating Ratio

Formula:

Operating Ratio = [(COGS + Operating Expenses) / Net Sales] × 100

Interpretation: This ratio reflects the percentage of net sales consumed by the cost of goods sold and operating expenses. The lower the ratio, the greater the operating efficiency. It's often used alongside the GP and NP ratios for a full profitability picture.

d. Return on Capital Employed (ROCE)

Formula:

ROCE = (Earnings Before Interest and Tax [EBIT] / Capital Employed) × 100

Interpretation: ROCE measures how efficiently long-term funds are used to generate operating profit. High ROCE values point to effective capital utilization, which is especially important for capital-intensive industries.

e. Return on Investment (ROI)

Formula:

ROI = (Net Profit / Total Investment) × 100

Interpretation: ROI assesses the overall profitability of investments made in the business. It helps stakeholders judge whether the returns justify the capital invested.

f. Earnings Per Share (EPS)

Formula:

EPS = (Net Profit After Tax – Preference Dividend) / Number of Equity Shares

Interpretation: EPS indicates the earning available to each equity shareholder. Investors rely on this ratio to compare companies of different sizes. A consistently rising EPS is usually a good sign for shareholders.

Using Profitability Ratios for Inter-Firm Comparison

Profitability ratios are especially powerful when comparing firms within the same industry. Inter-firm comparison helps highlight strengths and weaknesses, revealing who is leading in efficiency, cost control, and market strategy. When you compare ratios:

• Ensure the accounting policies (like depreciation or inventory valuation) are similar.
• Look at trends over several years, not just one snapshot.
• Consider industry averages or benchmarks for meaningful context.

Such a table lets you quickly spot which firm outperforms the other and the sector in each profitability aspect.

Example

Let's apply these ratios to a sample Profit & Loss statement. This step-by-step calculation will help you internalize each formula and its interpretation.

Profit & Loss Account Extract for XYZ Ltd. (₹ in lakhs):
Net Sales: 1500
Cost of Goods Sold: 900
Operating Expenses: 300
Interest: 40
Tax: 60
Net Profit After Tax: 170
Number of Equity Shares: 10 lakhs
Preference Dividend: 20

Step 1: Gross Profit

Gross Profit = Net Sales – COGS = 1500 – 900 = 600

Step 2: Operating Profit

Operating Profit = Gross Profit – Operating Expenses = 600 – 300 = 300

Step 3: Net Profit

Net Profit After Tax = 170

Step 4: Capital Employed

Assume Capital Employed = ₹1200 lakhs

Step 5: Compute Ratios

• Gross Profit Ratio: (600 / 1500) × 100 = 40%
• Net Profit Ratio: (170 / 1500) × 100 ≈ 11.33%
• Operating Ratio: [(900 + 300) / 1500] × 100 = (1200 / 1500) × 100 = 80%
• ROCE: (Operating Profit / Capital Employed) × 100 = (300 / 1200) × 100 = 25%
• EPS: (170 – 20) / 10 = ₹15 per share

Interpretation:

• The Gross Profit Ratio of 40% tells us the firm retains a healthy margin after covering direct production costs.
• The Net Profit Ratio (11.33%) suggests that about ₹11.33 out of every ₹100 in sales remain as profit after all expenses.
• An Operating Ratio of 80% implies the business spends ₹80 out of every ₹100 in sales on core operations—leaving ₹20 for non-operating items and profit.
• The ROCE (25%) indicates that the company makes ₹25 on every ₹100 of capital employed, reflecting strong efficiency.
• EPS of ₹15 means each share earned ₹15, a key figure for shareholders tracking returns.

When you interpret these ratios, always consider the context: industry standards, past performance, and economic conditions. Numbers tell a story, but that story changes with the setting. Keep questioning, keep comparing, and remember profitability ratios are your window into how well a business is truly performing.