As the name suggests profitability ratios are concerned with management’s performance regarding
Broadly this category can be divided into two:
Profitability ratios in relation to Sales : Since sales involves cost of sales as well as other administrative & selling expenses therefore these ratios give us information about management’s performance in terms of increasing sales and reducing cost of sales and other expenses.
Profitability ratios in relation to investment (by shareholders and lenders): These ratios gives us information about management’s performance of how effectively (how accurately) they have utilized funds (investments of shareholders and lenders) in generating sales and thus profits for the year.
Types of Profitability Ratios
To check the performance of the company that how effectively they have generated profits, following ratios are used.
- Return on Capital Employed Ratio
- Gross Profit Margin
Following pages will explain the listed above ratios using the written below method:
First question comes in mind is HOW TO CALCULATE THE PARTICULAR RATIO? I will write down the most common formula used for calculating a ratio along with alternative, if any.
With example I will calculate the ratio using the formula given above. PLEASE NOTE THAT, in examples I will use data from HYPOTHETICAL FINANCIAL STATEMENTS (as given here)so that you can calculate ratios from real financial statements in you practical life.
In which unit the ratio is measured i.e. in currency unit (dollars), percentages, days or whatever.
After calculating the ratio, the next logical question that comes in mind is WHAT DOES THIS RATIO MEAN? So I will teach
- How to interpret the ratio; and
- What particular user needs this ratio addresses. (You must have an understanding of users’ needs of financial statements; please refer the topic 1- financial statement users for details).
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