The Major Profitability Ratios

Topics: Financial ratios, Generally Accepted Accounting Principles, Inventory Pages: 17 (3507 words) Published: March 23, 2013
The major profitability ratios are: ON CAPITAL:

Describes the earning capacity of the enterprise and it is measured by the following ratio:

Profit before interest and taxation

Average operating Assets

The Return On Capital ratio measures how well the average operating assets (assets such as debtors, cash, fixed assets, stock) are generating the company s income, and is indicative of the management techniques applied by the company to utilise its assets.

A poor income rate of return could indicate that valuable assets are under utilised. As a result of this problem, an enterprise, which shows a negative Return on capital could be under the influence of poor management.

The earning capacity of XYZ Limited for 1998 and 1999

Return on||||||
|Av. OA|(286 + 230) ?2|(230 + 162) ?2|(162 + 144)|Industry ave| ||100 x 100|88 x 100|?2||
||258|196|70 x 100||
||38, 76%|44, 9%|153||

I N T E R P R E T A T I O N :

XYZ Limited s return on capital declined from

45.7% in 1998 to 44.9% in 1999. This decrease is mainly due to the increase in assets, but further investigation is required to analyse the extent of this decrease.

The decrease continued further from 44.9% in 1999 to 38.76% in 2000. Again this decrease is due to an increase in assets. The question that arises therefor is: “Is this phenomena as a result of mismanagement of assets, or just because

XYZ Limited is starting up and still growing?”

Additional investigation would be required to analyse the extent of the decrease. PROFIT RATIO:

The primary objective of an enterprise is to make a profit. Profit is earned from sales and serves as an important measure of return of capital.

The Net Profit percentage can be measured by the following ratio:

Net Profit


This Net Profit Ratio measures the overall effectiveness of the enterprise s operations, before interest, tax and other non-“operating” items. The shortfall of this ratio in terms of its effectiveness is perhaps the fact that its usefulness is limited to comparisons with other

companies. In addition, there is no guideline as to what the ideal absolute value should be.

Changes to the Net Profit % can be influenced by one of two components, viz.: -

? Gross Profit Percentage

? Operating Expenditure

In addition, the percentage of sales consumed by operating expenses (i.e. Gross Profit % - Net Profit %) is often indicative of management efficiency in controlling operating costs.

Disciplined management techniques, for example, by cutting costs can lead to two consequences, viz.: -

? A more profitable enterprise

? An efficiently operating enterprise

The Net Profit % of XYZ Limited is as follows: -

Net Profit % Margin|2000|1999|1998|
Net Operating Income|100|88|70|
Net Sales|900|800|700|

I N T E R P R E T A T I O N :

The Net Profit Percentage Margin increased steadily in proportion to the Gross Profit percentage during the horizon of 1998 to 1999 (10% to 11%). This improvement in the enterprise s return on capital indicates that a proportionately greater profit was earned from sales in 1999 that in 1998. The crux of the matter, however, is not yet known whether this improvement is as a result of larger Gross Profit or lower expenses. Further analysis would be required.

During the period of 1999 to 2000 the Net Profit Percentage Margin increased by a further 0.11% (11% in 1999 to 11,11% in 2000). Again this improvement can be ascribe to an improvement in the enterprise s return on capital. And as

noted in the previous horizon, it cannot be determined whether this improvement is as a result of larger Gross Profit or lower expenses. Further analysis would be required. Profit % Margin...
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