Ratios

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PROFITABILITY RATIOS

RETURN ON INVESTMENT (ROI):
The prime objective of making investments in any business is to obtain satisfactory return on capital invested. Hence, the return on capital employed is used as a measure of success of a business in realizing this objective. Return on Investment establishes the relationship between the profit and the capital employed. It indicates the percentage of return on capital employed in the business and it can be used to show the overall profitability and efficiency of the business.

Definition:
Capital employed and operating profits are the main items. Capital employed may be defined in a number of ways. However, two widely accepted definitions are "gross capital employed" and "net capital employed". Gross capital employed usually means the total assets, fixed as well as current, used in business, while net capital employed refers to total assets minus liabilities. On the other hand, it refers to total of capital, capital reserves, revenue reserves (including profit and loss account balance), debentures and long term loans.

Computation:
The profits for the purpose of calculating return on capital employed should be computed according to the concept of ”capital employed used". The profits taken must be the profits earned on the capital employed in the business. Thus, net profit has to be adjusted for the following: * Net profit should be taken before the payment of tax or provision for taxation because tax is paid after the profits have been earned and has no relation to the earning capacity of the business. * If the capital employed is gross capital employed then net profit should be considered before payment of interest on long-term as well as short-term borrowings. * If the capital employed is used in the sense of net capital employed than only interest on long term borrowings should be added back to the net profits and not interest on short term borrowings as current liabilities are deducted while calculating net capital employed. * If any asset has been excluded while computing capital employed, any income arising from these assets should also be excluded while calculating net profits. For example, interest on investments outside business should be excluded. * Net profits should be adjusted for any abnormal, non recurring, non operating gains or losses such as profits and losses on sales of fixed assets. * Net profits should be adjusted for depreciation based on replacement cost, if assets have been added at replacement cost.

Formula:
Return on Investment = (Operating profits /Capital employed)×100

Significance:
Return on Investment ratio is considered to be the best measure of profitability in order to assess the overall performance of the business. It indicates how well the management has used the investment made by owners and creditors into the business. It is commonly used as a basis for various managerial decisions. As the primary objective of business is to earn profit, higher the return on capital employed, the more efficient the firm is in using its funds. The ratio can be found for a number of years so as to find a trend as to whether the profitability of the company is improving or otherwise.

GROSS PROFIT RATIO (GP RATIO):
Definition:
Gross profit ratio (GP ratio) is the ratio of gross profit to net sales expressed as a percentage. It expresses the relationship between gross profit and sales.

Components:
The basic components for the calculation of gross profit ratio are gross profit and net sales. ‘Net sales’ signifies sales minus sales returns. Gross profit would be the difference between net sales and cost of goods sold. Cost of goods sold in the case of a trading concern would be equal to opening stock plus purchases, minus closing stock plus all direct expenses relating to purchases. In the case of manufacturing concern, it would be equal to the sum of the cost of raw materials, wages, direct expenses and all...
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