PROFITABILITY ANALYSIS Updated

ACC306 - FINANCIAL STATEMENT ANALYSIS
LEARNING OUTCOME
Compute, interpret and use ratios to comprehend the profitability
position of the concern
Why profit matters?

Primary objective of a business is to earn profits. Earning profit is
crucial for the survival and growth of a business in the long run
(diversify and expand).
Various stakeholders in society have certain expectations from a

business entity with which they deal.
Importance of Profitability to stakeholders

What is a Profitability Ratio?

Profitability ratios are financial metrics
used by analysts and investors to measure
and evaluate the ability of a company to
generate income (profit) relative to
revenue, balance sheet assets, operating
costs, and shareholders’ equity during a
specific period of time. They show how
well a company utilizes its assets to
produce profit and value to shareholders.
What is a Profitability Ratio?

A higher ratio or value is commonly
sought-after by most companies, as this
usually means the business is performing
well by generating revenues, profits, and
cash flow. The ratios are most useful when
they are analysed in comparison to similar
companies or compared to previous
periods.
Analyzing Business Profitability
GENERAL PROFITABILITY OVERALL PROFITABILITY

1. Gross Profit 1. Return on Shareholder Investment
2. Return on Equity Capital
2. Operating Ratio 3. Earning per Share
3. Operating Profit Ratio 4. Return on assets
5. Earning per share
4. Expenses Ratio
6. Diluted Earning per share
5. Net Profit Ratio 6. Dividend Payout Ratio
7. Price Earning Ratio
8. Diluted Earning per Share
9. Dividend Yield Ratio
Gross profit ratio as a percentage of

revenue from operations is computed to
have an idea about gross margin. It is
computed as follows:
Gross Profit Ratio = (Gross Profit/Net

Revenue of Operations) × 100
Gross profit ratio is calculated

as a percentage of revenue from
operations to have an idea about
gross margin.
It is computed as follows:
Gross Profit Ratio = (Gross
Profit/Net Revenue of
Operations) × 100
From the given details, decide what will be the cost of goods sold and amount
of gross profit ratio?
a) Rs. 93,000 and Rs.80,000

b) Rs. 93,500 and Rs. 86,500
c) Rs. 95,500 and Rs. 90,000
d) Rs. 83,500 and Rs. 93,500
From the given details, decide what will be the cost of goods sold and amount
of gross profit ratio?
a) Rs. 93,000 and Rs.80,000

b) Rs. 93,500 and Rs. 86,500
c) Rs. 95,500 and Rs. 90,000
d) Rs. 83,500 and Rs. 93,500
From the calculations in previous slide the gross profit ratio can be calculated
as:
86,500/1,80,000*100 = 48.06
DO IT YOURSELF!
What will be the Gross Profit Ratio (GP ratio) of the company in case it
has Gross sales: $1,000,000; Sales returns: $90,000 and Cost of goods
sold: $675,000?
a) 25%
b) 25.28%
c) 25.82%
d) 27%
ANSWER: C
With the help of above information, we can compute the gross profit ratio as follows:
= (235,000* / 910,000**)
= 0.2582 or 25.82%
*Gross profit = Net sales – Cost of goods sold
= $910,000 – $675,000
= $235,000
**Net sales = Gross sales – Sales returns
= $1,000,000 – $90,000
= $910,000
The GP ratio is 25.82%. It means the company may reduce the selling price of its products by
25.82% without incurring any loss.
With the help of above information, we can compute the gross profit ratio as follows:
= (235,000* / 910,000**)
= 0.2582 or 25.82%
*Gross profit = Net sales – Cost of goods sold
= $910,000 – $675,000
= $235,000
**Net sales = Gross sales – Sales returns
= $1,000,000 – $90,000
= $910,000
The GP ratio is 25.82%. It means the company may reduce the selling price of its products by
25.82% without incurring any loss.
NET PROFIT RATIO
The net profit percentage is the ratio

of after-tax profits to net sales.
It reveals the remaining profit after

all costs of production,
administration, and financing have
been deducted from sales, and
income taxes recognized.
VARIATIONS IN NET PROFIT RATIO

NET OPERATING PROFIT NET PROFIT RATIO
(Net Operating Profit ÷ Net sales) Net Profit/Net Sales X 100
x 100 Note: For Net Profit calculation all
non-operating expenses and
Gross Profit – Operating Expenses losses are also deducted and all
non-operating incomes are added.
(Administrative expenses and
Selling & Distribution expenses)
NON-OPERATING EXPENSES & NON-OPERATING INCOMES

LOSSES - Dividend Income
- Loss on sale of old assets - Interest received on Investment
- Provision for damages
NUTSHELL
Net profit = Net Operating Profit + Non-Operating Incomes – Non-

Operating Expenses
Net profit = Gross Profit – All Expenses + All other incomes
Accountants also deduct Income Tax while calculating Net Profit

Assume that Net Sales in a
company are Rs. 5,00,000; Cost of COME LETS’ SOLVE THIS JIGSAW
PUZZLE
Goods Sold Rs. 3,50,000; Selling
Expenses Rs. 12,000;
Administrative Expenses Rs. 8,000;
Interest Income Rs. 5,000 and Loss
on machinery sold Rs. 12,000.
Q1. What will be the amount of
Gross Profit?
a) Rs. 2,50,000 b) Rs. 3,50,000 c)
Rs. 1,50,000 d) Rs. 5,00,000
Assume that Net Sales in a

company are Rs. 5,00,000; Cost of
Goods Sold Rs. 3,50,000; Selling
Expenses Rs. 12,000;
Administrative Expenses Rs. 8,000;
Interest Income Rs. 5,000 and Loss
on machinery sold Rs. 12,000.
Q1. What will be the amount of
Gross Profit?
a) Rs. 2,50,000
b) Rs. 3,50,000
c) Rs. 1,50,000 [Sales-COGS]
d) Rs. 5,00,000
Assume that Net Sales in a company are Rs.
5,00,000; Cost of Goods Sold Rs. 3,50,000;
Selling Expenses Rs. 12,000; Administrative
Expenses Rs. 8,000; Interest Income Rs.
5,000 and Loss on machinery sold Rs.
12,000.
Q2. What will be the amount of Net
Operating Profit?
a) Rs. 1,38,000
b) Rs. 1,42,000
c) Rs. 1,50,000
d) Rs. 1,30,000
12,000.
Q2. What will be the amount of Net
Operating Profit?
a) Rs. 1,38,000
b) Rs. 1,42,000
c) Rs. 1,50,000
d) Rs. 1,30,000 [Gross Profit – Selling
expenses – administrative expenses]
12,000.
Q3. What will be the amount of Net Profit?
a) Rs. 1,23,000
b) Rs. 1,35,000
c) Rs. 1,50,000
d) Rs. 1,30,000
12,000.
Q3. What will be the amount of Net Profit?
a) Rs. 1,23,000 [1,30,000+5,000-12,000]
b) Rs. 1,35,000
c) Rs. 1,50,000
d) Rs. 1,30,000
Now that you have solved all 3
questions, find out :
i) Gross Profit Ratio
ii) Net Operating Profit Ratio and
iii) Net Profit Ratio.
Find it out and tell the answer in chat! I

discuss the solution in few minutes!
i) Gross Profit Ratio = (Gross Profit /
Net Sales) X 100 = 30%
ii) Net Operating Profit Ratio = (Net
Operating Profit/Sales) X 100 = 26%
iii) Net Profit Ratio = (Net Profit / Net
Sales) X 100 = (1,23,000/5,00,000) X
100 = 24.6%
RETURN ON
INVESTMENT/ RETURN
ON CAPITAL EMPLOYED
Measures overall
profitability of a business
Formula:
PBIT/Capital Employed X
100
Capital Employed
Equity Share Capital
Add: Preference Share Capital
Add: Reserves and other undistributed Profits
Add: Long term loan and Debentures
Less: Fictitious Assets (eg: Preliminary Expenses)
Less: Non-Operating Assets (eg: Investment)
Or Fixed Assets Less Depreciation

Add: Net Working Capital (CA-CL)
Note: ROI depends upon 2 factors

1. Net Profit Ratio
2. Capital Turnover Ratio
RETURN ON EQUITY
RETURN ON EQUITY (ROE)

The Return On Equity ratio essentially measures the rate of return that the owners of common stock of a
company receive on their shareholdings.
Return on equity signifies how good the company is in generating returns on the investment it received from
its shareholders.
There are two variations of it:

1. Return on Proprietors Equity and 2. Return on Equity Capital
RETURN ON PROPRIETORS’ EQUITY

This is also known as Return on Shareholders’ fund and shows net profit to owners’ capital
Net profit is calculated after charging interest on long term liabilities and payment of taxes
Shareholder Fund = Equity Capital + Preference Capital + Capital Reserve + General Reserve +
other undistributed profit
Significance & objectives
Very effective measure of profitability of enterprise
The ratio measures return on total equity of shareholders. It should be compared with ratio of
other similar companies to know whether rate of return is attractive?
Calculate return on shareholder fund on basis of given information:

10% preference capital = Rs. 1,00,000
Equity Capital = Rs. 2,50,000
Capital Reserve = Rs. 10,000
General Reserve = Rs. 60,000
Profit and Loss account = Rs. 30,000
Net Profit during the year = Rs. 76,500
Return on shareholder fund = (Net Profit / Total Shareholder Fund) X

100 = (76,500 / 4,50,000) X 100 = 17%
10% preference capital + Equity Capital + Capital Reserve + General
Reserve + Profit and Loss account = Rs. 1,00,000+ Rs. 2,50,000 + Rs.
10,000 + Rs. 60,000 + Rs. 30,000 = Rs. 4,50,000
RETURN ON EQUITY CAPITAL
This ratio establishes relationship between net profit available to equity shareholder and the
amount of capital invested by them
Return on Equity Capital = Net Profit after taxes and preference dividend X 100
Equity Shareholder Fund
Equity Shareholder Fund = Equity Capital + Capital Reserve + General Reserve + other
undistributed profit
Calculate Return on Equity Capital on basis of given information:

10% preference capital = Rs. 1,00,000
Equity Capital = Rs. 2,50,000
Capital Reserve = Rs. 10,000
General Reserve = Rs. 60,000
Profit and Loss account = Rs. 30,000
Net Profit during the year = Rs. 76,500
Return on shareholder fund = (Net Profit / Total Shareholder Fund) X

100 = (76,500 – 10,000 (This is Preference Dividend) / 3,50,000 X 100
= 19%
Equity Shareholder Fund = Equity Capital + Capital Reserve + General
Reserve + Profit and Loss account = Rs. 2,50,000 + Rs. 10,000 + Rs.
60,000 + Rs. 30,000 = Rs. 3,50,000
Significance & objectives
The ratio shows profit percentage for equity shareholders.
A higher rate of return on equity fund is favored by investors and a higher market valuation is
placed on such shares.
It is useful inter-firm comparison to judge comparative profitability of different firms.

Earning Per Share (EPS)
• Measures the net income (in rupees) earned by each share
• Formula
Net profit after tax – Preference dividend
Number of equity shares outstanding
Higher the ratio, better it is as it means

• the company is more profitable and
• the company has more profits to distribute to its shareholders.
• the company has strong financial position.
• it is the reliable company to invest money.
Price earning ratio (P/E ratio)
• Relationship b/w stock price and earnings of the company
• Shows how much amount an investor is willing to pay to buy 1 share

based on its’ earnings.
• Formula
Market price per share (MPS)
Earnings per share (EPS)
Interpretation
• For example:- if the P/E ratio = 10 times, this means that the market price
of the share of the company is 10 times the earnings of the company.
• High P/E ratio indicates that the share of the company is sold in the stock
market at a high price and the investors have high expectations.
• Low P/E ratio indicates low profits of the company as the EPS
(denominator) is less.
Return on Assets Ratio (ROA Ratio)
• Shows the relationship between net profits (after taxes) and assets
employed to earn the profits.
• This ratio measures the profitability of the firm in relation to assets

employed.
• Formula
Net Profit After Tax
Average Total Assets
Poll
• If EPS is Rs. 0.12 and market price of the share is Rs. 3.60, then the
P/E ratio will be:
a) 0.3
b) 3 times
c) 30
d) 3.33%
Dividend per share Ratio
• Shows amount of profit which is distributed to shareholders per share

• Formula
Dividend paid
Number of shares
Problem solving
• From the following information (in Rs.), calculate
a)Return on Investment and,
b)Return on Shareholder Funds
• Equity share capital = 400,000
• Preference share capital = 100,000
• 10% debenture = 400,000
• General reserve = 184,000
• Net profit after interest and after tax = 150,000
• Tax amount = 50,000
Problem solving
• From the following information calculate
(i) Earning per share
(ii) Price earning ratio
• 70,000 equity shares of Rs 10 each = Rs. 700,000
• Net Profit after tax = Rs. 1,75,000
• Market price of a share = Rs. 13
Dividend Payout Ratio
• The dividend payout ratio expresses the relationship between a
company’s net income and the total dividends paid out to
shareholders. It is a useful tool for understanding what percentage of
a company’s earnings has been apportioned to shareholders in
dividend form.
• Dividend Payout Ratio = Dividends Paid/Net Income

MCQ
Q. Joe’s Kitchen is a restaurant change that has several shareholders.
Joe reported $10,000 of net income on his income statement for the
year. Joe’s issued $3,000 of dividends to its shareholders during the
year. Calculate Joe’s dividend payout .
A. 29%
B. 30%
C. 32%
D. None
Dividend yield ratio
The dividend yield or dividend–price ratio of a share is the dividend per
share, divided by the price per share. It is also a company's total
annual dividend payments divided by its market capitalization,
assuming the number of shares is constant. It is often expressed as a
percentage.
MCQ
Stacy’s Bakery is an upscale bakery that sells cupcakes and baked goods
in Beverly Hills. Stacy’s is listed on a smaller stock exchange and the
current market price per share is $15. As of last year, Stacy paid
$15,000 in dividends with 1,000 shares outstanding. What is Stacy’s
yield ratio?
A. 1
B. 1.5
C. 2
D. None
Diluted EPS
• Diluted EPS is a calculation used to gauge the quality of a company's
earnings per share (EPS) if all convertible securities were exercised.
Convertible securities are all outstanding convertible preferred shares
, convertible debentures, stock options, and warrants.
MCQ
• If the beginning balance for May of the materials inventory account
was $27,500, the ending balance for May is $28,750, and $128,900
of materials were used during the month, the materials purchased
during the month cost _________?
A. $1,01,400
B. $1,27,650
C. $1,30,150
D. None

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ACC306 - FINANCIAL STATEMENT ANALYSIS

ACC306 - FINANCIAL STATEMENT ANALYSIS

Why profit matters?

Various stakeholders in society have certain expectations from a

Importance of Profitability to stakeholders

What is a Profitability Ratio?

What is a Profitability Ratio?

Analyzing Business Profitability

GENERAL PROFITABILITY OVERALL PROFITABILITY

Gross profit ratio as a percentage of

Gross Profit Ratio = (Gross Profit/Net

Gross profit ratio is calculated

a) Rs. 93,000 and Rs.80,000

a) Rs. 93,000 and Rs.80,000

NET PROFIT RATIO

The net profit percentage is the ratio

It reveals the remaining profit after

VARIATIONS IN NET PROFIT RATIO

NON-OPERATING EXPENSES & NON-OPERATING INCOMES

Net profit = Net Operating Profit + Non-Operating Incomes – Non-

Net profit = Gross Profit – All Expenses + All other incomes

Accountants also deduct Income Tax while calculating Net Profit

Assume that Net Sales in a

Now that you have solved all 3

questions, find out :

i) Gross Profit Ratio

ii) Net Operating Profit Ratio and

iii) Net Profit Ratio.

Find it out and tell the answer in chat! I

i) Gross Profit Ratio = (Gross Profit /

Net Sales) X 100 = 30%

ii) Net Operating Profit Ratio = (Net

Operating Profit/Sales) X 100 = 26%

iii) Net Profit Ratio = (Net Profit / Net

Sales) X 100 = (1,23,000/5,00,000) X

Or Fixed Assets Less Depreciation

Note: ROI depends upon 2 factors

RETURN ON EQUITY (ROE)

There are two variations of it:

RETURN ON PROPRIETORS’ EQUITY

Significance & objectives

Very effective measure of profitability of enterprise

Calculate return on shareholder fund on basis of given information:

Return on shareholder fund = (Net Profit / Total Shareholder Fund) X

RETURN ON EQUITY CAPITAL

Calculate Return on Equity Capital on basis of given information:

Return on shareholder fund = (Net Profit / Total Shareholder Fund) X

Significance & objectives

The ratio shows profit percentage for equity shareholders.

It is useful inter-firm comparison to judge comparative profitability of different firms.

Higher the ratio, better it is as it means

• Relationship b/w stock price and earnings of the company

• Shows how much amount an investor is willing to pay to buy 1 share

• This ratio measures the profitability of the firm in relation to assets

• Shows amount of profit which is distributed to shareholders per share

• Dividend Payout Ratio = Dividends Paid/Net Income

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