Ratio Analysis– Part 5 – Profitability Ratios Paper 3B: Financial Management Chapter 3 Unit I

CA B. Hari Gopal B.com, PGDBA, FCA, FCMA, DISA(ICAI), PMP (PMI, USA), EPBM (IIMC), MCT

Learning Objectives

1. Gain Knowledge on Profitability Ratios

2. Usage of various Profitability Ratios

3. Preparation of various Profitability Ratios

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Introduction to Profitability Ratios

• Background • Types of Profitability Ratios

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Profitability Ratios - Background

Profitability Ratios

Meaning

Categories

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From Owner’s Point of view

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Profitability ratios required for analysis from Owner’s point of view

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Required for analysis from Owner’s point of view

Return on Equity (DuPont Model)

Earnings Per Share

Dividend Per Share

Price Earning Ratio

Return on Equity

ROE is one of the most important indicators of a firm’s profitability and potential growth

Formulae: Profit After Taxes/ Net Worth

Measures the profitability of equity funds invested in the firm

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Return on Equity – DuPont Model

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Components of DuPont Model

Net Profit Margin

Asset Turnover

Equity Multiplier

DuPont Model – Net Profit Margin

Net profit margin is a safety cushion: Lower the margin, less room for error

Formulae: Net Income / Revenue

Net profit margin is simply the after tax profit a company generates for each rupee of revenue

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DuPont Model – Asset Turnover

Asset turnover ratio tends to be inversely related to the net profit margin.

Formulae: Revenue / Assets

A Measure of how effectively a company converts its assets in to sales

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DuPont Model – Equity Multiplier

Formulae: Assets / Net Worth

Equity Multiplier is a measure Financial leverage, allows investor to see what portion of the return is

the result of debt

It is possible for a company with good sales and margins to take excessive debt and artificially

increase its return on equity

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Earning Per Share

Formulae: Net Profit available to Equity Shareholders/

Number of Equity Shares outstanding

Measures the profitability of a firm in terms of earning per Equity share

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Dividend Per Share

Formulae: Net Profit distributed to Equity Shareholders/

Number of Equity Shares outstanding

Indicates the amount of profit distributed to each equity share

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Price Earning Ratio

Formulae: Market Price per Share / Earnings per Share

Indicates the expectations of the equity investors about the earnings of the firm

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Based on Assets / Investments

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Based on Assets / Investments

Return on Capital Employed (ROCE) / Return on Investment (ROI)

Return on Assets (ROA)

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Return on Capital Employed (ROCE)

Capital Employed = Total Assets – Current Liabilities (or) Fixed Assets + Working Capital

NOPAT = EBIT (1-t) – Non-operating Income

Formulae: NOPAT x 100 / Capital Employed

It is the percentage of return on funds invested in the business by its owners

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Return on Capital Employed (ROCE)

ROI can be improved either by improving operating profit or capital turnover or both

Capital Turnover Ratio = Sales / Capital Employed

Profitability Ratio = Return / Sales x 100

ROCE = Profitability Ratio x Capital Turnover Ratio

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Return on Assets

Return on Assets = Net Profit After Taxes / Average Tangible Assets

Return on Assets = Net Profit After Taxes / Average Total Assets (or)

This ratio measures the profitability of the firm in terms of assets employed in it.

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Based on Sales

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Profitability Ratio based on Sales

Classified in to following ratios

Gross Profit ratio – Gross Profit x 100 / Sales

Operating Profit ratio – Operating Profit x 100 / Sales

Net Profit ratio – Net Profit x 100 / Sales

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Based on Capital Market Info

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Based on Capital Market Information

Classified in to following ratios

Price – Earning Ratio = Average Share Price / EPS

Yield = Dividend / Average Share Price

Market Value / Book Value per share = Average Share Price / Book Value per share

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Lesson Summary

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2. We had discussed various categories of Profitability ratios in detail (including DuPont

Model) and their usage.

1. We have learnt the meaning and categories of Profitability ratios

Testing time

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Profitability Ratios - Multiple Choice Questions

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MCQ – 1

Return on Equity measures the _________ of Equity funds invested in the firm

C. Liquidity D. Profitability

Answer: D. Profitability

A. Activity B. Capital Structure

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MCQ – 2

The profitability of a firm from the point of view of ordinary shareholders can be measured in terms of __________

A. Earnings per share

C. Return on Investment

B. Dividend per share

D. Gross Profit Ratio

Answer : A. Earnings per share

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MCQ – 3

Following is excluded for calculation of Return on Capital Employed

A. Intangible Assets

C. Fictitious Assets

B. Fixed Assets

D. Current Assets

Answer : C. Fictitious Assets

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MCQ – 4 _______ ratio is used to compare the product profitability

A. Net Profit

C. Operating Profit

B. Gross Profit

D. Earnings per share

Answer : B. Gross Profit

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MCQ – 5

_____ indicates true return in which share capital is taken at its market value

A. Earnings per share

C. Price – Earning Ratio

B. Yield

D. Net Profit Ratio

Answer : B. Yield

What Next ……

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Follow the below Presentations

Ratio Analysis Part 1 – Overview

Ratio Analysis Part 2 - Liquidity Ratios

Ratio Analysis Part 3 - Leverage Ratios

Ratio Analysis Part 4 – Activity Ratios

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Thank You

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