Every business should earn sufficient profits to survive and grow over a long period of time. Infect efficiency of a business is measured in terms of profits. Profitability ratios are calculated to measure the efficiency of a business. Profitability ratio analysis of a business may be measured in two ways:
1. Profitability in relation to sales.
2. Profitability in relation to investment.
List of Profitability Ratios
1. Gross profit ratio.
2. Net profit ratio.
3. Operating ratio and expense ratios.
4. Return on investments.
5. Return on equity.
6. Earnings per share (EPS).
7. Dividend payout ratio.
8. Dividend yield ratio.
9. Price earnings ratio.
Gross profit ratio signifies the average margin on the items sold. It exhibits whether the selling prices tend to be adequate or not.
It additionally indicates the extent to which selling costs may be decreased without resulting in losses.
A lower gross profit ratio might indicate a higher cost of items sold because of higher cost of manufacturing. It may also be because of low selling prices.
A higher gross profit ratio, alternatively, indicates relatively low cost and is also a sign of good management.
A gross profit ratio might be increased by using the following steps:
(i) Lowering cost of goods sold, selling prices remaining constant.
(ii) Increasing selling prices, the cost of goods remaining constant.
(iii) Increasing the sale of those goods which have a higher gross margin.
Limitations of Ratio Analysis
Advantages: As stated earlier, ratio analysis is one of the most important tools of financial analysis. Financial health of a business can be diagnosed by this tool. Such an analysis offers the following advantages:
1. Useful in analysis of financial statements. Ratio analysis is the main tool available for examining the financial statements i.e. Loss and Profit Account and Balance Sheet. Such analysis is created not only from the management but additionally by outside parties such as creditors, bankers, investors and so on.
2. Useful in improving future performance. Ratio analysis signifies the weak spots from the business. This assists management in overcoming such weaknesses and enhancing the overall efficiency of the business later on.
3. Useful in lnterfirm comparison.
Comparison of the efficiency of one organization with another could be made only whenever absolute data is actually converted into equivalent ratios. If A firm is making a net profit of Rs. 50,000 while one more firm B is earning Rs. 1.00,000, it will not necessarily mean that B is actually better off unless this profit figure is changed into a ratio and then compared.
4. Useful in judging the efficiency of a business.
As previously stated, accounting ratios assist in judging the performance of a business. Solvency, liquidity, profitability etc. of a company can be easily evaluated using the help of different accounting ratios such as liquid ratio, current ratio, net profit ratio, debt -equity ratio, etc. Such an evaluation allows the management to judge the working efficiency of the different aspects of the enterprise.
5. Useful in simplifying accounting figures. Complex accounting data presented in Profit Loss Account and balance Sheet is simplified, summarised and systematised with the help of ratio analysis so as to make it easily understandable. For example, gross profit ratio, net profit ratio operating ratio etc. give a more easily understandable picture of the profitability of a business than the absolute profit figure.
Earnings per Share (EPS)
This ratio measures the earnings per equity share i.e. it measures the profitability of the firm on a per share basis.
EPS is one of the most commonly quoted and widely publicized ratios. Accounting standard (AS) 20 - Earning per Share has been made mandatory in nature by the Institute of Chartered Accountant of India. Accordingly, each company should show earning per share in its Profit and Loss Account.