Question

Choose one of the ratios that assess profitability. Explain how it is calculated. Explain what the ratio indicates to the financial statement user about the company.

Answer 1

The profitability ratio measures profitability or operational efficiency of a firm. These ratios reflect the final results of business operation.

Profitability ratios are calculated on the following basis:

1) On the basis of Sales -- i.e. Gross Profit Ratio, Operating Profit Ratio and Net Profit Ratio

2) On the basis of Owner's Point of view -- i.e. Return on INvestment, Return on Equity, Return on Assets etc.

We are choosing Return on Investment

Return on Investment (ROI)

- ROI measures or describes overall profitability of business for the capital employed.

- ROI indicates the return on the Total Capital Employed before making any distribution of those returns.

Here, Return means Net Profit, It is calculated as follows:

Net Profit

± Non-trading adjustments (but not accrual adjustments for amortization of preliminary expenses, goodwill, etc.)

+ Interest on long term debts + Provision for tax

. Interest/Dividend from non-trade investments

Capital Employed = Equity Share Capital

+ Reserve and Surplus

+ Pref. Share Capital

+ Debentures and other long term loan

. Misc. expenditure and losses

. Non-trade Investments

Formula for calculation of ROI = Total Earnings (Earnings before interest and taxes) / Total Capital Employed