Classification of Profit and Loss Account Ratios | Accounting

In this article we will discuss about the classification of profit and loss account ratios in accounting. They are:- 1. Gross Profit Ratio 2. Operating Ratios 3. Expenses Ratio 4. Net Profit Ratio. 

1. Gross Profit Ratio:

The Gross Profit Ratio is also known as Gross Margin Ratio, Trading Margin Ratio etc. It is expressed as a “Per Cent Ratio.” The difference between Net Sales and Cost of Goods Sold is known as Gross Profit. Gross profit is highly significant. The earning capacity of the business can be ascertained by taking the margin between cost of goods sold and sales.

It is very useful as a test of profitability and management efficiency. It is generally contented that the margin of gross profit should be sufficient enough to recover all operating expenses and other expenses and also leave adequate amount as Net Profit in relation to sales and owners’ equity. Thus, in a trading business, gross profit is net sales minus trading cost of sales.

Gross Profit Ratio shows the gap between revenue and trading costs. Maintenance of steady gross profit ratio is important. An analysis of Gross Profit Margin should be carried out in the light of information relating to purchasing, increasing or reducing the sales price of goods sold by mark up and mark downs, credit and collections and merchandising policies.

If Gross Profit Ratio is deducted from 100, then the balance will represent the ratio between Cost of Sales and Sales i.e., direct operating ratio. This ratio also indirectly highlights upon the margin of gross profit of the concern.

A higher ratio may be the result of one or all of the following:

1. Increase in the selling price of goods sold without any corresponding increase in the cost of goods sold.

2. Decrease in the cost of goods sold without corresponding decrease in selling price.

3. Both selling price and cost of goods sold may have changed, the combined effect being increase in gross margin.

4. Out of sales-mixes, product having higher gross profit margin, should have been sold in larger quantity.

5. Under-valuation of opening stock or over-valuation of closing stock.

On the other hand, if the Gross Profit Ratio is very low, it may be an indicator of lower and poor profitability.

A lower ratio may be the result of the following factors:

1. Decrease in the selling price of goods sold, without corresponding decrease in cost of goods sold.

2. Increase in cost of goods sold without any increase in selling price.

3. Unfavourable purchasing policies.

4. Over-valuation of opening stock or under-valuation of closing stock.

5. Inability of management to improve sales volume.

Normally, the Gross Profit Ratio should remain the same from year to year, because cost of sales will normally vary directly and in the same proportion with sales. Higher ratio is better. The financial manager must be able to detect the causes of a falling gross margin and initiate action to improve the situation. A ratio of 25% to 30% may be considered good.

2. Operating Ratios:

This ratio establishes the relationship between total operating expenses and sales. Total operating expenses include cost of goods, administrative expenses, financial expenses and selling expenses. Cost of goods sold are also known as direct operating Expenses and the rest are known as other operating expenses. Operating ratios are generally expressed in percentages.

Operating profit ratio can be computed by subtracting the operating ratio from 100. It is an important ratio. It is used to discuss the general profitability of the concern. A business concern is said to be efficient if it is able to keep up the cost of goods sold and other operating expenses as low as possible in relation to the net sales effected. This ratio shows the operational efficiency of the firm. Lower operating ratio shows the higher operating profit and vice versa. For manufacturing concern an operating ratio between 75% and 80% is expected.

3. Expenses Ratio:

The expenses are also known as supporting ratios to operating ratio. It becomes imperative that each aspect of cost of sales and/or operating expenses should be analysed in detail just to find out as how far the concern is able to save or is making over expenditure in respect of different items of expenses. For this, relationship of each item of expenses to sales is established. Thus these ratios reveal the relation of different expenses to net sales. There are many expenses ratio.

The following are a few:

4. Net Profit Ratio:

It is also called Net Profit to Sales Ratio (= Profit margin). The profit margin is indicative of management’s ability to operate the business with sufficient success not only to recover from revenues of the period, the cost of merchandise or services, the expenses of operating the business and the cost of borrowed funds, but also to leave a margin of reasonable compensation to the owners for providing their capital at risk. Higher the ratio of net operating profit to sales better is the operational efficiency of the concern.

Net Profit Ratio = Net Profit/Net Sales x 100

This ratio is used to measure the overall profitability and hence it is very useful to proprietors. It is an index of efficiency and profitability when used with gross profit ratio and operating ratio.