Profitability Ratios and it’s Categories | Accounting

The profitability of the firm is also measured in relation to investments. The term investment may refer to total assets, capital employed or the owners’ equity. The efficiency of an enterprise is judged by the amount of profits. But sometimes the conclusion drawn on the basis of profit-to- sales ratios may be misleading.

Because it is possible that profit in terms of sales is sufficient but sales with regard to capital may be inadequate. Therefore, the state of efficiency cannot be judged by the volume of profits alone: we have to consider the size of investment along-with profit. The shareholders can measure the success of a firm in terms of profit related to capital employed.

The efficiency can only be judged by calculating return on capital employed or with investments. The volume of profit depends to a great extent upon the volume of investments. Investments are represented by those assets which are acquired for conducting the business operations, mainly production and sales and the size of investments (asset) certainly affects the volume of profit.

The important categories of such ratios are discussed below:

(i) Return on Assets:

Profitability can be measured in terms of relationship between net profit and assets. This ratio is also known as profit-to-assets ratio. It measures the profitability of investments. The overall profitability can be known.

Return on Assets = Net Profit/Total Assets x 100

There are various approaches possible to define net profits and assets, according to the purpose and intent of the calculation of the ratios.

(ii) Return on Capital Employed:

This is the second type RoI (Return on Investment). This is also known as Return on Investment or Rate of Return. The prime objective of making investments in any business is to obtain satisfactory return on capital invested. It indicates the percentage of return on the capital employed in the business and it can be used to show the efficiency of the business as a whole.

Return on Capital Employed = Net Profit/Capital Employed x 100

The term capital employed refers to long-term funds supplied by the creditors and owners of the firm. It can be computed in two ways. First, it is equal to non-current liabilities (Long-term liabilities) plus owners’ equity. Alternatively, it is equivalent to net working capital plus fixed assets.

Thus, the capital employed basis provides a test of profitability related to the sources of long-term funds. A comparison of this ratio with similar firms, with the industry average and over time would provide sufficient insight into how efficiently the long-term funds of owners and creditors are being used. The higher the ratio, the more efficient use of the capital employed.

(iii) Return on Shareholders Equity:

This ratio establishes the profitability from the shareholders point of view.

Return on Shareholder’ Equity = Net Profit/Shareholders Fund x 100

The term Net Profit as used here, means net income after payment of interest and tax including net non-operating income (i.e. Non-operating income minus non-operating expenses). It is the final income that is available for distribution as dividends to shareholders. Shareholders’ funds include both preference and equity share capital and all reserves and surplus belonging to shareholders.