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# A NOTE ON FINANCIAL RATIO ANALYSIS <<Previous

PROFITABILITY RATIOS

These ratios help measure the profitability of a firm. There are two types of profitability ratios:

• Profitability ratios in relation to sales and

• Profitability ratios in relation to investments.

## PROFITABILITY RATIOS IN RELATION TO SALES

A firm which generates a substantial amount of profits per rupee of sales can comfortably meet its operating expenses and provide more returns to its shareholders. The relationship between profit and sales is measured by profitability ratios. There are two types of profitability ratios: Gross Profit Margin and Net Profit Margin.

Gross Profit Margin: This ratio measures the relationship between gross profit and sales. It is calculated as follows:

Gross Profit Margin = Gross Profit/Net sales * 100

This ratio shows the profit that remains after the manufacturing costs have been met. It measures the efficiency of production as well as pricing.

Net Profit Margin: This ratio is computed using the following formula:

Net profit / Net sales

This ratio shows the net earnings (to be distributed to both equity and preference shareholders) as a percentage of net sales. It measures the overall efficiency of production, administration, selling, financing, pricing and tax management. Jointly considered, the gross and net profit margin ratios provide an understanding of the cost and profit structure of a firm.

## PROFITABILITY RATIOS IN RELATION TO INVESTMENT

These ratios measure the relationship between the profits and investments of a firm. There are three such ratios: Return on Assets, Return on Capital Employed, and Return on Shareholders' Equity.

Return on Assets (ROA): This ratio measures the profitability of the assets of a firm. The formula for calculating ROA is:

ROA = EAT + Interest - Tax Advantage on Interest / Average Total Assets

Return on Capital Employed (ROCE): Capital employed refers to the long-term funds invested by the creditors and the owners of a firm. It is the sum of long-term liabilities and owner's equity. ROCE indicates the efficiency with which the long-term funds of a firm are utilized. It is computed by the following formula:

ROCE = (EBIT / Average Total Capital Employed) * 100

Return on Shareholders' Equity: This ratio measures the return on shareholders' funds. It can be calculated using the following methods:

• Rate of return on total shareholders' equity.
• Rate of return on ordinary shareholders.
• Earnings per share.
• Dividends per share.
• Dividend pay-out ratio.
• Earning and Dividend yield.

(i) Return on Total Shareholders' Equity

The total shareholders' equity consists of preference share capital, ordinary share capital consisting of equity share capital, share premium, reserves and surplus less accumulated losses.

Return on total shareholders' equity = (Net profit after taxes) * 100 /Average total shareholders' equity

(ii) Return on Ordinary Shareholder's Equity (ROSE)

This ratio is calculated by dividing the net profits after taxes and preference dividend by the average equity capital held by the ordinary shareholders.

ROSE = (Net Profit after Taxes - Preference Dividend) * 100 / Networth

(iii) Earnings per Share (EPS)

EPS measures the profits available to the equity shareholders on each share held. The formula for calculating EPS is:

EPS = Net Profits Available to Equity Holders / Number of Ordinary Shares Outstanding

(iv) Dividend per Share (DPS)

DPS shows how much is paid as dividend to the shareholders on each share held. The formula for calculating EPS is:

DPS = Dividend Paid to Ordinary Shareholders / Number of Ordinary Shares Outstanding

(v) Dividend Pay-out Ratio (D/P Ratio)

D/P ratio shows the percentage share of net profits after taxes and after preference dividend has been paid to the preference equity holders.

D/P ratio = Dividend per Share (DPS) / Earnings per Share * 100

(vi) Earning & Dividend Yield

Earning yield is also known as earning-price ratio and is expressed in terms of the market value per share.

Earning Yield = EPS / Market Value per Share * 100

Dividend Yield is expressed in terms of the market value per share.

Dividend Yield = (DPS / Market Value per Share) * 100

CALCULATING FINANCIAL RATIOS OF HLL

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