Profitability Ratios - Analysis and Interpretation of Financial Statement, Cost Accounting Video Lecture | Cost Accounting - B Com

hi there in this topic video we're going
to take a quick look at the key
profitability ratios now profitability
ratios are just one of a series of
ratios that help you assess the
performance of a business these look at
the returns earned by business both from
its trading activities from the sales
revenue it generates but also from how
much is invested in the business in
terms of capital employed and the reason
why profitability ratios are so
important is that profit of course is
perhaps the main certainly the most
interesting reward or return for
businesses and entrepreneurs taking
risks and investing in their business
and profit is really important not only
is it a return on investment but it's
also a very important source of finance
in terms of retained profits in the
business
it's a popular common measure of how
successful businesses and of course
profit is also linked with motivating
factors such as bonuses and other
incentives where performance is linked
to a profit the profit earned by the
business so let's just quickly remind
ourselves how we calculate profits while
in terms of the total profit for the
business it's a really simple
calculation its total sales or sales
revenue takeaway total costs fixed costs
plus variable costs do that calculation
you get the total profit or loss of a
business if costs are greater than sales
we make a loss but of course with profit
there are different levels and we'll
have a look at this when we see how we
calculate the different profitability
ratios so why measure profit well of
course it's important to measure it both
in absolute terms that completely or the
total value of profits earned perhaps
impound value or dollar value so for
example a business may make fifty
thousand pounds profit or fifty thousand
dollars in a in a year or a period but
like it's more importantly is also being
able to measure profit in relative terms
what is the profit as a proportion of
the revenues achieved or how much is
invested in a business that's also quite
interesting isn't it and that's really
what financial and profitability ratios
are all about and we normally get the
information we need for profitability
from two parts of the financial
statements from the income statement
that's where we're going to get our
profit figure and also if we're looking
at return the profit return on amount
invested we need to pick up some
information from the balance sheet so
let's quickly go through the four key
profitability ratios what are they how
are they calculated gross profit margin
is the first one and it's a simple
calculation
it's the gross profit which is sales
less cost of sales divided by the total
sales revenue of the business obviously
to get a percentage we multiply that
that division by 100 moving down the
income statement we get to a line called
operating profit which is gross profit
taking away the overheads of the
business so the operating profit margin
is also a percentage and it's expressed
as a percentage like gross profit of
sales revenue so we take the operating
profit number from the income statement
and divide it by the sales revenue
number from the income statement
multiply it by a hundred to give us the
operating profit margin moving a little
bit further down the income statement
towards the bottom we come to what's
known as the net profit or sometimes
otherwise known as the profit for the
year so it's a similar calculation to
the previous two we take the net profit
for the year divided by the sales
revenue for the same period and multiply
it by a hundred to get our net profit
margin and the fourth profitability
ratio is slightly different here we're
not looking at sales revenue with trying
to compare the profit earned compared
with the amount that's invested in a
business so this is where we need to
draw some information from the balance
sheet or the statement of financial
position so we take the operating profit
number and we divide it by what's known
as capital employed multiplied by a
hundred and that will give us our return
on capital employed or sometimes
otherwise known as our OCE let's have a
quick look at an example of how these
calculations are shown just so you can
see how the numbers are put together so
here on the left is a simple summary of
some information from the income
statement and the balance sheet we've
got
sales revenue we take away cost of sales
that gets us to the gross profit 300
thousand pounds or 300 thousand take
away the overheads gets us to the
operating profit of a hundred and twenty
five thousand and then it looks like
there's another twenty five thousand off
costs possibly finance or interest costs
gives us a net profit of one hundred
thousand and from the statement of
financial position or balance sheet
we've identified that the business has 1
million invested in it capital employed
of 1 million so remembering our ratio
calculations of our formula we all wish
our workings Carosa profit is therefore
300 divided by 500 we multiply that by
100 to get a percentage which gives us
60 percent the gross profit margin is 60
percent working down the income
statement we gets the operating profit
so we can use that to calculate
operating profit margin in this case
it's 125 thousand divided by the sales
revenue 500,000 again multiplied by 100
to give us our percentage 25 percent and
you can see a similar calculation for
net profit margin our net profit was
100,000 our sales revenue 500 thousand
so we divide one by the other and
multiply by 100 to get to a percentage
of 20 percent 20 percent finally return
on capital employed needs to use that
capital employed number from the balance
sheet and we're going to pick out the
operating profit number 125 thousand
divided by a million multiplied by 100
hopefully your numbers agree with mine
12.5 percent so that's been a brief
introduction to the ways in which you
calculate the four main profitability
ratios