Accounting: Accounting Ratios II: Operating Profit and Return on Investment Ratio

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  • It is the ratio between gross profit and net sales.

  • Operating Profit Ratio =

  • Operating profit = Gross Profit – (Administrative expenses + selling expenses)

  • It helps in controlling the cash.

Example: Calculate operating profit ratio from the following data:

Sales Rs.3,00,000

Gross profit Rs.1,20,000

Administration expenses Rs.35,000

Selling and distribution expenses Rs.25,000

Income on investment Rs.15,000

Loss by fire Rs.9,000

Solution:

Operating Profit Ratio =

Operating profit = Gross profit – (Administration expenses + Selling expenses)

= 1,20,000 – (35,000 + 25,000)

= 1,20,000 – 60,000

= 60,000

Operating Profit Ratio

= 20%

Return on Investment Ratio (ROI)

This is a basic profitability ratio. It is the ratio between net profit before interest, tax and dividend and capital employed.It measures the efficient utilization of resources i.e. capital. Higher ratio is preferable.

ROI =

Capital Employed = Equity share capital + preference share capital + Reserve and surplus + long term liabilities – fictitious assets – Non trading investment (or)

Capital Employed = (Fixed asset – depreciation) + (Current Asset – Current liabilities) or

Capital Employed = (Fixed Assets – Depreciation) + (Working capital)

Example: From the following data, calculate the return on capital employed : Net fixed assets Rs 100,000 current assets Rs 50,000, current liabilities Rs 25,000, Gross profit Rs 32,500, Interest on long-term debt Rs 7500 tax Rs 8750, office and administrative expenses Rs 2500, selling and distribution expenses Rs 5000. There were no long term investments.

Solution:

Net Profit before interest and tax = Gross profit – office admin expenses –

Selling and distribution expenses

= 32500 – 2500 – 5000

= 25000

Capital employed = Net fixed Assets + Current Assets – Current liabilities

= Rs 100,000 + 50,000 – 25,000

= Rs. 1,25,000

ROI =

= = 20%

Leverage Ratios

The leverage ratios are also known as capital structure ratios. Every company raises funds from different sources at a particular cost. Cost of funds may vary for different source of funds. Capital structure is the mix of different sources of funds. The mix consists of equity share capital, debentures and long term debt from different financial institutions and reserves and surpluses. Leverage or capital structure ratios are calculated to test the long term financial position of a firm.

Capital Gearing Ratio

It is the relationship between Equity share capital including reserves and surpluses and the fixed interest or dividend instruments i.e. preference share capital and long term debt instruments.

Capital Gearing Ratio =

Significance: Gearing should be kept in such a way that the company is able to maintain a steady rate of dividend. High gearing ratio is not good for a new company or a company of which future earnings are uncertain.

Example: From the following information find out capital gearing ratio.

Table 1 Supporting: Capital Gearing Ratio

Tablutation of: Source, 2005, 2006

Source

2005

2006

Equity Share Capital

Reserves & Surplus

8% Preference Share Capital

6% Debentures

500000

300000

250000

250000

400000

200000

300000

400000

Solution:

Capital Gearing Ratio =

For the year 2005;

Capital Gearing Ratio =

=

= 8:5 (Low Geared)

For the year 2006;

Capital Gearing Ratio =

=

= 6:7(Highly Geared)

Limitations of Accounting Ratios

  • Ignorance of Qualitative aspect: Ratio analysis considers only quantitative data and leave qualitative aspects of the data. Sometimes qualitative data may play vital role in decision making.

  • No single concept and not suitable for comparison: Ratio analysis can be used in different ways. That may vary from industry to industry or company to company. So, we cannot compare on a single concept.

  • Ignorance of price level changes: Price level changes make the comparison of figures difficult over a period of time. Before any comparison is made, proper adjustments for price level changes must be made. Misleading results if the quantitative accounting data is not correct or reliable.

  • Difficulty in forecasting: Ratios uses past data and make all analysis. This will not show the present or future conditions. It may not be useful to give future perspectives of the business in a right manner.

Types of Ratios and Their Classification

Image of Types of Ratios and Their classification:

Image of Types of Ratios and Their Classification:

Image of Types of Ratios and Their classification:

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