Profitability Analysis: A) Profitability in Relation To Sales

Profitability Analysis
From companys prospective the word Profitability means the ability of

a company to make profit from its business operation. The profitability of a
company shows the efficiently of a management about making profit can
making by using all the resources including material, human, financial etc.
that are available in the market. The companys management analyze their
profitability by using different accounting ratios. The profitability ratios are
normally divided into two main types. These are the ratios showing in
relation to sales and those ratios showing in relation to investment. More
broadly:
A) Profitability in Relation to Sales
Gross profit (GP) ratio
Return on assets (ROA)
Operating profit (OP) ratio
B) Profitability in Relation to Investment
Return on equity (ROE)
Net profit (NP) ratio
Return on capital employed (ROCE)
Assets turnover ratio
1) Grass Profit
For management the gross profit margin is very important. It
emphasize the efficiency of operation and shows the average spread
between the operating cost and revenue.
2) Operating Profit
Operating Profit Margin is also very important to emphasize the
profitability of the company because it shows the relationship between net
operating profit and net sales. A high net operating profit ratio shows the
increase in operational efficiency.
3) Net Profit Margin

The Net Profit Ratio expresses the relationship between net profit and
net sales. In simple words we can say that the net profit ratio is the measure
of the firms ability to turn each rupee of revenue into profit.
4) Return on Assets
The Return on Assets (ROA) ratio of a company indicates how
efficiently an entity can manage its assets to generate profit during
accounting period.
5) Return on Equity
Return on equity ratio used to assess how much owners funds are used
efficiently in business.
6) Return on Capital Employed

The return on capital employed ratio shows that how much profit are
generated for every $1 of capital employed. Higher capital employed ratio is
favorable because it means that high profit are generated for every $1 of
capital employed.
7) Assets Turnover Ratio

The assets turnover ratio shows how much sales are generated for
every $ 1 of total assets. A low assets turnover shows that the business is
not using its assets affectively to generate sales and vice versa.
Liquidity Analysis
The term liquidity means the ability of company to meet its short-term
obligations as they come due. Investors always took a close look on the
liquidity ratios when they are performing fundamental analysis of a
companies. Most common example of liquidity ratios are current ratios, acid
test or quick ratio and cash ratio. A company must possess the ability to
release cash from cash cycle to meet its short term financial obligations
when the creditors demand for their payments. In simple words, a company
should have the ability to convert its short term assets into cash. Liquidity
ratios try to measure the ability of a company to convert its short term
assets into cash.
1) Current Ratio
Current ratio measure the ability of a company to pay its short term
liabilities with its current assets. The current ratio shows how easily that
company will be able to pay off its current liabilities. A higher current ratio is
always more favorable because it shows a company can pay current debt
payments more easily.
2) Quick Ratio
Quick ratio measure a companys ability to pay its current liabilities
using its most liquid assets (Most liquid assets are more near to cash).
3) Cash Ratio
The cash ratio or cash coverage ratio is a liquidity ratio that measures
a firm's ability to pay off its current liabilities with only cash and cash
equivalents. The cash ratio is much more restrictive than the current ratio or
quick ratio because no other current assets can be used to pay off current
debt--only cash.
Solvency Analysis
Solvency is the ability of a company to meet its long term financial
obligations or debt. In short a companys solvency determined its ability to
pay debt and achieve long term growth and profitability. Ratios that are used
to analyze the long term solvency of a company are; debt to equity ratio,
equity ratio and debt ratio.
1) Debt to Equity Ratio

Companies normally uses two types of financing sources. These are
equity financing and debt financing. Debt to equity ratio shows the
percentage of companys financing that comes from outsiders i.e. banks or
other loan providers as well as investors. Higher debt to equity ratio shows
that company have a levered firm while low ratio shows company depend on
equity or internal source of financing.
2) Debt Ratio
Debt ratio shows the percentage of companys financing that comes
from outsiders. The high debt ratio shows that the company is a levered firm
and they rely more on debt financing rather than equity.
3) Equity Ratio
Equity ratio shows the percentage of companys financing that comes
from shareholders and other internal sources of companies like retained
earnings.
Working Capital Analysis

Working capital is very important for business because it is use in day
to day business operations. Working Capital can be defined as the capital
available for conducting the day to day operations of the business and more
importantly it consist of current assets and current liabilities. For a business
prospects proper management of working capital is essential to a companys
fundamental financial health and operational success as a business. The
most importantly working capital is a daily necessity for businesses because
normally require a regular amount of cash to make routine payments as well
as un routine payments, cover unexpected costs and purchase basic
materials used in production of goods etc. the important ratios that are used
for working capital analysis are:
Inventory Turnover days

Receivable Turnover days
Payable Turnover days
Operating Cycle
Cash Cycle
1) Inventory Days
Inventory turnover days shows that how long the inventory stay in the
business. The lower ratio is more efficient.
2) Receivable Turnover Days

This ratio shows the average length of time taken by the customer to
pay. A long average collection period means poor credit control and it occur
the cash flow problem.
3) Payable Turnover Days

Payable turnover days indicates the time taken to pay the suppliers.
High ratio is good because suppliers are giving more time to pay for supplies.
4) Operating Cycle
The term operating cycle we defined as is the number of days a
company takes in realizing its inventories in cash. It is called operating cycle
because this process of producing/purchasing inventories, selling them,
recovering cash from customers, using that cash to purchase/produce
inventories and so on is repeated as long as the company is in operations.
Operating cycle measures the operating efficiency of a company. Short
operating cycle is always good as companys cash conversion and recover
process is short.
5) Cash Cycle
The cash cycle measures the amount of days between paying the
vendor for the inventory and when the retailer actually receives the cash
from the customer. We calculate cash cycle by subtracting operating cycle
from payable turnover days. The smaller cash conversion cycle is good
because companys takes less time to convert inventories, receivables and
payable into cash.
Market Based Ratio Analysis

Market based ratios are normally used to compare the stock prices of
publicly traded companys stock prices and other financial measures of a
company like earnings and dividend rates. Investors use these ratio to
analyze the stock price trend and help them to figure out a stocks current
and future market value. In simple words we can say that market based
ratios shows investors what they should expect to receive from their
investments. Table 6 shows some of the basic market base ratios that
investors tend to analyze the current and future market value of shares and
as well as dividends.
1) EPS
EPS measures the amount of net earnings per share of outstanding
shares.
2) P/E Ratio
P/E ratio shows what the market is willing to pay for a shares of a
company based on its current earnings.

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Profitability Analysis

From companys prospective the word Profitability means the ability of

3) Net Profit Margin

6) Return on Capital Employed

7) Assets Turnover Ratio

1) Debt to Equity Ratio

Working Capital Analysis

Inventory Turnover days

2) Receivable Turnover Days

3) Payable Turnover Days

Market Based Ratio Analysis

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