This ratio indicate the performance of the firm in relation to its ability to derive returns or profit from investment or from sale of goods i.e profit margin or sales.
1. Profitability in relation to sales
The ratio indicate the ability of the firm to control its cost of sales, operating and financing expenses.
- They include:
a) Gross profit margin = Gross profit x 100
The ratio indicate the ability of the firm to control cost of sales expenses e.g gross profit margin of 40% means 60% of sales revenue was taken up by cost of sales while 40% was the gross profit.
b) Operating profit margin = Operating profit/Earning before interest & tax
The ratio indicates ability of the firm to control its operating expenses such as distribution cost, salaries and wages, travelling, telephone and electricity charges etc. e.g a ratio of 20% means:
i) 80% of sales relate to both operating and cost of sales expenses
ii) 20% of sales remained as operating margin profit
c) Net profit margin = Net profit x 100 (earning after tax) + interest
This ratio indicates the ability of the firm to control financing expenses in particular interest charges e.g. Net profit margin of 10% indicate that:
i) 90% of sales were taken up by cost of sales, operating and financing expenses
ii) 10% remained as net profits.
2. Profitability in relation to investment
a) Return on Investment (ROI) = Net profit x 100
or return on total asset (ROTA) Total asset
The ratio indicate the return on profit from investment of Sh.1 in total assets e.g a ratio of 20% means Sh.10 of total asset generated Sh.2 of net profit.
b) Return on equity (ROE) = Net profit x 100
or Return on net worth (RONW) equity
or Return on shareholders equity (ROSE)
The ratio indicate the return of profitability for every one shilling of equity capital contributed by the shareholders e.g a ratio of 25% means one shilling of equity generates Sh.0.25 profit attributable to ordinary shareholders.
c) Return on capital employed ROCE = Net profit x 100
or Return on net asset (RONA) Net Asset (Capital employed)
This ratio indicate the returns of profitability for every one shilling of capital employed in the firm.