PROFITABILITY /

EARNING CAPACITY
RATIOS

PROFITABILITY / EARNING CAPACITY RATIOS

Profitability or Earning Capacity ratios focus on:
1. the profit determined in the income statement
2. relationship with other elements in the financial reports from the income
statement (eg sales) or the balance sheet (eg assets & equity).
These ratios are important because they indicate to the owner just how profitable their
investment is and whether or not continued investment is worthwhile.
KEY RATIOS
. Gross profit
. Net profit
. Expenses to sales
. Return on owners equity
. Return on total assets

PROFITABILITY / EARNING CAPACITY RATIOS

Gross Profit Ratio
The Gross Profit Ratio
1. Indicates the ability of a trading business to generate gross profits from sales
2. Measures the number of cents in every dollar that represents gross profit
e.g. ratio 1:637 - meaning for every 1 dollar of sales, 64 cents represents gross profit &
36 cents represents COGS

Benchmark

Question Ratio Seeks to Answer

Industry Average

Is the profit from the sale of product/service sufficient to cover the

overheads generated in producing/providing that product or service?

PROFITABILITY / EARNING CAPACITY RATIOS

Net Profit Ratio
The Net Profit Ratio
1. Indicates the ability of the business to generate net profit from sales of goods & services
2. Reveals the number of cents in a dollar that represents net profit
e.g. ratio 1:35 - meaning for every 1 dollar of sales made, 35 cents represents net profit
3. Reflects the effectiveness of managers to minimise expenses per dollar of sales

Benchmark

Question Ratio Seeks to Answer

Industry Average

Is the return on the owners investment satisfactory, or should

alternatives be considered?

PROFITABILITY / EARNING CAPACITY RATIOS

Expenses to Sales Ratio
Expenses to Sales Ratio
1. Indicates the amount of sales dollars needed to cover expenses or a particular category of
expenses
2. Acts as a control mechanism on the individual expense categories.
3. Monitoring expenses is crucial to gross & net profit.

Benchmark

Question Ratio Seeks to Answer

Industry Average

Is any category of expenses indicating that controls over a particular

area of the business need to be tightened?

PROFITABILITY / EARNING CAPACITY RATIOS

Return On Equity Ratio
Return on Equity Ratio
1. Indicates the return to the owner on the amount invested in the business.
2. Profit is generally the primary motive for an owner investing their own resources or
borrowing to invest in a business. If the costs outweigh the benefits, then the most likely
decision is that the investment will not be undertaken.

Benchmark

Question Ratio Seeks to Answer

Current Interest
Rates

How effective is the return on the organizations investment in its

assets?

PROFITABILITY / EARNING CAPACITY RATIOS

Return On Total Assets Ratio
Return on Total Assets Ratio
1. Indicates the ability of the business to generate profits using its assets.
2. Measures the effectiveness of the assets to generate revenue.

Benchmark

Question Ratio Seeks to Answer

Industry Average

Are the assets generating income at the required level?

TASK
The following information has been extracted from the financial statements of Terri de Lacey's
business, Posh Shoes. You are required to prepare the profitability ratios.

ACCOUNT

$ AMOUNT

Net Sales

50 000

Gross Profit

35 000

Net Profit

15 000

Selling & Distribution Expenses

6 000

General & Administrative Expenses 12 000

Financial Expenses

2 000

Owners Equity (30 June 2013)

85 000

Owners Equity (30 June 2014)

100 000

Interest Expense

200

Total Assets (30 June 2013)

120 000

Total Assets (30 June 2014)

166 000

PROFITABILITY / EARNING CAPACITY RATIOS

TASK
1. Complete Review & Practice 3 on page 606 (textbook)
2. Complete exercise 12.9 on page 654 (textbook)