## Saturday, July 26, 2014

### Profitability Indicator Ratios: ( Profit Margin )

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Series : Ratio Analysis    (6 th Post)
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Q :  Is the business profitable  ?

# Profit in relation to Sales and Profit in relation to Assets

1. Profit in relation to sales – this indicates the margin available on sales;

2. Profit in relation to assets – this indicates the degree of return on the capital employed in business that means the earning efficiency.

For example, we will study the following;

Units A and B are in the same type of business and operate at the same levels of capacities.  Unit A employs capital of 250 lacs and unit B employs capital of 200lacs.  The sales and profits are as under:

Parameter                                                  Unit A                           Unit B

Sales                                                          1000lacs                       1000lacs
Profits                                                         100lacs                          90lacs
Profit margin on sales                                    10%                              9%
Return on capital employed                            40%                            45%

While Unit A has higher profit margins, Unit B has better returns on capital employed

## Profit margin on sales:

Gross profit margin on sales and net profit margin ratio –

Gross profit margin = Formula = Gross profit/net sales. Gross profit = Net sales (-) Cost of production before selling, general, administrative expenses and interest charges.  Net sales = Gross sales (-) Excise duty.  This indicates the efficiency of production and serves well to compare with another unit in the same industry or in the same unit for comparing it with past trend.  For example in Unit A and Unit B let us assume that the sales are same at Rs.100lacs.

Parameter                                                             Unit A   Unit B

Sales                                                                      100lacs 100lacs
Cost of production                                                    60lacs   65lacs
Gross profit                                                             40lacs   35lacs
Deduct:  Selling general,
Administrative expenses and interest                         35lacs    30lacs
Net profit                                                                  5lacs      5lacs

While both the units have the same net profit to sales ratio, the significant difference lies in the fact that while Unit A has less cost of production and more office and selling expenses, Unit B has more cost of production and less of office and selling expenses.  This ratio helps in controlling either production costs if cost of production is high or selling and administration costs, in case these are high.
Net profit/sales ratio – net profit means profit after tax but before distribution in any form = Formula = Net profit/net sales.  Tax rate being the same, this ratio indicates operating efficiency directly in the sense that a unit having higher net profitability percentage means that it has a higher operating efficiency.  In case there are tax concessions due to location in a backward area, export activity etc. available to one unit and not available to another unit, then this comparison would not hold well.

Example:

Go to  Moneycontrol.com  Website  here is  an Online Link for the same                      http://www.moneycontrol.com/financials/relianceindustries/ratios/RI#RI                                           Select the Ratios under the Financials Tab  & look for the  Liquidity And Solvency Ratios

# Next Post on Ratio Analysis:  Profitability Indicator Ratios (Effective Tax Rate)

In my quest for learning value investing I came acrros this interesting article and thought would like to share this with the community

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