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Ratios
Profitability Ratios
Under the syllabus, profitability ratios consist of three main ratios, the profit ratio, rate of return on assets and times interest earned. They are used to calculate the financial performance of a company.
Profit Ratio
Measures the amount of profit after tax generated per dollar of net sales.
Note: Net Revenue
Net – remove sales returns from revenue. Remember this as on the formula sheet it says ‘Total Revenue’ and does not mention ‘net’.
Interpretations
Acceptable ratio levels are dependent on each industry; therefore, profit ratios should be compared to industry averages as well as past performance.
Generally speaking, the usual interpretations are:
Low
Bad – less profit after tax per sale, less profitable position.
High
Good – more profit per dollar of sale, increased profitability position.
Rate of Return on Assets
Measures the amount of revenue generated by investment in assets.
Why is Interest Expense Included?
Some users calculate the formula without interest expense. The formula in the Year 12 syllabus uses interest expense in the formula because it is seen as more ideal to exclude the cost of borrowing as assets are usually financed by borrowing.
Interpretations
Acceptable ratio levels are dependent on each industry; therefore, rate of return on asset ratios should be compared to industry averages as well as past performance.
Generally speaking, the usual interpretations are:
Low
Bad – inefficient investment in assets in its ability to generate revenue
High
Good – good and efficient investment in assets to generate revenue
Times Interest Earned
The times interest earned ratio measures the amount of times profits (excluding borrowings) exceeds finance costs. The times interest ratio is measuresed in times (as the name suggests) and not a %. Do not multiply by 100.
Note: Capitalised Interest
For the year 12 course, you should not need to worry about capitalised interest.
But for the record, capitalised interest is the cost interest required to finance a long term non-current asset.
Low
Concerning as the business is having trouble meeting its debt obligations and debts are becoming a large component of expenses.
High
Great, as the business is comfortably meeting its debt obligations and using debt finance to expand the business’s profit margins.
