Profitability Ratios

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.