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CBSE Class 12 Commerce Accountancy Profitability Ratios Complete Information

CBSE Class 12 Commerce Accountancy Profitability Ratios Complete Information

CBSE Class 12 Commerce Accountancy Profitability Ratios : CBSE is an eminent educational board and since its inception, it provides qualitya education to all students across India. It is a self-financing body and maintains its praise worthy educational standards without taking any grant-in-aid from Government. Several public and private schools are affiliated to this board and its well-structured syllabi and examination pattern are equally implemented in these schools. Keeping in mind the students’ basic requirements in terms of knowledge and mental development, the syllabus of each class is structured in a comprehensive manner. All essential topics are incorporated in the syllabus to make students up-to-date in all respects. Several subject experts are associated with this board and they are involved in preparing syllabus from class I to 12. Hence, students get clear ideas on different topics and it inspires them to a great extent. Two important exams including AISSCE for class 10 and 12 are conducted by this board.

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CBSE Class 12 Commerce Accountancy Profitability Ratios Complete Information

CBSE Class 12 Commerce Accountancy Profitability Ratios :  Every firm is most concerned with its profitability. One of the most frequently used tools of financial ratio analysis is profitability ratios, which are used to determine the company’s bottom line and its return to its investors. Profitability measures are important to company managers and owners alike. If a small business has outside investors who have put their own money into the company, the primary owner certainly has to show profitability to those equity investors.

CBSE Class 12 Commerce Accountancy Profitability Ratios : Profitability ratios show a company’s overall efficiency and performance. Profitability ratios are divided into two types: margins and returns. Ratios that show margins represent the firm’s ability to translate sales dollars into profits at various stages of measurement. Ratios that show returns represent the firm’s ability to measure the overall efficiency of the firm in generating returns for its shareholders.

Margin Ratios

  • Gross Profit Margin: The gross profit margin looks at cost of goods sold as a percentage of sales. This ratio looks at how well a company controls the cost of its inventory and the manufacturing of its products and subsequently pass on the costs to its customers. The larger the gross profit margin, the better for the company. The calculation is: Gross Profit/Net Sales = ____%. Both terms of the equation come from the company’s income statement.
  • Operating Profit Margin: Operating profit is also known as EBIT and is found on the company’s income statement. EBIT is earnings before interest and taxes. The operating profit margin looks at EBIT as a percentage of sales. The operating profit margin ratio is a measure of overall operating efficiency, incorporating all of the expenses of ordinary, daily business activity. The calculation is: EBIT/Net Sales = _____%. Both terms of the equation come from the company’s income statement.
  • Net Profit Margin: When doing a simple profitability ratio analysis, net profit margin is the most often margin ratio used. The net profit margin shows how much of each sales dollar shows up as net income after all expenses are paid. For example, if the net profit margin is 5 percent, that means that 5 cents of every dollar are profit. The net profit margin measures profitability after consideration of all expenses including taxes, interest, and depreciation. The calculation is: Net Income/Net Sales = _____%. Both terms of the equation come from the income statement.
  • Cash Flow Margin: The Cash Flow Margin ratio is an important ratio as it expresses the relationship between cash generated from operations and sales. The company needs cash to pay dividends, suppliers, service debt, and invest in new capital assets, so cash is just as important as profit to a business firm. The Cash Flow Margin ratio measures the ability of a firm to translate sales into cash. The calculation is: Cash flow from operating cash flows/Net sales = _____%. The numerator of the equation comes from the firm’s Statement of Cash Flows. The denominator comes from the Income Statement. The larger the percentage, the better.

Returns Ratios

  • Return on Assets (also called Return on Investment): The Return on Assets ratio is an important profitability ratio because it measures the efficiency with which the company is managing its investment in assets and using them to generate profit. It measures the amount of profit earned relative to the firm’s level of investment in total assets. The return on assets ratio is related to the asset management category of financial ratios. The calculation for the return on assets ratio is: Net Income/Total Assets = _____%. Net Income is taken from the income statement and total assets is taken from the balance sheet. The higher the percentage, the better, because that means the company is doing a good job using its assets to generate sales.
  • Return on Equity: The Return on Equity ratio is perhaps the most important of all the financial ratios to investors in the company. It measures the return on the money the investors have put into the company. This is the ratio potential investors look at when deciding whether or not to invest in the company. The calculation is: Net Income/Stockholder’s Equity = _____%. Net income comes from the income statement and stockholder’s equity comes from the balance sheet. In general, the higher the percentage, the better, with some exceptions, as it shows that the company is doing a good job using the investors’ money.
  • Cash Return on Assets: The cash return on assets ratio is generally used only in more advanced profitability ratio analysis. It is used as a comparison to return on assets since it is a cash comparison to this ratio as return on assets is stated on an accrual basis. Cash is required for future investments. The calculation is: Cash flow from operating activities/Total Assets = _____%. The numerator is taken from the Statement of Cash Flows and the denominator from the balance sheet. The higher the percentage, the better.

Comparative Data

Financial ratio analysis is only a good method of financial analysis if there is comparative data available. The ratios should be compared to both historical data for the company and industry data.

CBSE Class 12 Commerce Accountancy Profitability Ratios Complete Information

CBSE Class 12 Commerce Accountancy Profitability Ratios : The fourth classification of ratios are known as profitability ratios. Profitability Ratios are of great importance to investors since they measure how effectively management is generating profits from corporate assets and from owner’s investments. The most common profitability ratios include; gross profit margin ratio, net profit margin ratio, return on total assets ratio, and the return on equity ratio. Let’s explain each separately, beginning with the Gross Profit Margin.

GROSS PROFIT MARGIN:

The gross profit margin provides an indication of how well a company is setting its product’s prices and controlling its production costs. Here’s how the gross profit margin is calculated;

Gross Profit Margin     =Sales – Cost of goods sold
Sales

CBSE Class 12 Commerce Accountancy Profitability Ratios : As you can see, two items are required before a company can calculate its gross profit margin; Sales and Cost of Goods Sold. As indicated earlier, sales represent a company’s total receipts from selling its products or services to customers. In other words, when a company sells products or services to its customers, the company is said to be making sales. Cost of Goods Sold, as the name implies, represents the costs incurred on all products sold. Furthermore, a business can only recognize, as an expense, the costs of the products it sells. Unsold products are still owned by a business and considered inventory.

The “Sales” account and the “Cost of Goods Sold” account both appear on a company’s income statement. The Widget Manufacturing Company’s income statement section needed for calculating its gross profit margin is presented below.

Sales from Widgets$112,500
Cost of Goods Sold (COGS)$ 85,040
Gross Margin$ 27,460

Using the above figures, we can calculate the Widget Company’s Gross Profit Margin as of December 31, 200Y.

Gross Profit Margin =Sales – Cost of goods sold
Sales
$112,500 – $ 85,040
$112,500
0.24

As you can see, the company’s gross profit margin is 0.24 . This means, $0.24 cents is made from every one dollar ($1.00) generated in sales. In other words, a cost of $0.76 ($1.00-$0.24) is incurred by the company for every $1.00 it takes in from sales. Let’s drive the point home by saying;

For every one dollar generated by the company, $0.76 cents is used to pay for the products it sells and the other $0.24 cents remains in the company to pay for its operating expenses, income taxes, dividends, etc…

Note: the higher the gross profit margin, the more stable a company is considered. Moreover, a higher gross profit margin indicates the company is making more from each sale. On the other hand, the lower a company’s gross profit margin, the less money it makes from each sale, and therefore the less stable the company appears. The next profitability ratio is called the Net Profit Margin.

NET PROFIT MARGIN

The Net Profit Margin ratio shows a company’s after tax profit per dollar of sales. Sub-par profit margins indicate the firm’s selling prices are relatively low or that its expenses are relatively high, or both. Here’s how the net profit margin is calculated;

Net Profit Margin           =Net income after taxes
Sales

As you can see, two items are required before a company can calculate its net profit margin; Sales and Net Income After Taxes. As indicated earlier, sales represent the company’s total receipts from selling its products or services to customers. In other words, when a company sells products or services to its customers, the company is said to be generating sales. Net Income After Taxes is calculated by subtracting a company’s cost of goods sold, operating expenses, and tax obligations from its revenues (Sales).

The sales account and the net income after taxes account both appear on a company’s income statement. The Widget Manufacturing Company’s income statement section, needed for calculating the net profit margin, is presented below.

WIDGET MANUFACTURING COMPANY
CONDENSED INCOME STATEMENT
FOR YEAR ENDING DEC. 31, 200Y
Sales from Widgets$112,500
Cost of Goods Sold (COGS)$ 85,040
Gross Margin$ 27,460
Operating Expenses (Marketing & Administrative)$ 18,950
Net Income Before Taxes$ 8,510
Less: Income Taxes$ 4,163
Net Income After Taxes$ 4,347

Using the above figures, we can calculate the Widget Company’s Net Profit Margin as of December 31, 200Y.

Net Profit Margin =Net income after taxes
Sales
=$ 4,347
$112,500
=0.04

As you can see, the company’s gross profit margin is 0.04 . This means, $0.04 cents is made from every one dollar ($1.00) generated in sales. In other words, a cost of $0.96 ($1.00-$0.04) is incurred by the company for every $1.00 it takes in from sales. Let’s drive the point home by saying;

For every one dollar generated by the company, $0.96 cents is used to pay for buying products, paying operating expenses, and for paying taxes. The other $0.04 cents remain in the company or is distributed to its owners.

CBSE Class 12 Commerce Accountancy Profitability Ratios :

Note: the higher the net profit margin, the more stable a company is considered. Moreover, a higher net profit margin indicates a company is more profitable, after all expenses and taxes have been paid. On the other hand, the lower a company’s net profit margin, the less money it will have to pay for taxes and expenses, and therefore the less stable the company appears. The next profitability ratio is called Return on Total Assets.

RETURN ON TOTAL ASSETS:

CBSE Class 12 Commerce Accountancy Profitability Ratios : Return on Total Assets is a ratio that measures how well a company is using its assets to generate profits. Below depicts how the Return on Total Assets Ratio is calculated;

Return on Total Assets=Net income after taxes
Total assetsAs you can see, two items are required before a company can its calculate return on total assets; namely, Total Assets and Net Income After Taxes. As indicated earlier, Total Assets are the sum of a company’s total current assets and its total fixed assets. Net Income After Taxes is calculated by subtracting a company’s cost of goods sold, operating expenses and tax obligations from its revenues.

Total assets are shown on a company’s balance sheet, while net income after taxes appears on its income statement. The Widget Manufacturing Company’s balance sheet and income statement sections, needed for calculating their Return on Total Assets , are presented below.

FROM THE BALANCE SHEETFROM THE INCOME STATEMENT
ASSETS:
Current Assets:
Cash$  2,550Sales from Widgets$112,500
Marketable securities$  2,000Cost of Goods Sold$ 85,040
Account Receivable (Net)$16,675Gross Margin $ 27,460
Inventories$26,470
Total Current Assets$47,695Operating Expenses$ 18,950
Fixed Assets:Net Income Before Taxes$ 8,510
Plant & Equipment$41,000
Less: Accumulated Depreciation$ 11,000Less: Income Taxes$ 4,163
Net Plant & Equipment$30,000
Net Income After Taxes$ 4,347
TOTAL ASSETS$77,695

Using the above figures, we can calculate the Widget Company’s Return on Total Assets as of December 31, 200Y.

Return on Total Assets=Net income after taxes
Total assets
=$ 4,347
$77,695
=0.06

As you can see, the company’s Return on Total Assets is 0.06 . This means, the company made $0.06 cents on every dollar it invested into assets. Let’s drive the point home by saying;

For every one dollar invested into assets, the company generated 6 cents in after tax profits.

CBSE Class 12 Commerce Accountancy Profitability Ratios : Remember, a company purchases assets so that it can generate profits. Therefore, the higher the Return on Total Assets ratio, the more stable a company is considered. Moreover, a higher Return on Total Assets ratio indicates a company is using its assets more efficiently to generate profits. On the other hand, the lower a company’s Return on Total Assets ratio, the less they are using their assets to generate profits, and therefore the less stable the company appears. The next profitability ratio is called Return on Equity.

RETURN ON EQUITY:

CBSE Class 12 Commerce Accountancy Profitability Ratios : Return on equity ratio is a measure of the rate of return on investment, in the enterprise, the owners have made. Below depicts how the return on equity ratio is calculated;

Return on Equity=Net income after taxes
Total Equity

As you can see, two items are required before a company can calculate its return on equity; namely, Total Equity and Net Income After Taxes. As indicated earlier, Total Equity represents all the investments made into the company by its owners. Net Income After Taxes is calculated by subtracting a company’s cost of goods sold, operating expenses and tax obligations from its revenues.

Total Equity is shown on a company’s balance sheet, while a company’s Net Income After Taxes appears on its income statement. The Widget Manufacturing Company’s balance sheet and income statement sections, needed for calculating the Return on Equity ratio, is presented below.

FROM THE INCOME STATEMENTFROM THE BALANCE SHEET
Equity:
Sales from Widgets$112,500Common Shares$25,000
Cost of Goods Sold$ 85,040Retained Earnings$ 7,820
Gross Margin$ 27,460TOTAL EQUITY$32,820
Operating Expenses$ 18,950
Net Income Before Taxes$ 8,510
Less: Income Taxes$ 4,163
Net Income After Taxes$ 4,347

Using the above figures, we can calculate the Widget Company’s Return on Equity as of December 31, 200Y.

Return on Equity=Net income after taxes
Total Equity
=$ 4,347
$32,820
=0.13

As you can see, the company’s return on equity is 0.13 . This means, the company made $0.13 cents on every dollar the owners invested. Let’s drive the point home by saying;

For every one dollar invested by the owners, the company generated 13 cents in after tax profit.

Remember, owners invest into a company so they can generate profits for themselves and their company. Therefore, the higher the return on equity ratio, the more stable a company is considered. Moreover, a higher return on equity indicates a company is using its owner’s funds wisely to generate profits. On the other hand, the lower a company’s return on equity ratio, the less efficient the owner’s funds are being utilized to generate profits, and therefore the less stable the company appears.

Profitability Ratios Summary:
CBSE Class 12 Commerce Accountancy Profitability Ratios : In summary, profitability ratios are of great importance to investors since they measure how effectively management is generating profits from the company’s assets and from the owner’s investments. The most common profitability ratios include; gross profit margin ratio, net profit margin ratio, return on total assets ratio, and the return on equity ratio. The gross profit margin is calculated by subtracting the cost of goods sold from the sales and dividing by the sales. The net profit margin is calculated by dividing a company’s net income after taxes by its sales. Return on Total Assets is calculated by dividing a company’s net income after taxes by its total assets. Return on Equity is calculated by dividing a company’s net income after taxes by its total equity. Below summarizes the profitability ratios for the Widget Manufacturing Company as of December 31, 200Y.

Gross Profit Margin =Sales – Cost of goods sold
Sales
=$112,500 – $ 85,040
$112,500
=0.24
Net Profit Margin =Net income after taxes
Sales
=$ 4,347
$112,500
=0.04
Return on Total Assets=Net income after taxes
Total assets
=$ 4,347
$77,695
=0.06
Return on Equity=Net income after taxes
Total Equity
=$ 4,347
$32,820
=.13

 CBSE Class 12 Commerce Accountancy Profitability Ratios Complete Information

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