Margin of Safety:

Definition and Explanation:


Margin of safety (MOS) is the excess of budgeted or actual sales over the break even volume of sales. It stats the amount by which sales can drop before losses begin to be incurred. The higher the margin of safety, the lower the risk of not breaking even.



Formula of Margin of Safety:

The formula or equation for the calculation of margin of safety is as follows:



[Margin of Safety = Total budgeted or actual sales − Break even sales]



The margin of safety can also be expressed in percentage form. This percentage is obtained by dividing the margin of safety in dollar terms by total sales. Following equation is used for this purpose.



[Margin of Safety = Margin of safety in dollars / Total budgeted or actual sales]



Example:

Sales(400 units @ $250) $100,000

Break even sales $87,500

Calculate margin of safety





Calculation:



Sales(400units @$250) $100,000

Break even sales $ 87,500

---------

Margin of safety in dollars $ 12,500

=======

Margin of safety as a percentage of sales:



12,500 / 100,000



= 12.5%





It means that at the current level of sales and with the company's current prices and cost structure, a reduction in sales of $12,500, or 12.5%, would result in just breaking even. In a single product firm, the margin of safety can also be expressed in terms of the number of units sold by dividing the margin of safety in dollars by the selling price per unit. In this case, the margin of safety is 50 units ($12,500 ÷ $ 250 units = 50 units).



Review Problem:

Voltar company manufactures and sells a telephone answering machine. The company's contribution margin income statement for the most recent year is given below:



Description

Total Per unit Percent of Sales

Sales (20,000 units) $ 1,200,000 $60 100%

Less variable expenses 900,000 $45 ?%

--------- -------- --------

Contribution margin 300,000 $15 ?%

Less fixed expenses 240,000 ====== =====

---------

Net operating income 60,000



======







Required: margin of safety of safety both in dollars and percentage form.



Solution to Review Problem:

Margin of safety = Total sales – Break even sales*



= $1,200,000 – $960,000



= $240,000



Margin of safety percentage = Margin of safety in dollars / Total sales



= $240,000 / $1,200,000



= 20%



*The break even sales have been calculated as follows:



Sales = Variable expenses + Fixed expenses + Profit



$60Q = $45Q + $240,000 + $0**



$15Q = $240,000



Q = $240,000 / $15 per unit



Q = 16,000 units; or at $60 per unit. $960,000

Definition of Break Even point

Definition of Break Even point:


Break even point is the level of sales at which profit is zero. According to this definition, at break even point sales are equal to fixed cost plus variable cost. This concept is further explained by the the following equation:



[Break even sales = fixed cost + variable cost]



The break even point can be calculated using either the equation method or contribution margin method. These two methods are equivalent.



Equation Method:

The equation method centers on the contribution approach to the income statement. The format of this statement can be expressed in equation form as follows:



Profit = (Sales − Variable expenses) − Fixed expenses



Rearranging this equation slightly yields the following equation, which is widely used in cost volume profit (CVP) analysis:



Sales = Variable expenses + Fixed expenses + Profit



According to the definition of break even point, break even point is the level of sales where profits are zero. Therefore the break even point can be computed by finding that point where sales just equal the total of the variable expenses plus fixed expenses and profit is zero.



Example:

For example we can use the following data to calculate break even point.



Sales price per unit = $250



variable cost per unit = $150



Total fixed expenses = $35,000



Calculate break even point





Calculation:

Sales = Variable expenses + Fixed expenses + Profit



$250Q* = $150Q* + $35,000 + $0**



$100Q = $35000



Q = $35,000 /$100



Q = 350 Units



Q* = Number (Quantity) of units sold.

**The break even point can be computed by finding that point where profit is zero





The break even point in sales dollars can be computed by multiplying the break even level of unit sales by the selling price per unit.



350 Units × $250 Per unit = $87,500



Contribution Margin Method:

The contribution margin method is actually just a short cut conversion of the equation method already described. The approach centers on the idea discussed earlier that each unit sold provides a certain amount of contribution margin that goes toward covering fixed cost. To find out how many units must be sold to break even, divide the total fixed cost by the unit contribution margin.

contribution margin format income statement.

contribution margin format income statement.




Masers A. Q. Asem Private Ltd

Contribution Margin Income Statement

For the month of-------------



Total Per Unit

Sales (350 Units) $87,500 $250

Less variable expenses 52,500 150

--------- ---------

Contribution margin 35,000 $100

Less fixed expenses 35,000 ======

----------

Net operating profit $0

======



Note that the break even is the level of sales at which profit is ZERO.



Once the break even point has been reached, net income will increase by unit contribution margin by each additional unit sold. For example, if 351 units are sold during the period then we can expect that the net income for the month will be $100, since the company will have sold 1 unit more than the number needed to break even. This is explained by the following contribution margin income statement.



Masers A. Q. Asem Private Ltd

Contribution Margin Income Statement

For the month of-------------



Total Per Unit

Sales (351 Units) $87,750 $250

Less Variable expenses 52,500 150

---------- ----------

Contribution margin 35,100 100

Less fixed expenses 35,000 ======

----------

Net operating loss $100

======



If 352 units are sold then we can expect that net operating income for the period will be $200 and so forth. To know what the profit will be at various levels of activity, therefore, manager do not need to prepare a whole series of income statements. To estimate the profit at any point above the break even point, the manager can simply take the number of units to be sold above the breakeven and multiply that number by the unit contribution margin. The result represents the anticipated profit for the period. Or to estimate the effect of a planned increase in sale on profits, the manager can simply multiply the increase in units sold by the unit contribution margin. The result will be expressed as increase in profits. To illustrate it suppose company is currently selling 400 units and plans to sell 425 units in near future, the anticipated impact on profits can be calculated as follows:



Increased number of units to be sold 25

Contribution margin per unit ×100



--------------------------------------------------------------------------------



Increase in the net operating income 2,500

======



To summarize these examples, if there were no sales, the company's loss would equal to its fixed expenses. Each unit that is sold reduces the loss by the amount of the unit contribution margin. Once the break even point has been reached, each additional unit sold increases the company's profit by the amount of the unit contribution margin.

example

Assume that Masers A. Q Asem Private Ltd. has been able to sell only one unit of product during the period. If company does not sell any more units during the period, the company's contribution margin income statement will appear as follows:




Masers A. Q. Asem Private Ltd

Contribution margin Income Statement

For the month of-------------



Total Per Unit

Sales (1 Unit only) $250 $250

Less Variable expenses 150 150

--------- ---------

Contribution margin 100 100

Less fixed expenses 35,000 ======

---------

Net operating loss $(34,900)

======



For each additional unit that the company is able to sell during the period, $100 more in contribution margin will become available to help cover the fixed expenses. If a second unit is sold, for example, then the total contribution margin will increase by $100 (to a total of $200) and the company's loss will decrease by $100, to $34800. If enough units can be sold to generate $35,000 in contribution margin, then all of the fixed costs will be covered and the company will have managed to at least break even for the month-that is to show neither profit nor loss but just cover all of its costs. To reach the break even point, the company will have to sell 350 units in a period, since each unit sold contribute $100 in the contribution margin.

Contribution margin

Contribution margin is the amount remaining from sales revenue after variable expenses have been deducted. Thus it is the amount available to cover fixed expenses and then to provide profits for the period. Contribution margin is first used to cover the fixed expenses and then whatever remains go towards profits. If the contribution margin is not sufficient to cover the fixed expenses, then a loss occurs for the period. This concept is explained in the following equations:




Sales revenue − Variable cost* = Contribution Margin



*Both Manufacturing and Non Manufacturing



Contribution margin − Fixed cost* = Net operating Income or Loss



*Both Manufacturing and Non Manufacturing

Cost Volume Profit Relationship - (CVP Analysis

Cost volume profit analysis (CVP analysis) is one of the most powerful tools that managers have at their command. It helps them understand the interrelationship between cost, volume, and profit in an organization by focusing on interactions among the following five elements:




Prices of products

Volume or level of activity

Per unit variable cost

Total fixed cost

Mix of product sold

Because cost-volume-profit (CVP) analysis helps managers understand the interrelationships among cost, volume, and profit it is a vital tool in many business decisions. These decisions include, for example, what products to manufacture or sell, what pricing policy to follow, what marketing strategy to employ, and what type of productive facilities to acquire.

Fixed Assets Turnover Ratio:

Definition:

Fixed assets turnover ratio is also known as sales to fixed assets ratio. This ratio measures the efficiency and profit earning capacity of the concern.
Higher the ratio, greater is the intensive utilization of fixed assets. Lower ratio means under-utilization of fixed assets. The ratio is calculated by using following formula:

Formula of Fixed Assets Turnover Ratio:

Fixed assets turnover ratio turnover ratio is calculated by the following formula:

Fixed Assets Turnover Ratio = Cost of Sales / Net Fixed Assets

Working Capital Turnover Ratio:

Definition:

Working capital turnover ratio indicates the velocity of the utilization of net working capital.
This ratio represents the number of times the working capital is turned over in the course of year and is calculated as follows:

Formula of Working Capital Turnover Ratio:

Following formula is used to calculate working capital turnover ratio

Working Capital Turnover Ratio = Cost of Sales / Net Working Capital

The two components of the ratio are cost of sales and the net working capital. If the information about cost of sales is not available the figure of sales may be taken as the numerator. Net working capital is found by deduction from the total of the current assets the total of the current liabilities.

Example:

Cash Bills Receivables Sundry Debtors Stock Sundry Creditors Cost of sales

10,000 5,000 25,000 20,000 30,000 150,000

Calculate working capital turnover ratio

Calculation:

Working Capital Turnover Ratio = Cost of Sales / Net Working Capital

Current Assets = $10,000 + $5,000 + $25,000 + $20,000 = $60,000

Current Liabilities = $30,000

Net Working Capital = Current assets – Current liabilities

= $60,000 − $30,000

= $30,000

So the working Capital Turnover Ratio = 150,000 / 30,000

= 5 times

Significance:

The working capital turnover ratio measure the efficiency with which the working capital is being used by a firm. A high ratio indicates efficient utilization of working capital and a low ratio indicates otherwise. But a very high working capital turnover ratio may also mean lack of sufficient working capital which is not a good situation.

Creditors / Accounts Payable Turnover Ratio:

Definition and Explanation:

This ratio is similar to the debtors turnover ratio. It compares creditors with the total credit purchases.
It signifies the credit period enjoyed by the firm in paying creditors. Accounts payable include both sundry creditors and bills payable. Same as debtors turnover ratio, creditors turnover ratio can be calculated in two forms, creditors turnover ratio and average payment period.

Formula:

Following formula is used to calculate creditors turnover ratio:

Creditors Turnover Ratio = Credit Purchase / Average Trade Creditors

Average Payment Period:

Average payment period ratio gives the average credit period enjoyed from the creditors. It can be calculated using the following formula:

Average Payment Period = Trade Creditors / Average Daily Credit Purchase

Average Daily Credit Purchase= Credit Purchase / No. of working days in a year

Or

Average Payment Period = (Trade Creditors × No. of Working Days) / Net Credit Purchase

(In case information about credit purchase is not available total purchases may be assumed to be credit purchase.)

Significance of the Ratio:

The average payment period ratio represents the number of days by the firm to pay its creditors. A high creditors turnover ratio or a lower credit period ratio signifies that the creditors are being paid promptly. This situation enhances the credit worthiness of the company. However a very favorable ratio to this effect also shows that the business is not taking the full advantage of credit facilities allowed by the creditors.

Debtors Turnover Ratio | Accounts Receivable Turnover Ratio:

A concern may sell goods on cash as well as on credit. Credit is one of the important elements of sales promotion. The volume of sales can be increased by following a liberal credit policy.
The effect of a liberal credit policy may result in tying up substantial funds of a firm in the form of trade debtors (or receivables). Trade debtors are expected to be converted into cash within a short period of time and are included in current assets. Hence, the liquidity position of concern to pay its short term obligations in time depends upon the quality of its trade debtors.

Definition:

Debtors turnover ratio or accounts receivable turnover ratio  indicates the velocity of debt collection of a firm. In simple words it indicates the number of times average debtors (receivable) are turned over during a year.

Formula of Debtors Turnover Ratio:

Debtors Turnover Ratio = Net Credit Sales / Average Trade Debtors

The two basic components of accounts receivable turnover ratio are net credit annual sales and average trade debtors. The trade debtors for the purpose of this ratio include the amount of Trade Debtors & Bills Receivables. The average receivables are found by adding the opening receivables and closing balance of receivables and dividing the total by two. It should be noted that provision for bad and doubtful debts should not be deducted since this may give an impression that some amount of receivables has been collected. But when the information about opening and closing balances of trade debtors and credit sales is not available, then the debtors turnover ratio can be calculated by dividing the total sales by the balance of debtors (inclusive of bills receivables) given. and formula can be written as follows.

Debtors Turnover Ratio = Total Sales / Debtors

Example:

Credit sales $25,000; Return inwards $1,000; Debtors $3,000; Bills Receivables $1,000.

Calculate debtors turnover ratio

Calculation:

Debtors Turnover Ratio = Net Credit Sales / Average Trade Debtors

= 24,000* / 4,000**

= 6 Times

*25000 less 1000 return inwards, **3000 plus 1000 B/R

Significance of the Ratio:

Accounts receivable turnover ratio or debtors turnover ratio indicates the number of times the debtors are turned over a year. The higher the value of debtors turnover the more efficient is the management of debtors or more liquid the debtors are. Similarly, low debtors turnover ratio implies inefficient management of debtors or less liquid debtors. It is the reliable measure of the time of cash flow from credit sales. There is no rule of thumb which may be used as a norm to interpret the ratio as it may be different from firm to firm.

Earnings Per Share (EPS) Ratio:

Definition:

Earnings per share ratio (EPS Ratio) is a small variation of return on equity capital ratio and is calculated by dividing the net profit after taxes and preference dividend by the total number of equity shares.

Formula of Earnings Per Share Ratio:

The formula of earnings per share is:

Earnings per share (EPS) Ratio = (Net profit after tax − Preference dividend) / No. of equity shares (common shares)

Example:

Equity share capital ($1): $1,000,000; 9% Preference share capital: $500,000; Taxation rate: 50% of net profit; Net profit before tax: $400,000.

Calculate earnings per share ratio.

Calculation:

EPS = 1,55,000 / 10,000

= $15.50 per share.

Significance:

The earnings per share is a good measure of profitability and when compared with EPS of similar companies, it gives a view of the comparative earnings or earnings power of the firm. EPS ratio calculated for a number of years indicates whether or not the earning power of the company has increased.

Dividend Payout Ratio:

Dividend payout ratio is calculated to find the extent to which earnings per share have been used for paying dividend and to know what portion of earnings has been retained in the business. It is an important ratio because ploughing back of profits enables a company to grow and pay more dividends in future.

Formula of Dividend Payout Ratio:

Following formula is used for the calculation of dividend payout ratio

Dividend Payout Ratio = Dividend per Equity Share / Earnings per Share

A complementary of this ratio is retained earnings ratio. Retained earning ratio is calculated by using the following formula:

Retained Earning Ratio = Retained Earning Per Equity Share / Earning Per Equity Share

Example:

Calculate dividend payout ratio and retained earnings from the following data:

Net Profit Provision for taxation Preference dividend

10,000 5,000 2,000

No. of equity shares Dividend per equity share

3,000 $0.40

Payout Ratio = ($0.40 / $1) × 100

= 40%

Retained Earnings Ratio = ($0.60 /$1) × 100

= 60%

Significance of the Ratio:

The payout ratio and the retained earning ratio are the indicators of the amount of earnings that have been ploughed back in the business. The lower the payout ratio, the higher will be the amount of earnings ploughed back in the business and vice versa. A lower payout ratio or higher retained earnings ratio means a stronger financial position of the company.

Dividend Yield Ratio:

Definition:

Dividend yield ratio is the relationship between dividends per share and the market value of the shares.
Share holders are real owners of a company and they are interested in real sense in the earnings distributed and paid to them as dividend. Therefore, dividend yield ratio is calculated to evaluate the relationship between dividends per share paid and the market value of the shares.

Formula of Dividend Yield Ratio:

Following formula is used for the calculation of dividend yield ratio:

Dividend Yield Ratio = Dividend Per Share / Market Value Per Share

Example:

For example, if a company declares dividend at 20% on its shares, each having a paid up value of $8.00 and market value of $25.00.

Calculate dividend yield ratio:

Calculation:

Dividend Per Share = (20 / 100) × 8

= $1.60

Dividend Yield Ratio = (1.60 / 25) × 100

= 6.4%

Significance of the Ratio:

This ratio helps as intending investor is knowing the effective return he is going to get on the proposed investment.

Return on Capital Employed Ratio (ROCE Ratio):

The prime objective of making investments in any business is to obtain satisfactory return on capital invested. Hence, the return on capital employed is used as a measure of success of a business in realizing  this objective.
Return on capital employed establishes the relationship between the profit and the capital employed. It indicates the percentage of return on capital employed in the business and it can be used to show the overall profitability and efficiency of the business.

Definition of Capital Employed:

Capital employed and operating profits are the main items. Capital employed may be defined in a number of ways. However, two widely accepted definitions are "gross capital employed" and "net capital employed". Gross capital employed usually means the total assets, fixed as well as current, used in business, while net capital employed refers to total assets minus liabilities. On the other hand, it refers to total of capital, capital reserves, revenue reserves (including profit and loss account balance), debentures and long term loans.

Calculation of Capital Employed:

Method--1. If it is calculated from the assets side, It can be worked out by adding the following:

1. The fixed assets should be included at their net values, either at original cost or at replacement cost after deducting depreciation. In days of inflation, it is better to include fixed assets at replacement cost which is the current market value of the assets.
2. Investments inside the business
3. All current assets such as cash in hand, cash at bank, sundry debtors, bills receivable, stock, etc.
4. To find out net capital employed, current liabilities are deducted from the total of the assets as calculated above.

Gross capital employed = Fixed assets + Investments + Current assets

Net capital employed = Fixed assets + Investments + Working capital*.

*Working capital = current assets − current liabilities.

Precautions For Calculating Capital Employed:

While capital employed is calculated from the asset side, the following precautions should be taken:

1. Regarding the valuation of fixed assets, nowadays it is considered necessary to value the assets at their replacement cost. This is with a view to providing for the continuing problem of inflations during the current years. Under replacement cost methods the fixed assets are to be revalued on the basis of their current market prices either by reference to reliable published index numbers, or on valuation of experts. When replacement cost method is used, the provision for depreciation should be recalculated since depreciation charged might have been calculated on original cost of assets.
2. Idle assets―assets which cannot be used in the business should be excluded from capital employed. However, standby plant and machinery essential to the normal running of the business should be included.
3. Intangible assets, like goodwill, patents, trade marks, rights, etc. should be excluded. However, if they have sale value or if they have been purchased they may be included. Investments made outside the business should be excluded.
4. All current assets should be properly valued. Any excess balance of cash or bank than required for the smooth running of the business should be excluded.
5. Fictitious assets, like preliminary expenses, accumulated losses, discount on issue of shares or debentures, advertisement, suspense account, etc. should be excluded.
6. Obsolete assets which cannot be used in the business or obsolete stock which cannot be sold should be excluded.

Method--2. Alternatively, capital employed can be calculated from the liabilities side of a balance sheet. If it is calculated from the liabilities side, it will include the following items:
Share capital:
     Issued share capital (Equity + Preference)
Reserves and Surplus:
    General reserve
    Capital reserve
Profit and Loss account
Debentures
Other long term loans
Some people suggest that average capital employed should be used in order to give effect of the capital investment throughout the year. It is argued that the profit earned remain in the business throughout the year and are distributed by way of dividends only at the end of the year. Average capital may be calculated by dividing the opening and closing capital employed by two. It can also be worked out by deducting half of the profit from capital employed.

Computation of profit for return on capital employed:

The profits for the purpose of calculating return on capital employed should be computed according to the concept of  "capital employed used". The profits taken must be the profits earned on the capital employed in the business. Thus, net profit has to be adjusted for the following:

• Net profit should be taken before the payment of tax or provision for taxation because tax is paid after the profits have been earned and has no relation to the earning capacity of the business.
• If the capital employed is gross capital employed then net profit should be considered before payment of interest on long-term as well as short-term borrowings.
• If the capital employed is used in the sense of net capital employed than only interest on long term borrowings should be added back to the net profits and not interest on short term borrowings as current liabilities are deducted while calculating net capital employed.
• If any asset has been excluded while computing capital employed, any income arising from these assets should also be excluded while calculating net profits. For example, interest on investments outside business should be excluded.
• Net profits should be adjusted for any abnormal, non recurring, non operating gains or losses such as profits and losses on sales of fixed assets.
• Net profits should be adjusted for depreciation based on replacement cost, if assets have been added at replacement cost.

Formula of return on capital employed ratio:

Return on Capital Employed=(Adjusted net profits*/Capital employed)×100

*Net profit before interest and tax minus income from investments.

Significance of Return on Capital Employed Ratio:

Return on capital employed ratio is considered to be the best measure of profitability in order to assess the overall performance of the business. It indicates how well the management has used the investment made by owners and creditors into the business. It is commonly used as a basis for various managerial decisions. As the primary objective of business is to earn profit, higher the return on capital employed, the more efficient the firm is in using its funds. The ratio can be found for a number of years so as to find a trend as to whether the profitability of the company is improving or otherwise.

Return on Shareholders Investment or Net Worth Ratio:

Definition:

It is the ratio of net profit to share holder's investment. It is the relationship between net profit (after interest and tax) and share holder's/proprietor's fund.
This ratio establishes the profitability from the share holders' point of view. The ratio is generally calculated in percentage.

Components:

The two basic components of this ratio are net profits and shareholder's funds. Shareholder's funds include equity share capital, (preference share capital) and all reserves and surplus belonging to shareholders. Net profit means net income after payment of interest and income tax because those will be the only profits available for share holders.

Formula of return on shareholder's investment or net worth Ratio:

[Return on share holder's investment = {Net profit (after interest and tax) / Share holder's fund} × 100]

Example:

Suppose net income in an organization is $60,000 where as shareholder's investments or funds are $400,000.

Calculate return on shareholders investment or net worth

Return on share holders investment = (60,000 / 400,000) × 100

= 15%

This means that the return on shareholders funds is 15 cents per dollar.

Significance:

This ratio is one of the most important ratios used for measuring the overall efficiency of a firm. As the primary objective of business is to maximize its earnings, this ratio indicates the extent to which this primary objective of businesses being achieved. This ratio is of great importance to the present and prospective shareholders as well as the management of the company. As the ratio reveals how well the resources of the firm are being used, higher the ratio, better are the results. The inter firm comparison of this ratio determines whether the investments in the firm are attractive or not as the investors would like to invest only where the return is higher.

Return on Equity Capital (ROEC) Ratio:

In real sense, ordinary shareholders are the real owners of the company. They assume the highest risk in the company. (Preference share holders have a preference over ordinary shareholders in the payment of dividend as well as capital.
Preference share holders get a fixed rate of dividend irrespective of the quantum of profits of the company). The rate of dividends varies with the availability of profits in case of ordinary shares only. Thus ordinary shareholders are more interested in the profitability of a company and the performance of a company should be judged on the basis of return on equity capital of the company. Return on equity capital which is the relationship between profits of a company and its equity, can be calculated as follows:

Formula of return on equity capital or common stock:

Formula of return on equity capital ratio is:

Return on Equity Capital = [(Net profit after tax − Preference dividend) / Equity share capital] × 100

Components:

Equity share capital should be the total called-up value of equity shares. As the profit used for the calculations are the final profits available to equity shareholders as dividend, therefore the preference dividend and taxes are deducted in order to arrive at such profits.

Example:

Calculate return on equity share capital from the following information:

Equity share capital ($1): $1,000,000; 9% Preference share capital: $500,000; Taxation rate: 50% of net profit; Net profit before tax: $400,000.

Calculation:

Return on Equity Capital (ROEC) ratio = [(400,000 − 200,000 − 45,000) / 1000,000 )× 100]

= 15.5%

Significance:

This ratio is more meaningful to the equity shareholders who are interested to know profits earned by the company and those profits which can be made available to pay dividends to them. Interpretation of the ratio is similar to the interpretation of return on shareholder's investments and higher the ratio better is.

Expense Ratio:

Definition:

Expense ratios indicate the relationship of various expenses to net sales. The operating ratio reveals the average total variations in expenses. But some of the expenses may be increasing while some may be falling. Hence, expense ratios are calculated by dividing each item of expenses or group of expense with the net sales to analyze the cause of variation of the operating ratio.
The ratio can be calculated for individual items of expense or a group of items of a particular type of expense like cost of sales ratio, administrative expense ratio, selling expense ratio, materials consumed ratio, etc. The lower the operating ratio, the larger is the profitability and higher the operating ratio, lower is the profitability.
While interpreting expense ratio, it must be remembered that for a fixed expense like rent, the ratio will fall if the sales increase and for a variable expense, the ratio in proportion to sales shall remain nearly the same.

Formula of Expense Ratio:

Following formula is used for the calculation of expense ratio:

Particular Expense = (Particular expense / Net sales) × 100

Example:

Administrative expenses are $2,500, selling expenses are $3,200 and sales are $25,00,000.

Calculate expense ratio.

Calculation:

Administrative expenses ratio = (2,500 / 25,00,000) × 100

= 0.1%

Selling expense ratio = (3,200 / 25,00,000) × 100

= 0.128%

Operating Ratio:

Definition:

Operating ratio is the ratio of cost of goods sold plus operating expenses to net sales. It is generally expressed in percentage.
Operating ratio measures the cost of operations per dollar of sales. This is closely related to the ratio of operating profit to net sales.

Components:

The two basic components for the calculation of operating ratio are operating cost (cost of goods sold plus operating expenses) and net sales. Operating expenses normally include (a) administrative and office expenses and (b) selling and distribution expenses. Financial charges such as interest, provision for taxation etc. are generally excluded from operating expenses.

Formula of operating ratio:

Operating Ratio = [(Cost of goods sold + Operating expenses) / Net sales] × 100

Example:

Cost of goods sold is $180,000 and other operating expenses are $30,000 and net sales is $300,000.

Calculate operating ratio.

Calculation:

Operating ratio = [(180,000 + 30,000) / 300,000] × 100

= [210,000 / 300,000] × 100

= 70%

Significance:

Operating ratio shows the operational efficiency of the business. Lower operating ratio shows higher operating profit and vice versa. An operating ratio ranging between 75% and 80% is generally considered as standard for manufacturing concerns. This ratio is considered to be a yardstick of operating efficiency but it should be used cautiously because it may be affected by a number of uncontrollable factors beyond the control of the firm. Moreover, in some firms, non-operating expenses from a substantial part of the total expenses and in such cases operating ratio may give misleading results.

Net Profit Ratio (NP Ratio):

Definition of net profit ratio:

Net profit ratio is the ratio of net profit (after taxes) to net sales. It is expressed as percentage.

Components of net profit ratio:

The two basic components of the net profit ratio are the net profit and sales. The net profits are obtained after deducting income-tax and, generally, non-operating expenses and incomes are excluded from the net profits for calculating this ratio. Thus, incomes such as interest on investments outside the business, profit on sales of fixed assets and losses on sales of fixed assets, etc are excluded.

Formula:

Net Profit Ratio = (Net profit / Net sales) × 100

Example:

Total sales = $520,000; Sales returns = $ 20,000;  Net profit $40,000

Calculate net profit ratio.

Calculation:

Net sales = (520,000 – 20,000) = 500,000

Net Profit Ratio = [(40,000 / 500,000) × 100]

= 8%

Significance:

NP ratio is used to measure the overall profitability and hence it is very useful to proprietors. The ratio is very useful as if the net profit is not sufficient, the firm shall not be able to achieve a satisfactory return on its investment.
This ratio also indicates the firm's capacity to face adverse economic conditions such as price competition, low demand, etc. Obviously, higher the ratio the better is the profitability. But while interpreting the ratio it should be kept in mind that the performance of profits also be seen in relation to investments or capital of the firm and not only in relation to sales.

Gross Profit Ratio (GP Ratio):

Definition of gross profit ratio:

Gross profit ratio (GP ratio) is the ratio of gross profit to net sales expressed as a percentage. It expresses the relationship between gross profit and sales.

Components:

The basic components for the calculation of gross profit ratio are gross profit and net sales. Net sales means that sales minus sales returns. Gross profit would be the difference between net sales and cost of goods sold. Cost of goods sold in the case of a trading concern would be equal to opening stock plus purchases, minus closing stock plus all direct expenses relating to purchases. In the case of manufacturing concern, it would be equal to the sum of the cost of raw materials, wages, direct expenses and all manufacturing expenses. In other words, generally the expenses charged to profit and loss account or operating expenses are excluded from the calculation of cost of goods sold.

Formula:

Following formula is used to calculate gross profit ratios:

[Gross Profit Ratio = (Gross profit / Net sales) × 100]

Example:

Total sales = $520,000; Sales returns = $ 20,000; Cost of goods sold $400,000

Required: Calculate gross profit ratio.

Calculation:

Gross profit = [(520,000 – 20,000) – 400,000]

 = 100,000

Gross Profit Ratio = (100,000 / 500,000) × 100

= 20%

Significance:

Gross profit ratio may be indicated to what extent the selling prices of goods per unit may be reduced without incurring losses on operations. It reflects efficiency with which a firm produces its products. As the gross profit is found by deducting cost of goods sold from net sales, higher the gross profit better it is. There is no standard GP ratio for evaluation. It may vary from business to business. However, the gross profit earned should be sufficient to recover all operating expenses and to build up reserves after paying all fixed interest  charges and dividends.

Causes/reasons of increase or decrease in gross profit ratio:

It should be observed that an increase in the GP ratio may be due to the following factors.

1. Increase in the selling price of goods sold without any corresponding increase in the cost of goods sold.
2. Decrease in cost of goods sold without corresponding decrease in selling price.
3. Omission of purchase invoices from accounts.
4. Under valuation of opening stock or overvaluation of closing stock.

On the other hand, the decrease in the gross profit ratio may be due to the following factors.

1. Decrease in the selling price of goods, without corresponding decrease in the cost of goods sold.
2. Increase in the cost of goods sold without any increase in selling price.
3. Unfavorable purchasing or markup policies.
4. Inability of management to improve sales volume, or omission of sales.
5. Over valuation of opening stock or under valuation of closing stock

Hence, an analysis of gross profit margin should be carried out in the light of the information relating to purchasing, mark-ups and markdowns, credit and collections as well as merchandising policies.

Inventory Turnover Ratio or Stock Turnover Ratio (ITR):

Every firm has to maintain a certain level of inventory of finished goods so as to be able to meet the requirements of the business. But the level of inventory should neither be too high nor too low.
A too high inventory means higher carrying costs and higher risk of stocks becoming obsolete whereas too low inventory may mean the loss of business opportunities. It is very essential to keep sufficient stock in business.
Contents:

1. Definition of Inventory Turnover Ratio (ITR)
2. Components of the Ratio
3. Formula of Stock Turnover or Inventory Turnover Ratio
4. Example
5. Significance of ITR

Definition:

Stock turn over ratio and inventory turn over ratio are the same. This ratio is a relationship between the cost of goods sold during a particular period of time and the cost of average inventory during a particular period. It is expressed in number of times. Stock turn over ratio/Inventory turn over ratio indicates the number of time the stock has been turned over during the period and evaluates the efficiency with which a firm is able to manage its inventory. This ratio indicates whether investment in stock is within proper limit or not.

Components of the Ratio:

Average inventory and cost of goods sold are the two elements of this ratio. Average inventory is calculated by adding the stock in the beginning and at the and of the period and dividing it by two. In case of monthly balances of stock, all the monthly balances are added and the total is divided by the number of months for which the average is calculated.

Formula of Stock Turnover/Inventory Turnover Ratio:

The ratio is calculated by dividing the cost of goods sold by the amount of average stock at cost.
 

(a) [Inventory Turnover Ratio = Cost of goods sold / Average inventory at cost]

Generally, the cost of goods sold may not be known from the published financial statements. In such circumstances, the inventory turnover ratio may be calculated by dividing net sales by average inventory at cost. If average inventory at cost is not known then inventory at selling price may be taken as the denominator and where the opening inventory is also not known the closing inventory figure may be taken as the average inventory.
 

(b) [Inventory Turnover Ratio = Net Sales / Average Inventory at Cost]

(c) [Inventory Turnover Ratio = Net Sales / Average inventory at Selling Price]

(d) [Inventory Turnover Ratio  = Net Sales / Inventory]

Example:

The cost of goods sold is $500,000. The opening stock is $40,000 and the closing stock is $60,000 (at cost).

Calculate inventory turnover ratio

Calculation:

Inventory Turnover Ratio (ITR) = 500,000 / 50,000*

= 10 times

This means that an average one dollar invested in stock will turn into ten times in sales

*($40,000 + $60,000) / 2
= $50,000

Significance of ITR:

Inventory turnover ratio measures the velocity of conversion of stock into sales. Usually a high inventory turnover/stock velocity indicates efficient management of inventory because more frequently the stocks are sold, the lesser amount of money is required to finance the inventory. A low inventory turnover ratio indicates an inefficient management of inventory. A low inventory turnover implies over-investment in inventories, dull business, poor quality of goods, stock accumulation, accumulation of obsolete and slow moving goods and low profits as compared to total investment. The inventory turnover ratio is also an index of profitability, where a high ratio signifies more profit, a low ratio signifies low profit. Sometimes, a high inventory turnover ratio may not be accompanied by relatively a high profits. Similarly a high turnover ratio may be due to under-investment in inventories.
It may also be mentioned here that there are no rule of thumb or standard for interpreting the inventory turnover ratio. The norms may be different for different firms depending upon the nature of industry and business conditions. However the study of the comparative or trend analysis of inventory turnover is still useful for financial analysis.

Proprietary Ratio or Equity Ratio:

Definition:

This is a variant of the debt-to-equity ratio. It is also known as equity ratio or net worth to total assets ratio.
This ratio relates the shareholder's funds to total assets. Proprietary / Equity ratio indicates the long-term or future solvency position of the business.

Formula of Proprietary/Equity Ratio:

Proprietary or Equity Ratio = Shareholders funds / Total Assets

Components:

Shareholder's funds include equity share capital plus all reserves and surpluses items. Total assets include all assets, including Goodwill. Some authors exclude goodwill from total assets. In that case the total shareholder's funds are to be divided by total tangible assets. As the total assets are always equal to total liabilities., the total liabilities, may also be used as the denominator in the above formula.

Example:

Share holders funds are $1,800,000 and the total assets, which are equal to total liabilities are $3,000,000.

Calculate proprietary ratio or  Equity ratio.

Calculation:

Proprietary or Equity Ratio = 1,800,000 / 3,000,000

This means that out of every $1 employed in the business, shareholders contribution is about 60 cents. Accordingly, the creditors contribution would be the remaining 40 cents.

Significance:

This ratio throws light on the general financial strength of the company. It is also regarded as a test of the soundness of the capital structure. Higher the ratio or the share of shareholders in the total capital of the company, better is the long-term solvency position of the company. A low proprietary ratio will include greater risk to the creditors.
This ratio may be further analyzed into the following two ratios:

1. Ratio of fixed assets to shareholders/proprietors' funds
2. Ratio of current assets to shareholders/proprietors' funds