Page 141 - DMGT310_ENTREPRENEURSHIP_AND_SMALL_BUSINESS_MANAGEMENT

Entrepreneurship and Small Business Management

Notes Profitability Ratios

Profitability ratios are indicators of measures of the success of the venture in generating profits
for the entrepreneur. A wide range of ratios is used to measure profitability. We shall be
concentrating on the three major indicators. These consist of, (a) gross profit margin, (b) return
on assets, and, (c) return on equity or return on investment (ROI).
The gross profit margin indicates the gross profits earned by the venture on the sales. It accounts
for the cost of the goods sold, without including other costs.

Sales– Cost of Goods Sold
Gross Profit Margin =
Sales
Lower gross profit margin ratio indicates that earnings that are needed to pay other costs,
including fixed costs are low. It is also an indicator of the venture inability to control its production
cost. A higher gross profit margin indicates production efficiency and venture capability to
compete during intense rivalry and in markets characterised by low entry barriers.

Return on assets is an indicator of determining venture efficiency in utilizing assets to create
wealth/profit.

Net Income
Return of Assets=
Total Assets

Lower return on assets is an indicator that the venture earnings are low for the amount of assets
deployed. It can be used to determine the venture efficiency viz-a-viz industry firms.
Return on equity or return on investment (ROI) is one of the basic measures for determination
of the profits by the equity holder on the investments. It is derived by determining the net
income generated by the venture on the equity.

Net Income
Return on Equity=
Stockholder'sEquity

Operations Ratios

These include the ratios used to measure internal operational efficiency of the venture. Any
isolative interpretation derived from these will largely be unproductive, sometimes even
misleading. These should be viewed in conjunction with other ratios and industry environment.
We shall be focusing only on three types of operations ratios that shall include, (a) accounts
receivable turnover ratio, (b) inventory turnover ratio, and (c) average days payable ratio.
Net Credit Sales
Accounts Receivables Turnover Ratio=
AverageAccountsReceivable

It measures how liquid accounts receivable are for the complete year. Average accounts receivable
is the average of the opening and closing balances for all the accounts receivables. It informs
number of rotation of the receivables during one financial year. It is generally evaluated as
being either positive or negative in comparison with the industry firms of similar types. Higher
turnover rate is indicator of prompt payment by the customers and resulting in less investment
in accounts receivables.

Inventory turnover ratio is determined by cost of goods sold to average inventory.

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