Accounting (Year 12) - Ratios
What are Profitability Ratios?
Profit ratios measure the financial performance of a company.
In other words, how each dollar is used to produce a profit.
The profit ratio measures how much each dollar of revenue is converted into profit. In other words, if the ratio was 0.2, this means that for every $1 of revenue, $0.20 of profit was made. It is calculated as the profit after income tax over the total revenue. Interpretations: High Number: Favourable, as a higher proportion of revenue is converted into profit. Low Number: Unfavourable, as a lower proportion of revenue is converted into profit. The interpretations are all relative to the industry average. For example, the profit margin on the average car yards would be different to average margins on groceries.
Rate of Return on Assets
The rate of return on assets measures the amount of profit generated from investment in assets. For example a ratio of 0.4 means that for every $1 invested in assets, it produces $0.40 in profit. It is calculated as profit before tax plus interest expense over average total 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.
High Number: Favourable, as it indicates efficient investment in assets to turnover a profit.
Low Number: Unfavourable, as it indicates inefficient investment in assets, turning over a reduced profit.
Times Interest Earned
The times interest earned ratio measures the amount of times profit (excluding borrowings) exceeds finance costs. For example, a times interest earned ratio of 5 suggests that the business produces profit that is 5 times greater than its borrowing costs. It can also be considered a liquidity indicator as it measures a business's ability to repay its debts.
High Number: Favourable, as the business is comfortably meeting its debt obligations and using debt finance to expand the business’s profit margins.
Low Number: Unfavourable, as the business is having trouble meeting its debt obligations and debts are becoming a large component of expenses.