A financial ratio is a relative magnitude of two selected numerical values taken from an enterprise's financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization.

Financial ratios are useful tools that help business managers and investors analyse and compare financial relationships between the accounts on the firm's financial statements.

• Profitability Ratios:
  1. Profitability Ratios indicate an organization’s ability to generate income and how well it utilizes its assets to produce profit and value to the owners and capital contributors. Income or profit is measures as surplus of total revenue over total cost during a given period of time.
  2. We are presenting below most commonly used Profitability Ratios:
• Contribution Margin
  1. Contribution Margin is also referred as “Variable Margin”. The contribution margin is computed as the selling price, minus the variable cost.It provides one way to show the profit potential of a particular product / services offered by an organization and shows the portion of sales that helps to cover the company's fixed costs.
  2. If contribution is sufficient to cover the fixed overhead of the organization, it is called as the break-even point.
  3. Contribution Margin = Sales or Revenue – Direct Variable Costs
  4. Contribution Margin Ratio = (Sales or Revenue – Direct Variable Costs) / Sales or Revenue
  5. Direct Variable Costs = A portion of the Cost of Goods / Services (COGS) which are variable with the production units / provision of services
  6. Contribution is a very good price determination tool (quotation to a prospect) as any incremental contribution, over & above the fixed overhead, is profit for the organization.
• Gross Profit
  1. Gross profit is the profit a company makes after deducting the costs associated with making and delivering its products, or the costs associated with providing its services (called as “cost of goods sold – COGS”), from its Revenue or Sales.
  2. Gross Profit = Revenue or Sales – Cost of Goods / Services Sold
  3. Cost of Goods / Services Sold = All direct cost associates with the production, delivery and provision of the goods & services excluding Selling & General Administrative (S&GA) expenses. Generally, COGS does not include non-operational / support function fixed & corporate overheads.
• BU EBITDA / Operating Margin
  1. EBITDA means Earnings Before Interest, Tax, Depreciation and Amortization. It is kind of operating profit excluding finance cost, non-operational earnings, depreciation, taxation etc.
  2. Business Unit (BU) EBITDA indicates EBITDA at business unit level excluding support function and corporate overheads. BU EBITDA is a useful Key Performance Indicators (KPI) for the Head of the Department (HOD) responsible for the performance of his / her unit / department.
  3. BU EBITDA = Sales or Revenue – Cost of Goods/Services Sold – All other costs under the decision of the department / unit
• EBITDA / Operating Margin
  1. EBITDA means Earnings Before Interest, Tax, Depreciation and Amortization. It is kind of operating profit excluding finance cost, non-operational earnings, depreciation, taxation etc.
  2. BU EBITDA = Sales or Revenue – Cost of Goods/Services Sold (COGS) – Selling & General Administrative (S&GA)
  3. EBITDA is very widely used performance matrix for an organization as it indicates operational profitability of the organization.
• EBIT
  1. EBIT means Earnings Before Interest and Tax. It is kind of operating profit excluding finance cost, non-operational earnings andtaxation.
  2. EBIT is used to measure the operational profit of an organization where fixed assets are significant and recurring in nature. This ratio overcomes shortcoming of the EBITDA ratio which completely ignores the impact of the fixed assets investment.
  3. EBIT = Sales or Revenue – Cost of Goods/Services Sold (COGS) – Selling & General Administrative (S&GA) – Depreciation & Amortization
• Profit Before Tax (PBT)
  1. Profit before tax is a measure that looks at a company's profits before the company has to pay corporate income tax. It essentially is all of a company’s profits without the consideration of any taxes.
  2. PBT = Sales or Revenue - Cost of Goods/Services Sold (COGS) - Selling & General Administrative (S&GA) + Non-operational Income - Finance Cost - Depreciation & Amortization
  or
  3. PBT = Sales or Revenue – All types of costs excluding taxes
  4. PBT is generally used for the statutory reporting and accounting purposes. It is not used for any management decision purpose as it may contain non-recurring, non-operational, extra-ordinary items which may influence the decision making process.
• Profit After Tax (PAT)
  1. Profit After Tax (PAT) is the total amount that a business earns after all costs and tax deductions have taken place. Profit after tax is also seen as a measure of a company’s profitability after all its expenses have been deducted and can be fully utilised by the company to conduct its business. Shareholders are also paid dividends from this amount.
  2. PAT = Sales or Revenue - Cost of Goods/Services Sold (COGS) - Selling & General Administrative (S&GA) + Non-operational Income - Finance Cost - Depreciation & Amortization – Taxes
  or
  3. PAT = Sales or Revenue – All types of costs & taxes
• Dividend Yield
  1. Dividend Yield ratio measures how much dividend, a shareholder will get as a percentage of its current share price. A higher ratio is better.
  2. Dividend Yield = Dividend per share / Share Price x 100
  3. Investors should consider only normal dividends and not special dividends while computing this ratio.
• Return on Capital Employed (ROCE)
  1. Return on capital employed (ROCE) is a financial ratio that can be used in assessing a company's profitability and capital efficiency. In other words, this ratio can help to understand how well a company is generating profits from its capital as it is put to use.
  2. ROCE = EBIT / Total Capital Employed
  3. EBIT = EBIT means Earnings Before Interest and Tax. It is kind of operating profit excluding finance cost, non-operational earnings andtaxation.
  4. Total Capital Employed = Shareholder’s Equity + Short Term Debt + Long Term Debt + Other Repayment Obligations
  or
  5. Total Capital Employed = Total Assets – Current Liabilities or Fixed Assets – Working Capital
  6. ROCE can be useful when comparing the performance of companies in capital-intensive sectors, particularly with large debts.
• Return on Equity (ROE)
  1. Return on Equity (ROE) is a measure of financial performance calculated by dividing net income (profit after tax) by shareholders' equity (Equity Share Capital + Reserves & Surplus). Because shareholders' equity is equal to a company’s assets minus its external liabilities & debt, ROE is also considered as the return on net assets.
  2. Return on Equity (ROE) = Profit After Tax (PAT) / Average Shareholder’s Equity
  3. Shareholder’s Equity = Equity Share Capital + Reserves & Surplus – Fictitious Assets
  or
  4. Shareholder’s Equity = All assets (including Intangibles but excluding Fictitious Assets e.g. Preliminary Expenses, Deferred Tax Assets etc.) – All external liabilities, preference share capital
  5. Average Shareholder’s Equity is calculated by adding equity at the beginning and end of the period divided by two. The beginning and end of the period should coincide with the period during which the net income (PAT) is earned.
• Return on Investment (ROI)
  1. Return on investment (ROI) is a performance measure used to evaluate the efficiency or profitability of an investment or compare the efficiency of a number of different investments. ROI tries to directly measure the amount of return on a particular investment, relative to the investment’s cost.
  2. ROI = Gain in Investments / Total Investments at cost
  3. Gain in investment = Current Value of Investments – Total Investments at Cost
  4. Although ROI is a quick and easy way to estimate the success of an investment, it has some serious limitations. For instance, ROI fails to reflect the time value of money, and it can be difficult to meaningfully compare ROIs because some investments will take longer to generate a profit than others.
• Internal Rate of Return (IRR)
  1. The internal rate of return is a metric used in financial analysis to estimate the profitability of potential investments. The internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows equal to zero in a discounted cash flow analysis.
  2. IRR can be derived using below formula:
     CF0 = Sum of {CFn / (1+IRR)^n}
     CF0 = Total initial investments at cost
     n = Year number in the series of years for which return is being calculated
     CFn= Net cash inflow during the year no. “n”
  3. The ultimate goal of IRR is to identify the rate of discount, which makes the present value of the sum of annual nominal cash inflows equal to the initial net cash outlay for the investment.