Ratio analysis I: profitability and efficiency ratios
Profitability ratios show how much profit each rupee of sales or capital earns. Efficiency ratios show how fast inventory, receivables and payables turn over.
Profitability and efficiency formulas
| Ratio | Formula | What it tells you |
|---|---|---|
| Gross profit margin | Gross profit ÷ revenue × 100 | Pricing and buying power |
| Operating profit margin | Operating profit (PBIT) ÷ revenue × 100 | Control of all operating costs |
| Net profit margin | Profit for the year ÷ revenue × 100 | What is left from each Rs. 100 of sales |
| Return on capital employed (ROCE) | PBIT ÷ (equity + non-current liabilities) × 100 | How well all long-term funds are used |
| Return on equity (ROE) | (Profit for the year − preference dividend) ÷ ordinary equity × 100 | Return earned for ordinary shareholders |
| Asset turnover | Revenue ÷ capital employed | Sales generated per rupee of capital |
| Inventory turnover | Cost of sales ÷ inventory | Times inventory is sold in a year |
| Inventory days | Inventory ÷ cost of sales × 365 | Days goods sit in the store |
| Receivables days | Trade receivables ÷ credit sales × 365 | Days customers take to pay |
| Payables days | Trade payables ÷ credit purchases (or cost of sales) × 365 | Days taken to pay suppliers |
Worked example 1: profitability ratios of Serendib Foods PLC
Use the 2026 statements of Serendib Foods PLC (Rs. '000): revenue 120,000; gross profit 42,000; operating profit 26,000; profit for the year 18,500; preference dividend 1,000; ordinary equity 40,000 + 33,500 = 73,500; total equity 83,500; debentures 25,000.
- Gross profit margin: 42,000 ÷ 120,000 × 100 = 35.0%.
- Operating profit margin: 26,000 ÷ 120,000 × 100 = 21.7%.
- Net profit margin: 18,500 ÷ 120,000 × 100 = 15.4%.
- Capital employed: 83,500 + 25,000 = 108,500. ROCE: 26,000 ÷ 108,500 × 100 = 24.0%.
- ROE: (18,500 − 1,000) ÷ 73,500 × 100 = 17,500 ÷ 73,500 × 100 = 23.8%.
- Asset turnover: 120,000 ÷ 108,500 = 1.11 times. Check: 21.67% × 1.106 = 24.0%, the ROCE.
Gross margin 35.0%, operating margin 21.7%, net margin 15.4%, ROCE 24.0%, ROE 23.8%, asset turnover 1.11 times.
Worked example 2: efficiency ratios
Serendib Foods (Rs. '000): cost of sales 78,000; inventory 13,000; trade receivables 15,000; trade payables 11,700; revenue 120,000, all on credit. Use closing balances and a 365-day year.
- Inventory turnover: 78,000 ÷ 13,000 = 6 times.
- Inventory days: 13,000 ÷ 78,000 × 365 = 60.83 days (check: 365 ÷ 6 = 60.83).
- Receivables days: 15,000 ÷ 120,000 × 365 = 45.63 days.
- Payables days, using cost of sales: 11,700 ÷ 78,000 × 365 = 54.75 days.
- Cash operating cycle: 60.83 + 45.63 − 54.75 = 51.71 days.
Inventory turns 6 times (about 61 days); customers pay in about 46 days; suppliers are paid in about 55 days; cash is tied up for about 52 days.
Interpreting the results (2025 figures given for comparison)
| Ratio | 2026 | 2025 | Comment |
|---|---|---|---|
| Gross profit margin | 35.0% | 32.0% | Better pricing or cheaper buying |
| Operating profit margin | 21.7% | 22.5% | Operating costs grew faster than sales |
| ROCE | 24.0% | 21.0% | Long-term funds used more productively |
| Receivables days | 45.6 | 38.0 | Customers pay more slowly: tighten credit control |
| Inventory days | 60.8 | 66.0 | Inventory is moving faster |
Tips for interpretation
- Always compare: with last year, with competitors, or with the industry average.
- For each ratio say what changed, the likely reason, and what management should do.
- A higher margin is good only if sales volumes hold up.
- Use average balances when the question gives opening and closing figures.
Analysts at Colombo stockbroking firms compare ROCE and margins of listed companies, for example one supermarket chain against another, before advising investors. A falling gross margin can signal a price war or higher import costs.
Short answer: “Define return on capital employed.” Operating profit (profit before interest and tax) as a percentage of capital employed (equity + non-current liabilities).
Structured question: “Calculate the gross profit margin, net profit margin and ROCE from the given statements.” Show each formula, substitute the figures, give each answer as a percentage to one decimal place, and comment briefly.
Essay: “Calculate and interpret the profitability and efficiency ratios of a company for two years.” A table of ratios for both years, then comments on margins, returns, and inventory, receivables and payables days, with likely reasons and advice.
ROCE = operating margin × asset turnover. Days ratios = balance ÷ annual flow × 365: inventory with cost of sales, receivables with credit sales, payables with purchases.