## Profitability Ratios Based on Sales

These ratios measure how efficiently a company converts its sales into profit at successive levels of the income statement.

### 1. Gross Profit (GP) Ratio

Formula: GP Ratio = (Gross Profit / Net Sales) × 100

Gross Profit = Gross Profit as per the Trading Account (Sales minus Cost of Goods Sold)
Net Sales = Sales minus returns
Significance: Indicator of basic / production-level profitability — how much margin is earned before operating overhead.

### 2. Operating Profit Ratio

Formula: Operating Profit Ratio = (Operating Profit / Net Sales) × 100

Two ways to compute Operating Profit:

Direct method: Sales − Cost of Sales (COGS + all operating expenses)
Indirect method: Start with Net Profit after tax, then add back Non-Operating Expenses (loss on sale of assets, preliminary expenses written off) and deduct Non-Operating Income (rent received, interest and dividends received)

Significance: Indicator of operating performance, stripping out financing costs and one-off non-operating items.

### 3. Net Profit (NP) Ratio

Formula: NP Ratio = (Net Profit / Net Sales) × 100

Net Profit = Profit as per P&L A/c (before or after tax, state which basis)
Significance: Indicator of overall profitability after all charges including interest and tax.

### 4. Contribution / Sales Ratio (P/V Ratio)

Formula: P/V Ratio = Contribution / Sales

Contribution = Sales − Variable Costs
Significance: Used in marginal costing to assess profitability structure and break-even analysis.

### Key Relationship

In a normal business: GP Ratio > Operating Profit Ratio > NP Ratio — each step deducts more costs.

### Operating Ratio (companion ratio)

Formula: Operating Ratio = (COGS + Operating Expenses) / Net Sales × 100

Note: Operating Ratio + Operating Profit Ratio = 100%

Worked example

### Example 1

Example 1 – FLOW Ltd.: Computing GP, Operating Profit and NP Ratios (from Question 8)

Data from P&L Account (₹ in lakhs):

Total Net Sales = Credit (12.00) + Cash (3.00) = ₹15.00 lakhs
COGS = ₹11.00 lakhs → Gross Profit = ₹4.00 lakhs
Operating Expenses: Admin (0.35) + Selling (0.25) + Depreciation (0.50) = ₹1.10 lakhs
Non-operating income: Royalty received = ₹0.09 lakhs
Interest = ₹0.47 lakhs; Tax = ₹1.26 lakhs; Net Profit = ₹1.26 lakhs

GP Ratio = 4.00 / 15.00 × 100 = 26.67%

Operating Profit = GP − Operating Expenses = 4.00 − 1.10 = ₹2.90 lakhs (interest and royalty excluded)

Operating Profit Ratio = 2.90 / 15.00 × 100 = 19.33%

Operating Ratio = (11.00 + 1.10) / 15.00 × 100 = 12.10 / 15.00 = 80.67% (note: 80.67% + 19.33% = 100% ✓)

NP Ratio = 1.26 / 15.00 × 100 = 8.40%

The step-down from 26.67% → 19.33% → 8.40% reflects successive deductions: first operating overhead, then financing costs and tax.

### Example 2

Example 2 – Deriving Sales from GP Ratio (from Question 1, FM Ltd.)

Given: Gross Profit = ₹12,00,000; GP Ratio = 25%

Step 1: Net Sales = Gross Profit / GP Ratio = 12,00,000 / 0.25 = ₹48,00,000

Step 2: COGS = Sales − GP = 48,00,000 − 12,00,000 = ₹36,00,000

This reverse calculation — finding Sales from a known profit figure and GP% — is one of the most common entry points in exam problems. Always master this step first.

⚠️ Common exam mistakes

Using gross sales (before returns) instead of net sales in the denominator of all profitability ratios.
Including interest and tax in operating expenses when computing Operating Profit Ratio — these are financing and fiscal charges, not operating items.
Confusing Operating Ratio with Operating Profit Ratio. Operating Ratio = (COGS + Operating Expenses) / Sales; Operating Profit Ratio = Operating Profit / Sales. They sum to 100%.
Including non-operating income (like rent received or dividend received) in the numerator of Operating Profit Ratio — non-operating items must be excluded.

Reference:

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