Activity & Profitability Ratios: Turnover, GP, NP & ROI — CBSE Class 12 Accountancy

Activity ratios measure how efficiently a company uses its assets. Profitability ratios measure how much it earns from its operations. Together, they form the second half of the CASA framework and are essential for the financial analysis questions in CBSE Class 12 and CA Foundation.

Ratio 1: Inventory Turnover Ratio

Inventory Turnover Ratio=Cost of Goods SoldAverage Inventory\text{Inventory Turnover Ratio} = \frac{\text{Cost of Goods Sold}}{\text{Average Inventory}}
Average Inventory=Opening Stock+Closing Stock2\text{Average Inventory} = \frac{\text{Opening Stock} + \text{Closing Stock}}{2}

Why Cost of Goods Sold — Not Sales?

Inventory is valued at cost, not at selling price. Using sales in the numerator would compare a cost-based figure with a revenue-based figure — an apples-to-oranges comparison. Always use COGS.

Worked Example

Cost of Goods Sold = ₹12,00,000 | Opening Stock = ₹1,50,000 | Closing Stock = ₹2,50,000

Average Inventory=1,50,000+2,50,0002=₹2,00,000\text{Average Inventory} = \frac{1{,}50{,}000 + 2{,}50{,}000}{2} = ₹2{,}00{,}000
Inventory Turnover=12,00,0002,00,000=6 times\text{Inventory Turnover} = \frac{12{,}00{,}000}{2{,}00{,}000} = \mathbf{6 \text{ times}}

Interpretation: The company sells through and replaces its entire stock 6 times a year — efficient inventory management.

Days' Inventory = 365 ÷ 6 = ~61 days (average time stock sits before being sold)

Ratio 2: Trade Receivables Turnover Ratio

Trade Receivables Turnover=Net Credit SalesAverage Trade Receivables\text{Trade Receivables Turnover} = \frac{\text{Net Credit Sales}}{\text{Average Trade Receivables}}
Average Trade Receivables=Opening Debtors+Closing Debtors2\text{Average Trade Receivables} = \frac{\text{Opening Debtors} + \text{Closing Debtors}}{2}

Key Points

  • Use net credit sales only — cash sales do not create receivables
  • Bills receivable are included in trade receivables
  • A higher ratio means faster collection and better credit management

Worked Example

Net Credit Sales = ₹15,00,000 | Average Trade Receivables = ₹3,00,000

Receivables Turnover=15,00,0003,00,000=5 times\text{Receivables Turnover} = \frac{15{,}00{,}000}{3{,}00{,}000} = \mathbf{5 \text{ times}}

Interpretation: Credit is recovered 5 times per year.

Average Collection Period = 365 ÷ 5 = 73 days — the company takes about 73 days on average to collect from credit customers.

Ratio 3: Trade Payables Turnover Ratio

Trade Payables Turnover=Net Credit PurchasesAverage Trade Payables\text{Trade Payables Turnover} = \frac{\text{Net Credit Purchases}}{\text{Average Trade Payables}}

Interpretation (Reversed Logic)

Unlike the other turnover ratios, a lower Trade Payables Turnover is generally favourable for the company — it means the company is taking longer to pay its suppliers, effectively enjoying a longer interest-free credit period.

Average Payment Period = 365 ÷ Trade Payables Turnover

A longer payment period means better use of supplier credit. However, excessively slow payment can damage supplier relationships and creditworthiness.

Activity Ratios Side-by-Side

Ratio

Formula

Higher = Better?

Inventory Turnover

COGS ÷ Avg Inventory

Yes — faster stock movement

Trade Receivables Turnover

Net Credit Sales ÷ Avg Receivables

Yes — faster collection

Trade Payables Turnover

Net Credit Purchases ÷ Avg Payables

No — lower = longer credit period enjoyed

Part B: Profitability Ratios

Profitability ratios answer: "How much profit is the company making, relative to its sales or capital?"

All three ratios below are expressed as percentages — remember to multiply by 100.

Ratio 4: Gross Profit Ratio

Gross Profit Ratio=Gross ProfitRevenue from Operations×100\text{Gross Profit Ratio} = \frac{\text{Gross Profit}}{\text{Revenue from Operations}} \times 100

Where: Gross Profit = Revenue from Operations − Cost of Goods Sold

What It Measures

The GP Ratio shows the profit margin after direct costs (materials, direct labour, manufacturing overhead) but before indirect expenses (selling costs, administration, finance costs). It reflects the efficiency of the production or trading process.

Worked Example

Gross Profit = ₹3,00,000 | Revenue from Operations = ₹10,00,000

GP Ratio=3,00,00010,00,000×100=30%\text{GP Ratio} = \frac{3{,}00{,}000}{10{,}00{,}000} \times 100 = \mathbf{30\%}

Interpretation: The company retains 30 paise as gross profit on every rupee of sales. The remaining 70 paise covers direct costs.

Ratio 5: Net Profit Ratio

Net Profit Ratio=Net ProfitRevenue from Operations×100\text{Net Profit Ratio} = \frac{\text{Net Profit}}{\text{Revenue from Operations}} \times 100

Where: Net Profit = Profit after all expenses, interest, and tax

What It Measures

The NP Ratio shows the overall profitability of the business after every single expense has been deducted. It reflects both operational efficiency and financial management.

Worked Example

Net Profit = ₹1,50,000 | Revenue from Operations = ₹10,00,000

NP Ratio=1,50,00010,00,000×100=15%\text{NP Ratio} = \frac{1{,}50{,}000}{10{,}00{,}000} \times 100 = \mathbf{15\%}

Interpretation: The company earns ₹15 net profit on every ₹100 of sales.

GP vs NP: Reading the Gap

Scenario

What It Suggests

GP Ratio much higher than NP Ratio

High indirect expenses (selling, admin, finance costs)

GP and NP Ratios close together

Tight control over indirect expenses

NP Ratio falling while GP Ratio is stable

Increasing non-operating costs or finance charges

Ratio 6: Return on Investment (ROI)

ROI=Net ProfitCapital Employed×100\text{ROI} = \frac{\text{Net Profit}}{\text{Capital Employed}} \times 100
Capital Employed=Shareholders’ Funds+Long-term Debts\text{Capital Employed} = \text{Shareholders' Funds} + \text{Long-term Debts}

(Alternative: Total Assets − Current Liabilities)

What It Measures

ROI shows the return generated on every rupee of total capital invested in the business — both owned (equity) and borrowed (long-term debt). It is the most comprehensive profitability measure because it considers all capital, not just sales.

Worked Example

Net Profit = ₹2,00,000 | Capital Employed = ₹10,00,000

ROI=2,00,00010,00,000×100=20%\text{ROI} = \frac{2{,}00{,}000}{10{,}00{,}000} \times 100 = \mathbf{20\%}

Interpretation: The business generates a 20% return on the total capital invested — investors and lenders together earn 20 paise on every rupee deployed.

Profitability Ratios at a Glance

Ratio

Formula

What It Measures

Gross Profit Ratio

(GP ÷ Revenue) × 100

Margin after direct costs

Net Profit Ratio

(NP ÷ Revenue) × 100

Overall profit margin

Return on Investment

(NP ÷ Capital Employed) × 100

Return on all capital deployed

Common Mistakes in Activity & Profitability Ratios

Mistake

Fix

Using sales (not COGS) for Inventory Turnover

Always use Cost of Goods Sold in the numerator

Using closing figures instead of averages

Use (Opening + Closing) ÷ 2 for all turnover denominators

Forgetting to multiply by 100 for profitability ratios

GP, NP, and ROI are expressed as percentages

Using total sales instead of credit sales for receivables

Receivables Turnover uses net credit sales only

What's Next?

In Part 4, get the complete exam strategy for ratio questions — the 5-step approach to 12-mark problems, a full formula reference card for all four categories, the most common errors and how to avoid them, and a targeted practice plan for CBSE Class 12 and CA Foundation.

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