Written by : AK Agrawal

An experiences Chartered Accountant and Techno-Functional consultant working in industry for over 10 years dealing with multinational corporate clients. He is loves reading latest trend of technology trend.

What is Profit Sharing Ratio? How to Calculate It?

AK Agrawal
AK Agrawal, Chartered Accountant

Oct 14, 2021 01:58

When joining a partnership, the prospective partners choose to draft a contract that specifies how earnings and losses get distributed to partnership members. As per the standard legal guidelines, the partners will split profits and losses equally without a partnership contract. If a contract exists, parties split earnings according to the terms agreed.
Any rationale can determine a profit-sharing ratio, but the two primary ones are accountability and capital size. Although an equivalent 50-50 partnership may function for a firm with two equally interested partners, other partnerships may not have been formed on such an equal level and may necessitate that one partner earns greater earnings. Thus, partners often indulge in Profit-Sharing Ratio calculations.

Who qualifies for profit-sharing?

Profit-sharing eligibility is determined by your profit-sharing and partnership agreements. Working with a lawyer and an accountant to draft a profit-sharing agreement may assist in guarantee that each one knows their role in the firm and how it relates to their profits. A written agreement should be in effect to help reduce future uncertainty and disputes.

Divide by Responsibilities

Profit-Sharing Ratio Calculation is also done based on the responsibilities taken by the partners. For instance, profits might get divided among partners based on their roles. When a partnership gets formed, the parties generally agree on how much responsibility each member will bear. Partner A and Partner B, for example, create a joint venture.
Partner A is in charge of the majority of the small business's day-to-day operations. Because of Partner A's increased responsibilities, the partnership agreement states that "Partner A shall get 70% of earnings and Partner B shall receive 30% of profits each year."

Capital Contribution

When creating a partnership, participants can contribute as much or as little cash as they wish. Frequently, one partner contributes more towards the partnership than others. If that's the scenario, the partner may choose to split earnings based on how much he contributes.

Let's get an idea about Profit-Sharing Ratio Calculation in the case of capital involved.

In this case, if Partner A contributes $500,000 in capital and Partner B contributes $200,000, the partners may include a clause in their partnership contract that allows, "Members shall split profits calculated based on capital in the partner's capital accounts on last day of the year." In this case, Partner A would get 80% of the earnings, while Partner B would receive 20%.

Factor Combination

The profit-sharing ratio could be any arbitrary amount that the partners agree on. That implies that the partners can consider the two primary variables and arrange a profit-sharing ratio that they deem mutually advantageous. As soon as the conditions are agreed upon in the partnership agreement, the earnings will get divided accordingly.

For instance, Partner A invests $400,000 in money and bears most of the partnership's obligation. Partner B gives $100,000 in cash but offers nothing in terms of partnership responsibilities. All partners can decide that Partner A receives 10% of earnings while Partner B gets 90% of profits or vice versa. The partners should agree; however, if they do not, revenues will get shared equally.

When is a New ratio applied?

There are several circumstances in which a firm may adopt a new ratio.

  • If the partners desire to alter their current profit-sharing ratio without including or excluding any members, they can do so.
  • When a new partner joins
  • When an old partner passes away or retires

The new profit sharing ratio upon retirement, on the other hand, is simply calculated by subtracting the retiring person's portion. In this case, the remaining members' gaining ratio will be = retiring person's share * Acquisition ratio.

Profit-Sharing Ratio Calculation

If two people, P and Q, each invest Rs. X and Rs. Y in a firm for a year. Their share of gains or loss at the conclusion of the year is as follows:
x: y = (P's profit share) : (Q's profit share)

If two people, P and Q, each invest Rs. X for m months and Rs. Y for n months, then,

(P's profit share) : (Q's profit share) = xm/yn

When investments vary over time, we must account for the changes when computing earnings.

Calculating the New Profit Sharing and Sacrificing Ratios:

When a new partner is accepted, he inherits a portion of the earnings from the previous partners. It decreases the old partners' profit shares, necessitating the calculation of a new profit-sharing ratio for the senior partners.

The new profit-sharing ratio is as follows:

The new profit sharing ratio is the percentage by which all partners (including new partners) share future gains and losses.
The new profit sharing ratio gets determined by the ratio at which the entering partner gets his share from the previous partners.

Old share – Sacrifice = New shar

Sacrificing ratio

The sacrificing ratio refers to the proportion in which the previous partners decided to give up their profit shares to benefit a new partner.
The sacrificing ratio equals the difference between the old and new profit-sharing ratios.

Old share – new share = Sacrifice

This ratio aims to estimate the amount of compensation (goodwill) to be given by the new partner to the existing partners for the share of profit ceded.

The following are the possible scenarios from the perspective of sacrifice ratio calculation:

  1. When the incoming partner's new share gets distributed.
  • The former partners' sacrifice is not accepted. (In the old ratio, sacrifice)
  • The old partners' unequal sacrifice (Unequal sacrifice)
  • Equal sacrifice on the side of the former partners (Equal sacrifice)
  • One of the partners made the ultimate sacrifice.
  1. When the entering partner's new share does not get distributed.
  • Old partners' share gets sacrificed.
  • A new profit-sharing ratio gets established.
Gaining ratio

A ratio wherein the partners mutually agreed to receive a portion of the profits generated by the other partners.

At the point of a partner's retirement or death, the gaining ratio is computed. It is the profit-sharing ratio in which the surviving partners acquire the profit-sharing of the departing partner. When one of the partners retires, the profit share ratio of the remaining partner changes. Continuing partners divide the retiring partner's portion among themselves.

New Ratio – Old Ratio = Gaining Ratio (if positive)

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AK Agrawal
AK Agrawal, Chartered Accountant

Oct 14, 2021 01:58

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