ACCOUNTING RATIOS

Financial Statement Analysis

1. Meaning of Accounting Ratios

Financial statements contain raw data. Ratio Analysis transforms this data into meaningful relationships
that help internal and external users assess solvency, efficiency, and profitability of a business
enterprise.

A ratio is a mathematical number expressing the relationship between two or more accounting figures. It
can be expressed as:

• Fraction: 10,000 / 1,00,000 = 0.10

• Percentage: 10,000 / 1,00,000 × 100 = 10%
• Proportion: 1 : 10
• Times / Rate: e.g., Inventory turns 6 times a year
When a ratio is derived from two accounting numbers taken from financial statements, it is called an
Accounting Ratio.

Important Condition

A ratio is meaningful only if the two numbers compared are logically related. Comparing unrelated
items (e.g., Furniture vs. Purchases) gives a mathematically valid but financially meaningless ratio.

2. Objectives of Ratio Analysis

Ratio analysis helps analysts:

1. Identify areas of the business that need more attention.

2. Discover potential areas for improvement.
3. Perform deeper analysis of profitability, liquidity, solvency, and efficiency.
4. Conduct cross-sectional analysis by comparing performance with industry benchmarks.
5. Derive information from financial statements for future projections and estimates.
 3. Advantages of Ratio Analysis
3.1 Helps Understand Efficacy of Decisions
Reveals whether operating, investing, and financing decisions have improved performance.

3.2 Simplifies Complex Figures

Summarises financial information and assesses managerial efficiency, credit worthiness, and earning
capacity.

3.3 Helpful in Comparative Analysis (Trend Analysis)

Multi-year ratio data helps identify trends and enables meaningful projections about the business.

3.4 Identification of Problem Areas

Pinpoints weak and strong areas, allowing management to focus corrective efforts and sustain high-
performing areas.

3.5 Enables SWOT Analysis

Ratios highlight changes in business performance, enabling management to assess Strengths,
Weaknesses, Opportunities, and Threats.

3.6 Various Comparisons

Ratios enable three types of comparison:

• Intra-firm / Time Series: Same firm over multiple periods.

• Inter-firm / Cross-sectional: Across different companies in the same industry.
• Standard Comparison: Against industry averages or preset benchmarks.

4. Limitations of Ratio Analysis

4A. Limitations Arising from Accounting Data

• Limitations of Accounting Data: Accounting data reflects conventions and personal

judgements, not necessarily the true state of affairs. Hence ratios derived from them may be
unreliable.
 • Ignores Price-Level Changes: Financial accounting uses stable money measurement. In
inflationary economies, comparing ratios across years is misleading because money values
change.
• Ignores Qualitative Aspects: Ratios are purely quantitative. Non-monetary factors like
employee morale, brand value, or management quality are completely excluded.
• Variations in Accounting Practices: Different firms use different methods for inventory
valuation, depreciation, and treatment of intangibles, making cross-sectional comparison invalid.
• Forecasting Limitations: Historical ratios alone cannot reliably predict future trends; non-
financial factors must also be considered.

4B. Limitations of the Ratios Themselves

• Means, Not an End: Ratios indicate problems but do not resolve them. They are signalling
tools.
• Cannot Resolve Problems: Their role is indicative and that of a 'whistle-blower'.
• Lack of Standardised Definitions: For example, 'liquid liabilities' may or may not include bank
overdraft, depending on interpretation.
• No Universal Standard Levels: There is no globally accepted ideal ratio value. In India, even
industry averages are often unavailable.
• Ratios Based on Unrelated Figures: A ratio comparing unrelated items (e.g., Creditors :
Furniture = 1:1) has no analytical value.

5. Types / Classification of Ratios

Ratios are classified in two ways:

Traditional Classification (based on financial statements):

• P&L Ratios: Both figures from Statement of Profit & Loss. E.g., Gross Profit Ratio.
• Balance Sheet Ratios: Both figures from the Balance Sheet. E.g., Current Ratio.
• Composite Ratios: One figure from each statement. E.g., Trade Receivables Turnover Ratio.

Functional Classification (based on purpose — more commonly used):

• Liquidity Ratios — Short-term solvency
 • Solvency Ratios — Long-term debt servicing ability
• Activity (Turnover) Ratios — Efficiency of resource utilisation
• Profitability Ratios — Earning capacity analysis

6. Liquidity Ratios
Liquidity ratios measure the firm's ability to meet short-term obligations as they fall due. They are
analysed using current assets and current liabilities from the balance sheet.

6.1 Current Ratio

Proportion of current assets to current liabilities. Measures short-term

Definition
financial health.

Current Ratio Current Assets ÷ Current Liabilities

Components:
• Current Assets include: Current investments, inventories, trade receivables, cash & cash
equivalents, short-term loans & advances, advance tax, prepaid expenses, accrued income.
• Current Liabilities include: Short-term borrowings (including bank overdraft), trade payables,
other current liabilities, short-term provisions.

Significance: Ideal range is 2:1. A very HIGH ratio implies idle/underutilised current
assets. A very LOW ratio signals inability to meet short-term obligations, threatening
credit worthiness.

Worked Example:
Inventories ₹50,000 | Trade Receivables ₹50,000 | Advance Tax ₹4,000 | Cash ₹30,000 | Trade Payables
₹1,00,000 | Bank Overdraft ₹4,000

Current Assets = 50,000 + 50,000 + 4,000 + 30,000 = ₹1,34,000

Current Liabilities = 1,00,000 + 4,000 = ₹1,04,000

Current Ratio 1,34,000 ÷ 1,04,000 = 1.29 : 1

6.2 Quick / Liquid / Acid-Test Ratio

Ratio of quick (liquid) assets to current liabilities. Excludes slow-

Definition
moving assets for a stricter test of short-term solvency.

Quick Ratio Quick Assets ÷ Current Liabilities

• Quick Assets = Current Assets − Inventories − Prepaid Expenses − Advance Tax

Significance: Ideal level is 1:1. A ratio below 1 is risky. A ratio well above 1 implies
unnecessary deployment of funds in less profitable short-term investments.

Worked Example (continued from above):

Quick Assets = 1,34,000 − (50,000 + 4,000) = ₹80,000 | Current Liabilities = ₹1,04,000

Quick Ratio 80,000 ÷ 1,04,000 = 0.77 : 1

7. Solvency Ratios
Solvency ratios assess the firm's ability to service long-term debt — both regular interest payments and
repayment of principal. Long-term lenders and investors rely on these ratios for security assessment.

7.1 Debt-Equity Ratio

Measures the proportion of long-term external debt to shareholders'

Definition
own funds (equity).
 Debt-Equity Ratio Long-term Debts ÷ Shareholders' Funds

• Long-term Debts = Long-term borrowings + Other long-term liabilities + Long-term provisions

• Shareholders' Funds (Equity) = Share Capital + Reserves & Surplus + Money received against
share warrants + Share application money pending allotment
• Alternatively: Shareholders' Funds = Non-current Assets + Working Capital − Non-current
Liabilities

Significance: Ideal ratio is 2:1. A LOW ratio = more security for lenders. A HIGH ratio is
risky and may lead to bankruptcy. However, from the owners' perspective, higher debt
(trading on equity) can boost returns if ROCE > interest rate paid.

7.2 Debt to Capital Employed Ratio

Debt to Capital Employed Long-term Debt ÷ Capital Employed

• Capital Employed = Shareholders' Funds + Long-term Debts (OR) Total Assets − Current
Liabilities

Significance: Shows proportion of long-term debt in total capital. Low ratio → security
for lenders. High ratio → potential for trading on equity.

7.3 Proprietary Ratio

Proprietary Ratio Shareholders' Funds ÷ Capital Employed

 Significance: A higher ratio indicates greater owner financing, providing better security
to creditors. Note: Debt to Capital Employed Ratio + Proprietary Ratio = 1 (e.g., 0.25 +
0.75 = 1).

7.4 Total Assets to Debt Ratio

Total Assets to Debt Total Assets ÷ Long-term Debts

Significance: A higher ratio means long-term debt is well-covered by assets — primarily

financed by owner's funds. Provides comfort to lenders.

7.5 Interest Coverage Ratio

Measures how many times the firm can cover its interest obligation out of
Definition
operating profits. Also called Times Interest Earned.

Interest Coverage Ratio EBIT ÷ Interest on Long-term Debts

• EBIT = Net Profit After Tax × [100/(100 − Tax Rate)] + Interest

Significance: A HIGHER ratio = greater safety for interest payments. Low ratio signals the firm
may struggle to service its debt.

Worked Example:
Net Profit after tax = ₹60,000 | Tax Rate = 40% | 15% Long-term Debt = ₹10,00,000

Net Profit before Tax = 60,000 × 100/60 = ₹1,00,000

Interest = 15% × 10,00,000 = ₹1,50,000

EBIT = 1,00,000 + 1,50,000 = ₹2,50,000

 Interest Coverage Ratio 2,50,000 ÷ 1,50,000 = 1.67 times

8. Activity (Turnover) Ratios

Activity ratios indicate the speed at which the firm converts its assets into revenue from operations.
Higher turnover = better asset utilisation = improved efficiency and profitability. Also called Efficiency
Ratios.

8.1 Inventory Turnover Ratio

How many times inventory is converted into revenue from operations

Definition
(sold and replaced) during the accounting period.

Inventory Turnover Cost of Revenue from Operations ÷ Average Inventory

• Cost of Revenue from Operations = Opening Inventory + Purchases + Direct Expenses

(Wages, Carriage Inward) − Closing Inventory
• Average Inventory = (Opening Inventory + Closing Inventory) ÷ 2
• If only one figure is given, use it directly as average inventory.

Significance: LOW ratio → bad buying, obsolete inventory, slow sales — a danger
signal. HIGH ratio is generally good, but could also indicate buying in small lots or
selling at thin margins to realise cash quickly.

8.2 Trade Receivables Turnover Ratio

Speed at which credit sales are collected. Higher ratio = quicker cash
Definition
realisation from debtors.
 Net Credit Revenue from Operations ÷ Average Trade
Trade Receivables Turnover
Receivables

• Average Trade Receivables = (Opening Debtors + Bills Receivable + Closing Debtors + Bills
Receivable) ÷ 2
• Note: Debtors are taken BEFORE any provision for doubtful debts.
• Average Collection Period = 365 ÷ Trade Receivables Turnover Ratio (in days)

Significance: Higher ratio = speedy collection. Enables calculation of the average

collection period, which helps assess credit and collection policies.

8.3 Trade Payables Turnover Ratio

Speed at which the firm pays its suppliers. Reflects payment patterns
Definition
and creditor management.

Trade Payables Turnover Net Credit Purchases ÷ Average Trade Payables

• Average Trade Payables = (Opening Creditors + Bills Payable + Closing Creditors + Bills
Payable) ÷ 2
• Average Payment Period = 365 ÷ Trade Payables Turnover Ratio

Significance: A LOW ratio may mean liberal credit from suppliers OR delayed payments
(which can damage reputation). Higher ratio indicates faster payment, which may reflect
strong supplier relationships.

8.4 Net Assets / Capital Employed Turnover Ratio

 Net Assets Turnover Revenue from Operations ÷ Capital Employed

Significance: Higher turnover = better activity and profitability. This is further broken
down into Fixed Assets Turnover and Working Capital Turnover.

8.4a Fixed Assets Turnover Ratio

Fixed Assets Turnover Net Revenue from Operations ÷ Net Fixed Assets

8.4b Working Capital Turnover Ratio

Working Capital Turnover Net Revenue from Operations ÷ Working Capital

• Working Capital = Current Assets − Current Liabilities

Significance: High turnover of working capital and fixed assets reflects efficient
utilisation, higher liquidity, and improved profitability.

9. Profitability Ratios
Profitability ratios analyse the earning capacity of the business relative to revenue or funds employed.
They reflect the overall efficiency of management in utilising resources.

9.1 Gross Profit Ratio

 Gross profit earned as a percentage of revenue from operations.
Definition
Indicates the margin on core operations.

Gross Profit Ratio (Gross Profit ÷ Net Revenue from Operations) × 100

• Gross Profit = Net Revenue from Operations − Cost of Revenue from Operations

Significance: Indicates margin available to cover operating and non-operating expenses.

A LOW ratio signals unfavourable purchase/sales policies. HIGHER is always better.

9.2 Operating Ratio

Total operating cost (COGS + operating expenses) as a percentage of

Definition
revenue. Measures cost efficiency of operations.

Operating Ratio [(COGS + Operating Expenses) ÷ Net Revenue] × 100

• Operating Expenses include: Office & administrative expenses, selling & distribution
expenses, depreciation, employee benefit expenses.
• Excludes: Non-operating items like interest paid, dividend received, loss/profit on sale of assets,
speculation gains.

Significance: A LOWER operating ratio is a healthier sign — less cost per rupee of sales.
Useful for both inter-firm and intra-firm comparisons.

9.3 Operating Profit Ratio

 Operating Profit ÷ Revenue × 100 OR (100 − Operating
Operating Profit Ratio
Ratio)

• Operating Profit = Revenue from Operations − Operating Cost

9.4 Net Profit Ratio

All-inclusive profit (after all expenses and taxes) as a percentage of

Definition
revenue. Reflects overall business efficiency.

Net Profit Ratio (Net Profit After Tax ÷ Revenue from Operations) × 100

Significance: Measures overall net margin. It is the main variable in computing Return on
Investment. Of great significance to investors and analysts.

9.5 Return on Capital Employed (ROCE) / Return on Investment (ROI)

Overall return generated on all long-term funds employed — both

Definition
owned and borrowed. Measures efficiency of capital utilisation.

ROCE / ROI (EBIT ÷ Capital Employed) × 100

• Capital Employed = Shareholders' Funds + Long-term Debts OR Non-current Assets +

Working Capital
• EBIT = Profit Before Interest and Tax
 Significance: Reveals how efficiently all available capital is being used. A standard for
inter-firm comparison. If ROCE > interest rate paid, using debt (leverage) is profitable for
shareholders.

9.6 Return on Shareholders' Funds / Return on Net Worth (RONW)

RONW (Profit After Tax ÷ Shareholders' Funds) × 100

Significance: Should be higher than ROCE, else company funds have not been used
profitably from the shareholders' perspective.

9.7 Earnings Per Share (EPS)

Profit Available for Equity Shareholders ÷ Number of

EPS
Equity Shares

• Profit for Equity Shareholders = Profit After Tax − Preference Dividend

Significance: Critical metric for equity shareholders and for market valuation. Higher
EPS supports higher market price and greater dividend capacity.

9.8 Book Value Per Share

Book Value Per Share Equity Shareholders' Funds ÷ Number of Equity Shares

• Equity Shareholders' Funds = Shareholders' Funds − Preference Share Capital

 Significance: Indicates the intrinsic per-share value based on book records. Influences
market price of shares.

9.9 Dividend Payout Ratio

Dividend Payout Ratio Dividend Per Share ÷ Earnings Per Share

Significance: Reflects the company's dividend policy. A HIGH ratio means more
earnings distributed; LOW ratio means earnings retained for reinvestment (growth).

9.10 Price / Earning Ratio (P/E Ratio)

P/E Ratio Market Price Per Share ÷ Earnings Per Share

Significance: Reflects investor expectations about future growth. A HIGH P/E indicates investors are
willing to pay a premium for future earnings. Varies by industry and company growth potential.

10. Quick Reference — All Ratios at a Glance

The table below summarises all ratios covered in this chapter with their formulae, ideal levels, and
category for rapid revision.

Ratio Formula Ideal Level Category

Current Ratio Current Assets / Current ~2:1 Liquidity

Liabilities

Quick / Liquid Ratio Quick Assets / Current Liabilities ~1:1 Liquidity

Debt-Equity Ratio Long-term Debt / Shareholders' ≤ 2:1 Solvency

Funds
 Ratio Formula Ideal Level Category

Debt to Capital Long-term Debt / Capital Lower better Solvency

Employed Employed

Proprietary Ratio Shareholders' Funds / Capital Higher better Solvency

Employed

Total Assets to Debt Total Assets / Long-term Debt Higher better Solvency

Interest Coverage EBIT / Interest on LT Debt Higher better Solvency

Inventory Turnover Cost of Revenue / Avg Inventory Higher better Activity

Trade Receivables TO Net Credit Revenue / Avg Trade Higher better Activity
Receivables

Trade Payables TO Net Credit Purchases / Avg Trade Context Activity

Payables

Net Assets Turnover Revenue from Operations / Higher better Activity

Capital Employed

Fixed Assets Turnover Revenue from Operations / Net Higher better Activity
Fixed Assets

Working Capital Revenue from Operations / Higher better Activity

Turnover Working Capital

Gross Profit Ratio Gross Profit / Revenue × 100 Higher better Profitability

Operating Ratio (COGS + Op. Exp.) / Revenue × Lower better Profitability

100

Operating Profit Ratio Operating Profit / Revenue × 100 Higher better Profitability

Net Profit Ratio Net Profit / Revenue × 100 Higher better Profitability

Return on Investment EBIT / Capital Employed × 100 Higher better Profitability

Return on Net Worth PAT / Shareholders' Funds × 100 Higher better Profitability
 Ratio Formula Ideal Level Category

EPS Profit for Equity / No. of Equity Higher better Profitability

Shares

Book Value per Share Equity Shareholders' Funds / No. Context Profitability
of Shares

Dividend Payout Ratio Dividend per Share / EPS Policy-based Profitability

P/E Ratio Market Price / EPS Context Profitability

11. Effect of Transactions on Ratios

A very common exam concept: given an existing ratio level, determine whether a transaction
IMPROVES, REDUCES, or leaves UNCHANGED the ratio.

11A. Effect on Current Ratio (Assume existing ratio > 1)

Transaction Effect Reason

Payment of a current liability (e.g., by IMPROVES Both CA and CL fall, but ratio
cheque) increases

Goods purchased on credit REDUCES CL increases more

proportionally

Sale of fixed asset (at any price) IMPROVES CA increases, CL unchanged

Cash sale of goods above cost IMPROVES CA increases by profit amount

Payment of unclaimed dividend IMPROVES CL (dividend payable)

eliminated

Issue of equity shares for cash IMPROVES CA (cash) increases, CL

unchanged
11B. Effect on Debt-Equity Ratio

Transaction Effect Reason

Issue of equity shares DECREASES ratio Equity (denominator) increases

Redemption of debentures DECREASES ratio Long-term debt (numerator)

decreases

Cash received from debtors NO CHANGE Only current assets

composition changes

Sale of goods on cash basis NO CHANGE Affects only current assets

Purchase of goods on credit NO CHANGE Current liability, not long-term

debt

12. Key Memory Aids & Exam Tips

12.1 Ratio Benchmarks to Remember

Ratio Ideal Level If Violated…

Current Ratio 2:1 < 2 → liquidity risk; > 2 → idle resources

Quick Ratio 1:1 < 1 → risky; > 1 → idle liquid funds

Debt-Equity Ratio 2 : 1 (max) Higher → more financial risk for lenders

Interest Coverage Higher the better Low → cannot safely service interest

Gross Profit Ratio Higher the better Low → unfavourable purchase/sales policy

Operating Ratio Lower the better High → poor cost control

12.2 Key Distinctions

 • Current Ratio vs Quick Ratio: Quick ratio excludes inventories, prepaid expenses, and
advance tax — giving a stricter test of immediate liquidity.
• ROCE vs RONW: ROCE uses EBIT and includes all capital (debt + equity). RONW uses PAT
and only shareholders' funds. RONW should be > ROCE for leverage to benefit shareholders.
• Gross Profit vs Net Profit: GP ratio focuses on trading operations only. NP ratio includes all
non-operating items (interest, tax, other income/expenses).
• Inventory Turnover vs Trade Receivables Turnover: Both use average of opening and
closing balances. If only closing balance is available, use it directly without dividing by 2.
• Debt-Equity vs Proprietary: These are complementary. Their sum always equals 1. Proprietary
ratio = 1 − Debt to Capital Employed ratio.

12.3 Common Calculation Tricks

• Finding missing figures from two ratios: Use Current Ratio and Quick Ratio together. Let CL
= x. CA = (Current Ratio × x). Quick Assets = (Quick Ratio × x). Inventory = CA − Quick
Assets.
• Working back from Inventory Turnover: If turnover and average inventory are known, COGS
= Turnover × Avg. Inventory. Revenue = COGS × 100/(100 − GP%).
• Gross Profit from Inventory Turnover: Calculate COGS, then Revenue using GP%, then GP
= Revenue − COGS.
• Net Profit before Interest & Tax: = Net Profit after Tax × [100/(100 − Tax Rate)] + Interest on
long-term debt.