CHAPTER 9

Ratio Analysis

Introduction
The analysis of the financial statements and interpretations of financial results of a particular period
of operations with the help of 'ratio' is termed as "ratio analysis." Ratio analysis used to determine the
financial soundness of a business concern. Alexander Wall designed a system of ratio analysis and
presented it in useful form in the year 1909.
Meaning and Definition
The term 'ratio' refers to the mathematical relationship between any two inter-related variables. In
other words, it establishes relationship between two items expressed in quantitative form.
According J. Batty, Ratio can be defined as "the term accounting ratio is used to describe significant
relationships which exist between figures shown in a balance sheet and profit and loss account in a
budgetary control system or any other part of the accounting management."
Ratio can be used in the form of (1) percentage (20%) (2) Quotient (say 10) and (3) Rates. In other
words, it can be expressed as a to b; a: b (a is to b) or as a simple fraction, integer and decimal. A ratio
is calculated by dividing one item or figure by another item or figure.
Analysis or Interpretations of Ratios
The analysis or interpretations in question may be of various types. The following approaches are
usually found to exist:
(a) Interpretation or Analysis of an Individual (or) Single ratio.
(b) Interpretation or Analysis by referring to a group of ratios.
(c) Interpretation or Analysis of ratios by trend.
(d) Interpretations or Analysis by inter-firm comparison.
Principles of Ratio Selection
The following principles should be considered before selecting the ratio:
234 A Textbook of Financial Cost and Management AccounQd~

(1) Ratio should be logically inter-related.

(2) Pseudo ratios should be avoided.
(3) Ratio must measure a material factor of business.
(4) Cost of obtaining information should be borne in mind.
(5) Ratio should be in minimum numbers.
(6) Ratio should be facilities comparable.
Advantages of Ratio Analysis
Ratio analysis is necessary to establish the relationship between two accounting figures to highlight
the significant information to the management or users who can analyse the business situation and to
monitor their performance in a meaningful way. The following are the advantages of ratio analysis:
(1) It facilitates the accounting information to be summarized and simplified in a required form.
(2) It highlights the inter-relationship between the facts and figures of various segments of
business.
(3) Ratio analysis helps to remove all type of wastages and inefficiencies.
(4) It provides necessary information to the management to take prompt decision relating to
business.
(5) It helps to the management for effectively discharge its functions such as planning, organizing,
controlling, directing and forecasting.
(6) Ratio analysis reveals profitable and unprofitable activities. Thus, the management is able to
concentrate on unprofitable activities and consider to improve the efficiency.
(7) Ratio analysis is used as a measuring rod for effective control of performance of business
activities.
(8) Ratios are an effective means of communication and informing about financial soundness made
by the business concern to the proprietors, investors, creditors and other parties.
(9) Ratio analysis is an effective tool which is used for measuring the operating results of the
enterprises.
(10) It facilitates control over the operation as well as resources of the business.
(11) Effective co-operation can be achieved through ratio analysis.
(12) Ratio analysis provides all assistance to the management to fix responsibilities.
(13) Ratio analysis helps to determine the performance of liquidity, profitability and solvency
position of the business concern.
Limitations of Ratio Analysis
Ratio analysis is one of the important techniques of determining the performance of financial strength
and weakness of a firm. Though ratio analysis is relevant and useful technique for the business concern,
the analysis is based on the information available in the financial statements. There are some situations,
where ratios are misused, it may lead the management to wrong direction. The ratio analysis suffers from
the following limitations:
Ratio Analysis 235
(1) Ratio analysis is used on the basis of financial statements. Number of limitations of financial
statements may affect the accuracy or quality of ratio analysis.
(2) Ratio analysis heavily depends on quantitative
I
facts and figures and it ignores qualitative data.
Therefore this may limit accuracy.
(3) Ratio ~alysis is a poor measure of a firm's performance due to lack of adequate standards laid
for ideal ratios.
(4) It is not a substitute for analysis of financial statements. It is merely used as a tool for
measuring the performance of business activities.
(5) Ratio analysis clearly has some latitude for window dressing.
(6) It makes comparison of ratios between companies which is questionable due to differences in
methods of accounting operation and financing.
(7) Ratio analysis does not consider the change in price level, as such, these ratio will not help in
drawing meaningful inferences.
CLASSIFICATION OF RATIOS
Accounting Ratios are classified on the basis of the different parties interested in making use of the
ratios. A very l?rge number of accounting ratios are used for the purpose of determining the financial
position of a concern for different purposes. Ratios may be broadly classified in to:
(1) Classification of Ratios on the basis of Balance Sheet.
(2) Classification of Ratios on the basis of Profit and Loss Account.
(3) Classification of Ratios on the basis of Mixed Statement (or) Balance Sheet and Profit and Loss
Account.
This classification further grouped in to:
I. Liquidity Ratios
II. Profitability Ratios
III. Turnover Ratios
IV. Solvency Ratios
V. Over all Profitability Ratios
These classifications are discussed hereunder :
1. Classification of Ratios on the basis of Balance Sheet: Balance sheet ratios which establish the
relationship between two balance sheet items. For example, Current Ratio, Fixed Asset Ratio, Capital
Gearing Ratio and Liquidity Ratio etc.
2. Classification on the basis of Income Statements: These ratios deal with the relationship
between two items or two group of items of the income statement or profit and loss account. For example,
Gross Profit Ratio, Operating Ratio, Operating Profit Ratio, and Net Profit Ratio etc.
3. Classification on the basis of Mixed Statements: These ratios also known as Composite or Mixed
Ratios or Inter Statement Ratios. The inter statement ratios which deal with relationship between the item
of profit and loss account and item of balance sheet. For example, Return on Investment Ratio, Net Profit
to Total Asset Ratio, Creditor's Turnover Ratio, Earning Per Share Ratio and Price Earning Ratio etc.
236 A Textbook of Financial Cost and Management Accounting

A chart for classification of ratios by statement is given below showing clearly the types of ratios
may be broadly classified on the basis of Income Statement and Balance Sheet.
Classification of Ratios by Statement
~ ~ ~
On the basis of On the basis of On the basis of

I Balance Sheet I I Profit and Loss Account I I ProfitandandBalance

Loss Account I
Sheet
1 1 t
1. Current Ratio 1. Gross Profit Ratio 1. Stock Turnover Ratio
2. Liquid Ratio 2. Operating Ratio 2. Debtors Turnover Ratio
3. Absolute Liquid Ratio 3. Operating Profit Ratio 3. Payable Turnover Ratio
4. Debt Equity Ratio 4. Net Profit Ratio 4. Fixed Asset Turnover Ratio
5. Proprietary Ratio 5. Expense Ratio 5. Return on Equity
6. Capital Gearing Ratio 6. Interest Coverage Ratio 6. Return on Shareholder's Fund
7. Assets-Proprietorship Ratio 7. Return on Capital Employed
8. Capital Inventory to 8. Capital Turnover Ratio
Working Capital Ratio 9. Working Capital Turnover Ratio
9. Ratio of Current Assets 10. Return on Total Resources
to Fixed Assets 11. Total Assets Turnover

I. LIQUIDITY RATIOS
Liquidity Ratios are also termed as Short-Term Solvency Ratios. The term liquidity means the extent
of quick convertibility of assets in to money for paying obligation of short-term nature. Accordingly,
liquidity ratios are useful in obtaining an indication of a firm's ability to meet its current liabilities, but it
does not reveal h0w effectively the cash resources can be managed. To measure the liquidity of a firm, the
following ratios are commonly used:
(1) Current Ratio.
(2) Quick Ratio (or) Acid Test or Liquid Ratio.
(3) Absolute Liquid Ratio (or) Cash Position Ratio.
(1) Current Ratio
Current Ratio establishes the relationship between current Assets and current Liabilities. It attempts
to measure the ability of a firm to meet its current obligations. In order to compute this ratio, the following
formula is used :

Current Assets
Current Ratio =
Current Liabilities

The two basic components of this ratio are current assets and current liabilities. Current asset
normally means assets which can be easily converted in to cash within a year's time. On the other hand,
current liabilities represent those liabilities which are payable within a year. The following table represents
the components of current assets and current liabilities in order to measure the current ratios :
Ratio ATUliysis 237
Components of Current Assets and Current Liabilities
Current Assets Current Liabilities
1. Cash in Hand L Sundry Creditors
2. Cash at Bank (Accounts Payable)
3. Sundry Debtors 2. Bills Payable
4. Bills Receivable 3. Outstanding and Accrued Expenses
5. Marketable Securities 4. Income Tax Payable
( Short-Term) 5. Short-Term Advances
6. Other Short-Term Investments 6. Unpaid or Unclaimed Dividend
7. Inventories : 7. Bank Overdraft (Short-Term period)
(a) Stock of raw materials
(b) Stock of work in progress
(c) Stock of finished goods

Interpretation of Current Ratio: The ideal current ratio is 2: 1. It indicates that current assets
double the current liabilities is considered to be satisfactory. Higher value of current ratio indicates more
liquid of the firm's ability to pay its current obligation in time. On the other hand, a low value of current
ratio means that the firm may find it difficult to pay its current ratio as one which is generally recognized
as the patriarch among ratios.
Advantages of Cu"ent Ratios:
(1) Current ratio helps to measure the liquidity of a firm.
(2) It represents general picture of the adequacy of the working capital position of a company.
(3) It indicates liquidity of a company.
(4) It represents a margin of safety, i.e., cushion of protection against current creditors.
(5) It helps to measure the short-term financial position of a company or short-term solvency of a
firm.
Disadvantages of Cu"ent Ratio:
( 1) Current ratios cannot be appropriate to all busineses it depends on many other factors.
(2) Window' dressing is another problem of current ratio, for example, overvaluation of closing
stock.
(3) It is a crude measure of a firm's liquidity only on the basis Of quantity and not quality of current
assets.
Calculation of Current Ratio:
Illustration: 1
The following information relates to Mishra & Co. for the year 2003, calculate current ratio:
Current Assets Rs. 5,00,000
Current Liabilities Rs. 2,00,000
238 , A Textbook of Financial Cost and Management Accounting
Solution:
Current Assets
Current Ratio =
Current Liabilities
5,00,000
=
2,00,000
= 2.5 (or) 2.5 :1
The current ratio of 2.5 means that current assets are 2.5 times of current liabilities.

Illustration: 2
Calculate Current Ratio from the following Information
Liabilities Rs. Assets Rs.
Sundry creditors 40,000 Inventories 1,20,000
Bills payable 30,000 Sundry debtors 1,40,000
Dividend payable 36,000 Cash at Bank 40,000
Accrued expenses 14,000 Bills Receivable 60,000
Short-term advances 50,000 Prepaid expenses 20,000
Share Capital 1,50,000 Machinery 2,00,000
Debenture 2,00,000 Patents 50,000
Land & Building 1,50,000

Solution:
Current Assets
Current Ratio =
Current Liabilities

Current Assets = Rs. 1,20,000 + 1,40,000 + 40,000 + 60,000 + 20,000

= Rs. 3,80,000

Current Liabilities = Rs. 40,000 + 30,000 + 36,000 + 14,000 + 50,000

Rs. 1,70,000
3,80,000
Current Ratio = 1,70,000
= 2.24 (or) 2.24 :1

(2) Quick Ratio (or) Acid Test or Liquid Ratio

Quick Ratio also termed as Acid Test or Liquid Ratio. It is supplementary to the current ratio. The
acid test ratio is a more severe and stringent test of a firm's ability to pay its short-term obligations 'as and
when they become due. Quick Ratio establishes the relationship between the quick assets and current
liabilities. In order to compute this ratio, the below presented formula is used :
Liquid Assets
(Current Assets - Stock and Prepaid Expenses)
Liquid Ratio = ---------------------------------------
Current Liabilities
Quick Ratio can be calculated by two basic components of quick assets and current liabilities.
Quick Assets = Current Assets - (Inventories + Prepaid expenses)
Current liabilities represent those liabilities which are payable within a year.
Ratio Analysis 239

The ideal Quick Ratio of I: I is considered to be satisfactory. High Acid Test Ratio is an indication
that the firm has relatively better position to meet its current obligation in time. On the other hand, a low
value of quick ratio exhibiting that the firm's liquidity position is not good.

Advantages
(I) Quick Ratio helps to measure the liquidity position of a firm.
(2) It is used as a supplementary to the current ratio.
(3) It is used to remove inherent defects of current ratio.

Illustration: 3
Calculate Quick Ratio from the information given below :
Rs.
Current Assets 4,00,000
Current Liabilities 2,00,000
Inventories (stock) 25,000
Prepaid Expenses 25,000
Land and Building 4,00,000
Share Capital 3,00,000
Good Will 2,00,000

Solution:
Quick Assets
Quick Ratio = Current Liabilities

Current Assets - (Inventories + Prepaid Expenses)

= Current Liabilities
Rs. 4,00,000 - (25,000 + 25,(00)
= Rs. 2,00,000
Rs. 4,00,000 - 50,000
= Rs. 2,00,000
Rs. 3,50,000
= 2,00,000

= 1.75 (or) 1.75: 1

(3) Absolute Liquid Ratio

[Link] Liquid Ratio is also called as Cash Position Ratio (or) Over Due Liability Ratio. This ratio
established the relationship between the absolute liquid assets and current ~iabilities. Absolute Liquid
Assets include cash in hand, cash at bank, and marketable securities or temporary investments. The
optimum value for this ratio should be one, i.e., 1: 2. It indicates that 50% worth absolute liquid assets are
considered adequate to pay the 100% worth current liabilities in time. If the ratio is relatively lower than
one, it represents that the company's day-to-day cash management is poor. If the ratio is considerably
more than one, the absolute liquid ratio represents enough funds in the form of cash to meet its short-term
240 A Textbook of Financial Cost and Management Accounting

obligations in time. The Absolute Liquid ~ariq CaR be calculated by dividing the total of the Absolute
Liquid Assets by Total Current Liabilfties. Thus,

Absolute Liquid Assets

Absolute Liquid Ratio = Current Liabilities

Illustration: 4
Calculate Absolute Liquid Ratio from the following Information
Liabilities Rs. Assets Rs.
Bills Payable 30,000 Goodwill 2,00,000
Sundry Creditors 20,000 Land and Building 2,00,000
Share Capital 1,00,000 Inventories 50,000
Debenture 2,00,000 Cash in Hand 30,000
Bank Overdraft 25,000 Cash at Bank 20,000
Sundry Debtors 50,000
Bills Payable 75,000
Marketable Securities 10,000
Solution:

Absolute Liquid Assets

Absolute Liquid Ratio = Current Liabilities

Absolute Liquid Assets = Cash in Hand + Cash at Bank +

Marketable Securities
= Rs. 30,000 + 20,000 + 10,000
= Rs.60,000
Current Liabilities = Rs. 30,000 + 20,000 + 25,000
= Rs.75,000

60,000
Absolute Liquid Ratio = 75,000

= 0.8
The ratio of 0.8 is quite satisfactory because, it is much higher than the optimum value of 50%.
Illustration: 5
You are given the following information:
Rs.
Cash in Hand 10,000
Cash at Bank 15,000
Sundry Debtors 75,000
Stock 60,000
Bills Payable 25,000
Bills Receivable 30,000
Sundry Creditors 40,000
Outstanding Expenses 20,000
Prepaid Expenses 10,000
Dividend Payable 15,000
Ratio Analysis 241
Land and Building 2,00,000
Goodwill 1,00,000
Calculate: (a) Current Ratio (b) Liquid Ratio (c) Absolute Liquidity Ratio

Solution:

Current Assets
(a) Current Ratio =
Current Liabilities

Current Assets : Rs.

Cash in Hand 10,000
Cash at Bank 15,000
Sundry Debtors 75,000
Stock 60,000
Bills Receivable 30,000
Prepaid Expenses 10,000
Total Current Assets Rs. 2,00,000

Current Liabilities Rs.

Bills Payable 25,000
Sundry Creditors 40,000
Outstanding Expenses 20,000
Dividend Payable 15,000
Total Current Liabilities = 1,00,000
Rs. 2,00,000
Current Ratio =
Rs. 1,00,000
2 times (or) 2:1

Liquid Assets
(b) Liquid Ratio =
Current Liabilities
Liquid Assets = Current Assets - (Stock and Prepaid Expenses)
= Rs. 2,00,000 - (60,000 + 10,(00)
= Rs. 2,00,000 - 70,000
= Rs. 1,30,000

1,30,000
Liquid Ratio = = 1.3 times (or) [Link]
1,00,000

Absolute Liquid Assets

(c) Absolute Liquid Ratio =
Current Liabilities i

Absolute Liquid Assets = Cash in hand + Cash at Bank

+ Marketable Securities
= Rs. 10,000 + 15,000 + Nil
Rs.25,000
242 A Textbook of Financial Cost and Management Accounting

25,000
Absolute Liquid Ratio = 1,00,000

= 0.2.5
Illustration: 6
Given:
Current Ratio = 2.6
Liquid Ratio = 1.4
Working Capital = Rs. 1,10,000
Calculate: (I) Current Assets (2) Current Liabilities (3) Liquid Assets and (4) Stock.
Solution:
Calculation of current assets and current liabilities :
Working Capital = Current Assets - Current Liabilities
Current Ratio = Current Assets: Current Liabilities
(or)
Current Assets
=2.6:1
Current Liabilities
Working Capital = Current Assets - Current Liabilities
Working Capital = 2.6 - I
= 1.6
Working Capital (Given) = 1,10,000
... 1.6 = 1,10,000

2.6
( 1) Current Assets = 1,10,000 x =Rs. 1,78,750
1.6

(2) Current Liabilities = 1, 10,000 x =Rs. 68,750

1.6

(3) Calculation of Liquid Assets :

Liquid Ratio (Given) = 1.4

Liquid Assets
Liquid Ratio = Current Liabilities

Liquid Assets
1.4 =
Rs.68,750

Liquid Assets = 68750 x 1.4

= Rs.96,250
(4) Calculation of Stock:
Liquid Assets = Current Assets - (Stock + Prepaid Expenses)
Stock = Current Assets - Liquid Assets
= Rs. 1,78.750 - Rs. 96,250
= Rs.82,500
Ratio Analysis 243

II. PROFITABILITY RATIOS

The term profitability means the profit earning capacity of any business activity. Thus, profit earning
may be judged on the volume of profit margin of any activity and is calculated by subtracting costs from
the total revenue accruing to a firm during a particular period. Profitability Ratio is used to measure the
overall efficiency or performance of a business. Generally, a large number of ratios can also be used for
determining the profitability as the same is related to sales or investments.
The following important profitability ratios are discussed below:
1. Gross Profit Ratio.
2. Operating Ratio.
3. Operating Profit Ratio.
4. Net Profit Ratio.
5. Return on Investment Ratio.
6. Return on Capital Employed Ratio.
7. Earning Per Share Ratio.
8. Dividend Payout Ratio.
9. Dividend Yield Ratio.
lO. Price Earning Ratio.
11. Net Profit to Net Worth Ratio.
(1) Gross Profit Ratio
Gross Profit Ratio established the relationship between gross profit and net sales. This ratio is
calculated by dividing the Gross Profit by Sales. It is uSllally indicated as percentage.

Gross Profit
Gross Profit Ratio = Net Sales
x 100

Gross Profit = Sales - Cost of Goods Sold

Net Sales = Gross Sales - Sales Return (or) Return Inwards
Higher Gross Profit Ratio is an indication that the firm has higher profitability. It also reflects the
effective standard of performance of firm's business. Higher Gross Profit Ratio will be result of the
following factors.
(1) Increase in selling price, i.e., sales higher than cost of goods sold.
(2) Decrease in cost of goods sold with selling price remaining constant.
(3) Increase in selling price without any corresponding proportionate increase in cost.
(4) Increase in the sales mix.
A low gross profit ratio generally indicates the result of the following factors :
(l) Increase in cost of goods sold.
(2) Decrease in selling price.
244 A Textbook of Financial Cost and Management Accounting
(3) Decrease in sales volume.
(4) High competition.
(5) Decrease in sales mix.
Advantages
(1) It helps to measure the relationship between gross profit and net sales.
(2) It reflects the efficiency with which a firm produces its product.
(3) This ratio tells the management, that a low gross profit ratio may indicate unfavourable
purchasing and mark-up policies.
(4) A low gross profit ratio also indicates the inability of the management to increase sales.
Illustration: 7
Calculate Gross Profit Ratio from the following figures :
Rs.
Sales 5,00,000
Sales Return 50,000
Closing Stock 35,000
Opening Stock 70,000
Purchases 3,50,000

Solution:
Gross Profit
Gross Profit Ratio = Net Sales
x 100

Net Sales = Sales - Sales Return

= Rs. 5,00,000 - 50,000
= Rs. 4,50,000
Gross Profit = Sales - Cost of Goods Sold
Cost of goods sold = Opening Stock + Purchase - Closing Stock
= Rs. 70,000 + 3,50,000 - 35,000
= =
Rs. 4,20,000 - 35,000 Rs. 3,85,000
Gross Profit = Rs. 4,50,000 - 3,85,000 = Rs. 65,000
65,000
Gross Profit Ratio = x 100
4,50,000
= 14.44 %
(2) Operating Ratio
Operating Ratio is calculated to measure the relationship between total operating expenses and sales ..
The total operating expenses is the sum total of cost of goods sold, office and administrative expenses and
selling and distribution expenses. In other words, this ratio indicates a firm's ability to cover total operating
expenses. In order to compute this ratio, the following formula is used:
Operating Cost
Operating Ratio = Net Sales
x 100

Operating Cost = Cost of goods sold + Administrative Expenses

+ Selling and Distribution Expenses
Net Sales = Sales - Sales Return (or) Return Inwards.
Ratio Analysis 245

Illustration: 8
Find out Operating Ratio :
Cost of goods sold Rs. 4,00,000
Office and Administrative Expenses Rs. 30,000
Selling and Distribution Expenses Rs. 20,000
Sales Rs. 6,00,000
Sales Return Rs. 20,000

Solution:
Operating Cost
Operating Ratio = Net Sales
x 100

Operating Cost = Cost of goods sold + Administrative Expenses

+ Selling and Distribution Expenses
= Rs. 4,00,000 + 30,000 + 20,000
= Rs. 4,50,000
= Rs. 6,00,000 - 20,000
= Rs. 5,80,000
4,50,000
Operating Ratio = 5,80,000
x 100

= 77.58 %
This ratio indicated that 77.58% of the net sales have been consumed by cost of goods sold, administrative
expenses and selling and distribution expenses. The remaining. 23.42% indicates a firm's ability to cover the interest
charges, income tax payable and dividend payable.
(3) Operating Profit Ratio

Operating Profit Ratio indicates the operational efficiency of the firm and is a measure of the firm's
ability to cover the total operating expenses. Operating Profit Ratio can be calculated as :

Operating Profit
Operating Profit Ratio = Net Sales
x 100

Operating Profit = Net Sales - Operating Cost

(or)
= Net Sales - (Cost of Goods Sold + Office
and Administrative Expenses + Selling
and Distribution Expenses)
(or)
= Gross Profit - Operating Expenses
(or)
= Net Profit + Non-Operating Expenses -
Non-Operating Income.
Net Sales = Sales - Sales Return (or) Return Inwards
246 A Textbook of Financial Cost and Management Accounting

Illustration: 9
From the following information given below, you are required to calculate Operating Profit Ratio :
Rs.
Gross Sales 6,50,000
Sales Return 50,000
Opening Stock 25,000
Closing Stock 30,000
Purchases 4,10,000
Office and Administrative Expenses 50,000
Selling and Distribution Expenses 40,000

Solution:
Operating Profit
Operating Profit Ratio ::: x 100
Net Sales
Operating Profit = Net Sales - Total Operating Cost
Net Sales = Gross Sales - Sales Return
= Rs. 6,50,000 - 50,000
= Rs. 6,00,000
Total Operating Cost Cost of Goods Sold + Office and Administrative
Expenses + Selling and Distribution Expenses
Cost of Goods sold = Opening Stock + Purchase - Closing Stock
= Rs. 25,000 + 4,10,000 - 30,000
= Rs. 4,05,000
Total Operating Expenses Rs. 4,05,000 + 50,000 + 40,000
= Rs. 4,95,000
Operating Profit = Net Sales - Total Operating Expenses
Rs. 6,00,000 - 4,95,000
Rs. 1,05,000
1,05,000
Operating Profit Ratio x 100
6,00,000
= 17.5

llIustration: 10
Calculate Operating ~ofit Ratio [Link] following "figures :
Net Sales Rs. 4,00,000
Cost of Goods Sold = Rs. 3,00,000
Office and Administrative Expenses = Rs. 20,000
Selling and Distribution Expenses = Rs. 15,000

Solution:
Operating Profit
Operating Profit Ratio = x 100
Net Sales
Operating Profit Sales - Total Operating Cost
Total Operating Cost = Cost of goods sold + Office and
Administrative Expenses + Selling
And Distribution Expenses
Ratio Analysis 247

= Rs. 3,00,000 + 20,000 + 15,000

= Rs. 3,35,000
Operating Profit = Rs. 4,00,0000 - 3,35,000
= Rs.65,OOO
65,000
Operating Profit Ratio = 4,00,000
x 100

= 16.25 %
(4) Net Profit Ratio
Net Profit Ratio is also termed as Sales Margin Ratio (or) Profit Margin Ratio (or) Net Profit to Sales
Ratio. This ratio reveals the firm's overall efficiency in operating the business. Net profit Ratio is used to
measure the relationship between net profit (either before or after taxes) and sales. This ratio can be
calculated by the following formula :
Net Profit After Tax
Net Profit Ratio = Net Sales
x 100

Net profit includes non-operating incomes and profits. Non-Operating Incomes such as dividend
received, interest on investment, profit on sales of fixed assets, commission received, discount received
etc. Profit or Sales Margin indicates margin available after deduction cost of production, other operating
expenses, and income tax from the sales revenue. Higher Net Profit Ratio indicates the standard
performance of the business concern.
Advantages
(1) This is the best measure of profitability and liquidity.
(2) It helps to measure overall operational efficiency of the business concern.
(3) It facilitates to make or buy decisions.
(4) It helps to determine the managerial efficiency to use a firm's resources to generate income on
its invested capital.
(5) Net profit Ratio is very much useful as a tool of ihvestment evaluation.
Illustration: 11
From the folloWing Trading and Profit and Loss Account of Ramesh & Co. for the year 31 st Dec.
2003 :

-- Rs. Rs.
To Opening Stock 60,000 By Sales 4,00,000
To Purchase 2,75,000 By Closing Stock 75,000
To Wages 25,000
To Gross Profit c/d 1,15,000
4,75,000 4,75,000
To Administrative Expenses 45,000 By Gross Profit bid 1,15,000
To Selling and Distribution Expenses 10,000 By Interest on Investment 10,000
To Office Expenses 5,000
To Non Operating Expenses 15,000
To Net Profit 50,000
1,25,000 1,25,000
248 A Textbook of Financial Cost and Management Accounting

You are required to calculate :

(1) Gross Profit Ratio.
(2) Operating Ratio.
(3) Operating Profit Ratio.
(4) Net Profit Ratio.

Solution:

Gross Profit
( J) Gross Profit Ratio x 100
Net Sales
1,15,000
= 4,00,000
x 100

= 28.75 %

Total Operating Cost

(2) Operating Ratio = x 100
Net Sales
Total Operating Cost = Cost of Goods Sold + Operating Expenses
Cost of goods sold Opening Stock + Purchases - Closing Stock
Rs. 60,000 + 2,75,000 - 75,000
Rs. 2,60,000
Operating Expenses = Office Expenses + Administrative Expenses
+ Selling and Distribution Expenses
= Rs. 5000 + 45,000 + 10,000
= Rs.60,OOO
Total Operating Cost Rs.2,60,OOO + 60,000
Rs. 3,20,000
3,20,000
Operating Ratio = 4,00,000
x 100

= 80%

Net Operating Profit

(3) Operating Profit Ratio = Net Sales
x 100

Net Operating Profit Net Sales - Total Operating Cost

= Rs. 4,00,000 - 3,20,000
= Rs.80,OOO
80,000
Operating Profit Ratio = x 100
4,00,000
20%

Net Profit (after tax)

(4) Net Profit Ratio = Net Sales
x 100

50,000
x 100
4,00,000
= 12.5 %
Ratio Analysis 249
Answers
(1) Gross Profit Ratio = 28.75%
(2) Operating Ratio = 80%
(3) Operating Profit Ratio = 20%
(4) Net Profit Ratio = 12.5 %

Illustration: 12
The following are the summarized profit and loss account of Sun India Ltd. for the year ending 31 51
Dec. 2003 and the Balance sheet as on that date:
Dr. Profit and Loss Account Cr.
Particulars Rs. Particulars Rs. Rs.
To Opening Stock 10,000 By Sales 1,20,000
To Purchases 60,000 Less : Sales Return 10,000 1,10,000
To Freight Expenses 5,000 By Closing Stock 15,000
To Gross Profit cld 50,000
1,25,000 1,25,000
To Operating Expenses: By Gross Profit bId 50,000
Office Expenses 5,000 By Non-Trading Income:
Administrative Expenses 15,000
Selling and Distribution Expenses 5,000 Interest on Investment 5,000
Profit on sale of fixed Assets 1,000
To Non-Operating Expenses:
Loss on Sale of Fixed Assets 1,000 Dividend Received 4,000
To Net Profit 34,000
60,000 60,000

Balance Sheet for the year ending 31st Dec. 2001

Liabilities Rs. Assets Rs.
Share Capital 15,000 ~ash in Hand 2,000
Reserves 3,000 Cash at Bank 3,000
Debenture 12,000 Marketable Securities 5,000
Current Liabilities 20,000 Inventories 15,000
Profit and Loss Nc 5,000 Sundry Debtors 6,000
Prepaid Expense 4,000
Land and Building 20,000
55,000 55,000

You are required to calculate:

(a) Current Ratio
(b) Liquid Ratio
(c) Gross Profit Ratio
(d) Operating Ratio
(e) Operating Profit Ratio
(f) Net Profit Ratio
250 A Textbook of Financial Cost and Management Accounting
Solution:
Current Assets
(a) Current Ratio = Current Liabilities
Current Assets = Rs. 2,000 + 3,000 + 5000 + 15,000 + 6,000 + 4,000
= Rs.35,OOO
35,000
Current Ratio = 20,000
= 1.75 (or) 1.75:1

Liquid Assets
(b) Liquid Ratio = Current Liabilities
Liquid Assets = Current Assets - (Stock and Prepaid Expenses)
= Rs. 35,000 - (15,000 + 4,(00)
= Rs. 16,000
16,000
Liquid Ratio = 20.000
= 0.8 (or) 0.8:1

Gross Profit
(c) Gross Profit Ratio = Net Sales
x 100

50,000
= x 100
1,10,000
= 45.45 %

Total Operating Cost

(d) Operating Ratio = Net Sales
x 100

Total Operating Cost = Cost of Goods Sold + Operating Expenses

Cost of Goods Sold = Opening Stock + Purchases - Closing Stock
= Rs. 10,000 + 60,000 - 15,000
= Rs.55,OOO
Operating Expenses = Office Expenses + Administrative Expenses
+ Selling and Distribution Expenses
= Rs. 5,000 + 15,000 + 5000
= Rs.25,OOO
Total operating cost = Rs. ~~.OOO + 25,000 = Rs. 80,000
80,000
Operating Ratio = I, ~[Link]
x 100 = 72.72%

Net Operating Profit

(e) Operating Profit Ratio = x 100
Net Sales
Net Operating Profit = Net Sales - Total Operating Cost
= Rs. 1,10,000 - 80,000 = Rs. 30,000
30,000
Operating Profit Ratio = x 100 =27.27%
1,10.000
Ratio Analysis 251

Alternatively
Net Operating Profit = Net Profit + Non-Operating Expenses
- Non-Operating Income
Net Operating Profit = Rs. 34,000 + 1,000 - (5,000 + 1,000 + 4,000)
= Rs. 35,000 - 10.000 = Rs.25,ooo
25,000
Operating Profit Ratio = 1,10,000
x 100

= 22.72%

Net Profit (after tax)

if) Net Profit Ratio = Net Sales
x 100

34,000
<= x 100
1,10,000
= 30.90 %
Answers
(a) Current Ratio = 1.75 (or) 1.75 :1
(b) Liquid Ratio = 0.8 (or) 0.8 : 1
(c) Gross Profit Ratio = 45.45%
(d) Operating Ratio = 72.72%
(e) Operating Profit Ratio = 27.27% or 22.72%
if) Net Profit Ratio = 30.90%
(5) Return on Investment Ratio
This ratio is also called as ROL This ratio measures a return on the owner's or shareholders'
investment. This ratio establishes the relationship between net profit after interest and taxes and the
owner's investment. Usually this is calculated in percentage. This ratio, thus. can be calculated as :

Net Profit (after interest and tax)

Return on Investment Ratio = ------------------------xlOO
Shareholders' Fund (or) Investments
Shareholder's Investments = Equity Share Capital + Preference
Share Capital + Reserves and Surplus
- Accumulated Losses
Net Profit = Net Profit - Interest and Taxes
Advantages
(1) This ratio highlights the success of the business from the owner's point of view.
(2) It helps to measure an income on the shareholders' or proprietor's investments.
(3) This ratio helps to the management for important decisions making.
(4) It !acilitates in determining efficiently handling of owner's investment.
252 A Textbook of Financial Cost and Management Accounting
Illustration: 13
Calculate Return on Investment Ratio from the following information :
Rs.
1000 Equity shares @ of [Link] each 10,000
2000, 5% preference share @ of Rs. lO each 20,000
Reverses 5,000
Net profit before interest and Tax lO,ooo
Interest 2,000
Taxes 3,000

Solution:

Net Profit after Interest and Tax

Return on Investment Ratio = - - - - - - - - - - - - x 100
Shareholders' Investment
Shareholders' Investment = Equity Share Capital + Preference Share
Capital + Reserves and Surplus
- Accumulated Losses
Shareholders' Investment = Rs.I0,000+ 20,000 + 5,000 - Nil
= Rs.35,000
Net Profit after Interest and Taxes = Rs. lO,ooo - (2,000 + 3,000)
= [Link],ooo - 5,000 = 5,000
5,000
Return on Investment Ratio = 35,000
x 100

= 14.28 %

(6) Return on Capital Employed Ratio

Return on Capital Employed Ratio measures a relationship between profit and capital employed.
This ratio is also called as Return on Investment Ratio. The term return means Profits or Net Profits. The
term Capital Employed refers to total investments made in the business. The concept of capital employed
can be considered further into the following ways :
(a) Gross Capital Employed
(b) Net Capital Employed
(c) Average Capital Employed
(d) Proprietor's Net Capital Employed
(a) Gross Capital Employed = Fixed Assets + Current Assets
(b) Net Capital Employed = Total Assets - Current Liabilities
Opening Capital Employed + Closing
Capital Employed
(c) Average Capital Employed = 2
(or)
Average Capital Employed = Net Capital Employed + Y2 of Profit After Tax
(d) Proprietor's Net Capital Employed = Fixed Assets + Current Assets
- Outside Liabilities
(both long-term and short-term)
Ratio Analysis 253
In order to compute this ratio, the below presented formulas are used:
Net Profit After Taxes
(1) Return on Capital Employed = Gross Capital Employed
x 100

(or)
Net Profit After Taxes Before Interest
(2) Return on Capital Employed = Gross Capital Employed
x 100

(or)
Net Profit After Taxes Before Interest
(3) Return on Capital Employed = Average Capital Employed or
x 100

Net Capital Employed

Illustration: 14
The following is the Balance sheet of MIs Sharma Ltd. for the year ending Dec. 31 51 2003.
Liabilities Rs. Assets Rs.
Equity Share Capital 4,00,000 Good Will 1,50,000
Reserves 40,000 Building 2,00,000
Profit and Loss Alc 80,000 Machinery 2,50,000
Debenture 1,00,000 Stock 80,000
Secured Loans 1,00,000 Sundry Debtors 60,000
Creditors 80,000 Bills Receivable 40,000
Provision for Tax 50,000 Cash at Bank 50.000
Bills Payable 40,000 Preliminary Expenses 60,000
8,90,000 8,90,000
You are required to calculate:
(a) Current Ratio
(b) Liquid Ratio
(c) Gross Capital Employed
(d) Net Capital Employed
(e) Average Capital Employed
(f) Return on Capital Employed Ratio

Solution:
Current Assets
(a) Current Ratio =
Current Liabilities
Current Assets = Stock + Sundry Debtors + Bills Receivable
+ Cash at Bank + Preliminary Expenses
= Rs. 80,000 + 60,000 + 50,000 + 60,000
= Rs. 2,50,000
Current Liabilities = Creditors + Provision for Tax + Bills Payable
= Rs. 80,000 + 50,000 + 40,000
= Rs. 1,70,000
2,50,000
Current Ratio = = 1.47 (or) 1.47 :1
1,70,000
254 A Textbook of Financial Cost and Management Accounting

(b) Uquid Assets = Liquid Assets - (Stock and Preliminary Expenses)

= Rs. 2,50,000 - ( 80,000 + 60,(00)
= Rs. 1,10,000
1,10,000
Liquid Ratio = 1,70,000
= 0.64 (or) 0.64 :1

(c) Gross Capital Employed = Fixed Assets + Current Assets

Fixed Assets = Goodwill + Building + Machinery
= 1,50,000 + 2,00,000 + 2,50,000
= Rs. 6,00,000
Current Assets = Rs. 2,50,000
Gross Capital Employed = Rs. 6,00,000 + 2,50,000
= Rs. 8,50,000
(d) Net Capital Employed = Total Assets - Current Liabilities
Total Assets = Rs. 8,50,000
Current Liabilities = Rs. 1,70,000
Net Capital Employed = Rs. 8,50,000 - 1,70,000
= Rs. 6,80,000
(e) Average Capital Employed = Net Capital Employed + !h of Profit After Tax
* of profit after tax =
=
!h (80,000 - 50,(00)
Rs.15,000
Average Capital Employed = Rs. 7,20,000 + 15,000
= Rs. 7,35,000
Net Profit After Tax
if) Return on Capital Employed = x 100
Gross Capital Employed
80,000 - 50,000
= ------xl00
8,50,000
30,000
= x 100
8,50,000
= 3.52%
Alternatively

Net Profit After Tax

Return on Capital Employed = Net Capital Employed
x 100

30,000
x 100
7,20,000
= 4.16 %
Answers

(a) Current Ratio = 1.47 (or) 1.47 : 1

(b) Liquid Ratio = 0.64 (or) 0.64 :1
(c) Gross Capital Employed = Rs: 8,50,000
(d) Net Capital Employed = Rs. 7,20,000
(e) Average Capital Employed = Rs.7,35,ooo
(f) Return on Capital Employed = 3.52 % (or) 4.16 %
Ratio Analysis 255
(7) Earning Per Share Ratio
Earning Per Share Ratio (EPS) measures the earning capacity of the concern from the owner's point
of view and it is helpful in detennining the price of the equity share in the market place. Earning Per Share
Ratio can be calculated as :

Net Profit After Tax and Preference Dividend

Earning Per Share Ratio =
No. of Equity Shares
Advantages
(1) This ratio helps to measure the price of stock in the market place.
(2) This ratio highlights the capacity of the concern to pay dividend to its shareholders.
(3) This ratio used as a yardstick to measure the overall perfonnance of the concern.
Illustration: 15
Calculate the Earning Per Share from the following data :
Net Profit before tax Rs. 2,00,000.
Taxation at 50% of Net Profit.
10 % Preference share capital (Rs. 10 each) Rs. 2,00,000, Equity share capital (Rs. 10 each)
Rs. 2,00,000.

Solution:
Net Profit After Tax and
Preference Dividend
Earning Per Equity Share = No. of Equity Shares
Net Profit before Tax = Rs. 2,00,000
50
Taxation at 50 % of Net Profit = 2,00,000 x
100
= Rs. 1,00,000
Net Profit after Tax = Rs. 2,00,000 - 1,00,000
= Rs. 1,00,000
10
10 % of Preference Dividend = 2,00,000 x
100
= Rs.20,OOO
Net Profit after Tax and = Rs. 1.00,000 - 20,000
Preference Dividend = Rs.80,OOO
2,00,000
No. of Equity Shares = 10
= 20,000 Shares
80,000
Earning Per Equity Share = 20,000
= Rs. 4 Per Share
256 A Textbook of Financial Cost and Management Accounting

(8) Dividend Payout Ratio

This ratio highlights the relationship between payment of dividend on equity share capital and the
profits available after meeting tax and preference dividend. This ratio indicates the dividend policy adopted
by the top management about utilization of divisible profit to pay dividend or to retain or both. The ratio,
thus, can be calculated as :

Equity Dividend
Dividend Payout Ratio = Net Profit After Tax and Preference Dividend
x 100

(or)

Dividend Per Equity Share

= Earning Per Equity Share
x 100

Illustration: 16
Compute Dividend Payout Ratio from the following data:
Net Profit Rs. 60,000
Provision for tax Rs. 15,000
Preference dividend Rs. 15,000
No. of Equity Shares Rs. 6,000
Dividend Per Equity Share = 0.30
Solution:
Equity Dividend
Dividend Payout Ratio = x 100
Net Profit After Tax and Preference Dividend
Equity Dividend = No. of Equity Shares x Dividend Per Equity Share
= 6,000 x 0.30
Rs. 1,800
Net Profit After Tax Rs. 60,000 - (15,000 + 15,000)
Preference Dividend = Rs. 60,000 - 30,000
= Rs.30,000
Alternatively

Dividend Per Equity Share

Dividend Payout Ratio = x 100
Earning Per Equity Share
Dividend Per Equity Share = 0.30
Net Profit After tax and Preference Dividend
Earning Per Equity Share =
No. of Equity Shares
30,000
= =Rs. 5 Per Share
6,000
0.30
Dividend Payout Ratio = 5
x 100

= 6%
Ratio Analysis 257
(9) Dividend Yield Ratio:
Dividend Yield Ratio indicates the relationship is established between dividend per share and market
value per share. This ratio is a major factor that determines the dividend income from the inve!>tors' point
of view. It can be calculated by the following formula :

Dividend Per Share

Dividend Yield Ratio = Market Value Per Share
x 100

Illustration: 17
The following details have been given to you for MIs I.M. Pandey Ltd., you are required to find out
(1) Dividend Yield Ratio (2) Dividend Payout Ratio and (3) Earning Per Share Ratio.
10 % Preference Shares of Rs. 10 each Rs. 5,00,000
60,000 Equity Shares of Rs. 10 each Rs. 6,00,000
Rs. 11,00,000
Additional Information
Profit after tax at 50 %
Equity Dividend Paid 20 %
Market Price of Equity Share Rs. 30

Solution:
Rs.
Profit after Tax = 1,50,000
Less: Preference dividend (10% of 5,00,000) = 50,000
Equity Earnings = 1,00,000

Profit after tax and preference dividend = Rs. 1,00,000

No. of Equity Shares = 60,000 Shares
Dividend Per Share
(J) Dividend Yield Ratio = Market Value Per Share
x 100

20 % ofRs. 10
= Rs.30
x 100

2
= 30
x 100 = 6.66%

Net Profit after tax preference dividend

(2) Earning Per Equity Share = No. of Equity Shares
x 100

1,00,000
= =Rs. 1.67 Per Share
60,000
Dividend Per Equity Share
(3) Dividend Payout Ratio = Earning Per Equity Share
x 100

2
= - - x 100
1.67
= 119.76%
258 A Textbook of Financial Cost and Management Accounting

Alternatively
Equity Dividend
Dividend Payout Ratio = -------------------------------xl00
Net Profit After Tax and Preference Dividend
Equity Dividend = =
20 % of Rs. 10 Rs.2
... Equity Dividend for 60,000 Shares = =
60,000 x 2 Rs.l,20,OOO
1,20,000
Dividend Payout Ratio = 1,00,000
x 100

= 120%
Illustration: 18
Compute: (1) Earning Per Share (2) Dividend Yield Ratio from the following information:
Net Profit =Rs. 3,00,000
Market Price Per Equity Share =Rs. 40
No. of Equity Shares = 30,000
Provision for Tax =Rs. 50,000
Preference Dividend =Rs. 30,000

Solution:

Net Profit After Tax and Preference Dividend

(1) Earning Per Share = No. of Equity Shares
x 100

Net Profit After Tax and }

Preference Dividend = Rs. 3,00,000 - ( 50,000 + 30,(00)
= =
Rs. 3,00,000 - 80,000 Rs.2,20,OOO
2,20,000
(2) Earning Per Share =
30,000
= Rs.7.33
Earning Per Share
Dividend Yield Ratio = Market Value Per Share
x 100

7.33
= -- x 100
40
= 18.33%
(10) Price Earning Ratio
This ratio highlights the earning per share reflected by market share. Price Earning Ratio establishes
the relationship between the market price of an equity share and the earning per equity share. This ratio
helps to find out whether the equity shares of a company are undervalued or not. This ratio is also useful
in financial forecasting. This ratio is calculated as :

Market Price Per Equity Share

Price Earning Ratio = Earning Per Share
Ratio Analysis 259
Illustration: 19
Calculate (1) Earning Per Share (2) Dividend Yield Ratio and (3) Price Earning Ratio from the
following figures:
Net Profit ---¥:;-- Rs. 6,00,000
Market price Per Equity Shares = Rs. 60
No. of Equity Shares = 40,000
Provision for Tax = Rs. 1,60,000
Preference Dividend = Rs. 50,000
Depreciation = Rs.70,000
Bank Overdraft = Rs.50,000

Solution:
Net Profit After Tax and Preference Dividend
(1) Earning Per Share = No. of Equity Shares
Net Profit After Tax and }
Preference Dividend = Rs. 6,00,000 - (l,60,000 + 50,000)
= Rs. 6,00,000 - 2,10,000 = Rs. 3,90,000
3,90,000
Earning Per Share = 40,000
= Rs.9.75
Earning Per Share
(2) Dividend Yield Ratio = x 100
Market Value Per Share
9.75
= x 100
60
= 16.25%
Market Price Per Equity Share
(3) Price Earning Ratio =
Earning Per Share
60
= 9.75
= 6.15
Interpretations: The market price of a share is Rs. 60 and earning per share is Rs. 9.75, the price earning
ratio would be 6.15. It means that the market value of every one rupee of earning is 6.15 times or Rs. 6.15.
(11) Net Profit to Net Worth Ratio
This ratio measures the profit return on investment. This ratio indicates the established relationship
between net profit and shareholders' net worth. It is a reward for the assumption of ownership risk. This
ratio is calculated as :

Net Profit After Taxes

Net Profit to Net Worth = Shareholders' Net Worth
x 100

Shareholder Net Worth = Total Tangible Net Worth

Total Tangible Net Worth = Company's Net Assets - Long-Term Liabilities
(or)
= Shareholders' Funds + Profits Retained in business
260 A Textbook of Financial Cost and Management Accounting

Advantages
(1) This ratio determines the incentive to owners.
(2) This ratio helps to measure the profit as well as net worth.
(3) This ratio indicates the overall performance and effectiveness of the firm.
(4) This ratio measures the efficiency with which the resources of a firm have been employed.
Illustration: 20
Compute Net Profit to Net Worth Ratio from the following data :
Rs.
Net Profit 80,000
Provision for Tax 15,000
Shareholders' Fund 8,00,000
Dividend to Equity Shares 20,000
Dividend to Preference
Shares @ 10 % } 10,000

Solution:
Net Profit After Taxes
Net Profit to Net Worth = - - - - - - - - - x 100
Total Tangible Net Worth
Net Profit after Taxes =
Rs. 80,000 - 15,000 Rs.65, 000
Total Tangible Net Worth = Shareholders' fund + Profit retained in business
Profit Retained in Business = Profit - (Taxes + Preference dividend + Equity dividend)
= Rs. 80,000 - (15,000 + 20,000 + 10,(00)
= Rs. 80,000 - 45,000
= Rs.35,OOO
Total Tangible Net Worth = Rs. 8,00,000 + 35,000
= Rs. 9,15,000
65,000
Net Profit Net Worth = x 100 =7.10%
9,15,000
Net Profit to Net ·Worth Ratio = 7.10 %

III. TURNOVER RATIOS

Turnover Ratios may be also termed as Efficiency Ratios or Performance Ratios or Activity Ratios.
Turnover Ratios highlight the different aspect of financial statement to satisfy the requirements of different
parties interested in the business. It also indicates the effectiveness with which different assets are vitalized
in a business. Turnover means the number of times assets are converted or turned over into sales. The
activity ratios indicate the rate at which different assets are turned over.
Depending upon the purpose, the following activities or turnover ratios can be calculated:
1. Inventory Ratio or Stock Turnover Ratio (Stock Velocity)
2. Debtor's Turnover Ratio or Receivable Turnover Ratio (Debtor's Velocity)
2 A. Debtor's Collection Period Ratio
3. Creditor's Turnover Ratio or Payable Turnover Ratio (Creditor's Velocity)
3 A. Debt Payment Period Ratio
Ratio Analysis 261

4. Working Capital Turnover Ratio

5. Fixed Assets Turnover Ratio
6. Capital Turnover Ratio.
(1) Stock Thrnover Ratio
This ratio is also called as Inventory Ratio or Stock Velocity Ratio.
Inventory means stock of raw materials, working in progress and finished goods. This ratio is used to
measure whether the investment in stock in trade is effectively utilized or not. It reveals the relationship
between sales and cost of goods sold or average inventory at cost price or average inventory at selling
price. Stock Turnover Ratio indicates the number of times the stock has been turned over in business
during a particular period. While using this ratio, care must be taken regarding season and condition. price
trend. supply condition etc. In order to compute this ratio, the following formulae are used :

Cost of Goods Sold

(1) Stock Turnover Ratio = Average Inventory at Cost
Cost of Goods Sold = Opening Stock + Purchases + Direct
Expenses - Closing Stock
(or)
= Total Cost of Production + Opening Stock
of Finished Goods - Closing Stock of Finished
Goods
Total Cost of Production = Cost of Raw Material Consumed
+ Wages + Factory Cost
(or)
= Sales - Gross Profit
Opening Stock + Closing Stock
Average Stock = 2
Net Sales
. (2) Stock Turnover Ratio = Average Inventory at Cost
Net Sales
(3) Stock Turnover Ratio = Average Inventory at Selling Price
Net Sales
(4) Stock Turnover Ratio =
Inventory
The above said formulas can be used on the basis of the information given in the illustration.
Advantages
(1) This ratio indicates whether investment in stock in trade is efficiently used or not.
(2) This ratio is widely used as a measure of investment in stock is within proper limit or not.
(3) This ratio highlights the operational efficiency of the business concern.
(4) This ratio is helpful in evaluating the stock utilization.
262 A Textbook of Financia1 Cost and Management Accounting

(5) It measures the relationship between the sales and the stock in trade.
(6) This ratio indicates the number of times the inventories have been turned over in business
during a particular period.
Illustration: 21
From the following information calculate stock turnover ,ratio:
Gross Sales Rs. 5,00,000
Sales Return Rs. 25,000
Opening Stock Rs. 70,000
Closing Stock at Cost Rs. 85,000
Purchase Rs. 3,00,000
Direct Expenses Rs. 1,00.000
Solution:

Cost of Goods Sold

Inventory Turnover Ratio =
Average Inventory at Cost
Cost of Goods Sold = Opening Stock + Purchases + Direct Expenses
- Closing Stock
Rs. 70,000 + 3,00,000 + 1,00,000 - 85,000
= Rs. 3,85,000
Opening Stock + Closing Stock
Average Stock =
2
70,000 + 85,000
= =Rs. 77,500
2
3,85,000
Inventory Turnover Ratio = 77,500
= 4.97 times

Illustration: 22
The following figures are extract from the Trading Account of X Ale, you are required to calculate
stock Turnover Ratio :
Opening Stock Rs. 30,000
Purchases Rs. 1,10,000
Direct Expenses Rs. 10,000
Gross Profit Rs. 75,000
Gross Sales Rs. 2,20,000
Sales Return Rs. 10,000
Closing Stock at Cost Rs. 15,000
Solution:

Cost of Goods Sold

Stock Turnover Ratio =
Average Inventory at Cost
Cost of Goods Sold Opening Stock + Purchases
+ Direct Expenses - Closing Stock
Rs. 30,000 + 1,10,000 + 10,000 - 15,000
Rs. 1,35,000
Ratio Analysis 263

Alternatively
Cost of Goods Sold = Sales - Gross Profit
Net Sales = Sales - Sales Return
= Rs. 2,20,000 - 10,000 = Rs. 2,10,000
Cost of Goods Sold = =
Rs. 2,10,000 - 75,000 Rs. 1,35,000
Opening Stock + Closing Stock
Average Inventory =
2
30,000 + 15,000 45,000
= 2
=
2
Rs.22,500
1,35,000
Stock Turnover Ratio = =6 times
22,500

Alternatively

Net Sales
Stock Turnover Ratio = Average Inventory at Cost
2,10,000
= 22,500
= 9.33 times
(2) Debtor's Turnover Ratio
Debtor's Turnover Ratio is also termed as Receivable Turnover Ratio or Debtor's Velocity.
Receivables and Debtors represent the uncollected portion of credit sales. Debtor's Velocity indicates the
number of times the receivables are turned over in business during a particular period. In other words, it
represents how quickly the debtors are converted into cash. It is used to measure the liquidity position of a
concern. This ratio establishes the relationship between receivables and sales. Two kinds of ratios can be
used to judge a firm's liquidity position on the basis of efficiency of credit collection and credit policy.
They are (A) Debtor's Turnover Ratio and (B) Debt Collection Period. These ratios may be computed as :

Net Credit Sales

(1) Debtor's Turnover Ratio =
Average Receivables
or
Average Accounts Receivable
Net Credit Sales = Total Sales - (Cash Sales + Sales Return)
Accounts Receivable = Sundry Debtors or Trade Debtors
+ Bills Receivable
Opening Receivable + Closing Receivable
Average Accounts Receivable =
2
It is to be noted that opening and closing receivable and credit sales are not available, the ratio may
be calculated as
Total Sales
Debtor's Turnover Ratio =
Accounts Receivable
264 A Textbook of Financial Cost and Management Accounting

Illustration: 23
Calculate Debtor's Turnover Ratio, from the following data:
Rs.
Sundry Debtors as on 1.1.2003 70,000
Sundry Debtors as on 31.12.2003 90,000
Bills Receivable as on 1.1.2003 20,000
Bills Receivable as on 31.12.2003 30,000
Total Sales for the year 2003 7,00,000
Sales Return 20,000
Cash sales for the year 2003 1,00,000

Solution:
Net Credit Sales
Debtor's Turnover Ratio =
Average Account Receivable
Net Credit Sales = Total Sales - (Cash Sales + Sales Return)
= Rs. 7,00,000 - (1,00,000 + 20,(00)
= Rs. 5,80,000
Opening Receivable + Closing Receivable
Average Accounts Receivable =
2
(70,000 + 20,(00) + (90,000 + 30,(00)
2
90,000 + 1,20,000 2,lO,OOO
=
2
= 2
= Rs. 1,05,000
5,80,000
Debtors Turnover Ratio =
1,05,000
= 5.52 times
2 (A) Debt Collection Period Ratio
This ratio indicates the efficiency of the debt collection period and the extent to which the debt have
been converted into cash. This ratio is complementary to the Debtor Turnover Ratio. It is very helpful to the
management because it represents the average debt collection period. The ratio can be calculated as follows:

Months (or)Days in a year

(a) Debt Collection Period Ratio =
Debtor's Turnover
(or)
Average Accounts Receivable x
Months (or) Days in a year
(b) Debt Collection Period Ratio =
Net Credit Sales for the year

Advantages of Debtor's Turnover Ratio

(1) This ratio indicates the efficiency of firm's credit collection and efficiency of credit policy.
(2) This ratio measures the quality of receivable, i.e., debtors.
Ratio Analysis 265

(3) It enables a firm to judge the adequacy of the liquidity position of a concern.
(4) This ratio highlights the probability of bad debts lurking in the trade debtors.
(5) This ratio measures the number of times the receivables are turned over in business during a
particular period.
(6) It points out the liquidity of trade debtors, i.e., higher turnover ratio and shorter debt collection
period indicate prompt payment by debtors. Similarly, low turnover ratio and higher collection
period implies that payment by trade debtors are delayed :
Illustration: 24
From the following information calculate:
(a) Debtor's Turnover Ratio and (b) Debt Collection Period Ratio.
Total Sales Rs. 1,00,000
Cash Sales Rs. 25,000
Sales Return Rs. 5,000
Opening Accounts Receivable Rs. 10,000
Closing Accounts Receivable Rs. 15,000
Solution:
Net Credit Sales
(a) Debtor's Turnover Ratio = Average Receivables
Net Credit Sales = Total Sales - (Cash Sales + Sales Return)
= Rs. 1,00,000 - (25,000 + 5,000)
= Rs.70,000
Opening Receivables + Closing Receivables
Average Receivables = 2
10,000 + 15,000 25,000
= 2
=
2
= Rs. 12,500

70,000
Debtor's Turnover Ratio = =5.6 times
12,500
Month (or) Days in a year
(b) Debt Collection Period Ratio =
Debtor's Turnover
12
= 5.6
= 2.14 months
Alternatively
Average Accounts Receivable x
Months in a year
Debt Collection Period Ratio = Net Credit Sales for the year
12,500 x 12
=
70,000
= 2.14 months
266 A Textbook of Financial Cost and Management Accounting

Illustration: 25
From the following profit and loss Account and balance sheet relating to Ramesh Company
presented as on 31 st March, 2003 :
Dr. Profit and Loss Ac<;ount Cr.
Particulars Rs. Particulars Rs. Rs.
To Opening Stock 3,000 By Gross Sales Rs. 2,00,000
To Purchase 1,20,000 Less: Sales Return Rs.5,OOO 1,95,000
To Wages (Direct) 7,000 By Closing Stock 5,000
To Gross Profit cld 70,000
2,00,000 2,00,000
To Administrative Expn. 15,000 By Gross Profit bId 70,000
To Selling and } By Dividend Received 10,000
Distribution expenses 20,000
To Loss on sale of }
Fixed Assets 5,000
To Net Profit 40,000
80,000 80,000

Balance Sheet as on 31st March 2002

Liabilities Rs. Assets Rs.
Equity Share Capital 5,00,000 Land 1,50.000
(5000 Equity Shares of 100 each) Building 2,00,000
General Reserve 50,000 Plant & Machinery 2,00,000
Profit and Loss Alc 70,000 Stock 80,000
Sundry Creditors 80,000 Debtors 50,000
Bank Balance 20,000
7,00,000 7,00,000

From the above information you are required to calculate:

(1) Gross Profit Ratio.
(2) Operating Ratio.
(3) Operating Profit Ratio.
(4) Net·Profit to Capital Employed Ratio.
(5) Current Ratio.
(6) Liquid Ratio.
(7) Stock Turnover Ratio.
(8) Debtor's Turnover Ratio.
(9) Debt Collection Period Ratio.
Solution:

Gross Profit
(1) Gross Profit Ratio ::; x 100
Net Sales
70,000
= x 100
1,95,000
= 35.89%
Ratio Analysis 267

Operating Cost
(2) Operating Ratio = Net Sales
x 100

Operating Cost = Cost of goods sold + Administrative

Expenses + Selling and distribution Expenses
Cost of Goods Sold = Opening Stock + Purchases + Direct Wages
- Closing Stock
= Rs. 3,000 + 1,20,000 -+ 7,000 - 5,000
= Rs. 1,30,000 - 5,000 = Rs.l,25,OOO
Operating Cost = Rs. 1,25,000 + 15,000 + 20,000
= Rs. 1,60,000
1,60,000
Operating Ratio = x 100 = 82.05%
1,95,000
Operating Profit
(3) Operating Profit Ratio = Net Sales
x 100

Operating Profit = Net Sales - Total Operating Cost

= Rs. 1,95,000 - 1,60,000 =Rs. 35,000
35,000
Operating Profit Ratio = 1,95,000
x 100

= 17.94%
Net Profit
(4) Net Profit TO -Capital Employed Ratio = Capital Employed
x 100

Capital Employed = Share Capital + General Reserve

+ Profit and Loss Nc
= Rs. 5,00,000 + 50,000 + 70,000
= Rs. 6,20,000
40,000
Net Profit to Capital Employed Ratio = 6,20,000
x 100

= 6.45 %
Current Assets
(5) Current Ratio = Current Liabilities
Current Assets = Stock + Debtors + Bank Balances
= Rs. 80,000 + 50,000 + 20,000
= Rs. 1,50,000
1,50,000
Current Ratio = = 1.88 (or) 1.88 :1
80,000
Liquid Assets
(6) Liquid Ratio =
Current Liabilities
Liquid Assets = Current Assets - Stock and Prepaid Expenses
= Rs. 1,50,000 - 80,000
= Rs.70,000
70,000
Liquid Ratio = ---
80,000
= 87.5 (or) 87.5 : 1
268 A Textbook of Financial Cost and Management Accounting

Cost of Goods Sold

(7) Stock Turnover Ratio = Average Inventory
Opening Stock + Closing Stock
Average Inventory = 2
3,000 + 5,000
=
2
= Rs.4,000
1,25,000
Stock Turnover Inventory = 4,000
= 31.25 times

Alternatively
•
Net Sales
Stock Turnover Ratio = Average Inventory
1,95,000
= =48.75 times
4,000
Net Credit Sales
(8) Debtor's Turnover Ratio = Average Receivables
It is to be noted that credit sales, opening and closing receivables are not given in the problem, the ratio may be
calculated as :
Total Sales
Debtor's Turnover Ratio = Accounts Receivable
1,95,000
= 50,000
= 3.9 times
Month or Days in II year
(9) Debt Collection Period Ratio =
Debtor's Turnover

365 days
= = 93.58 days
3.9
(or)
12 months
= 3.9
= 3.07 months
(3) Creditor's Thrnover Ratio
Creditor's Turnover Ratio is also called as Payable Turnover Ratio or Creditor's Velocity. The credit
purchases are recorded in the accounts of the buying companies as Creditors to Accounts Payable. The
Term Accounts Payable or Trade Creditors include sundry creditors and bills payable. This ratio
establishes the relationship between the net credit purchases and the average trade creditors. Creditor's
velocity ratio indicates the number of times with which the payment is made to the supplier in respect of
Ratio Analysis 269
credit purchases. Two kinds of ratios can be used for measuring the efficiency of payable of a business
concern relating to credit purchases. They are: (1) Creditor's Turnover Ratio (2) Creditor's Payment Period
or Average Payment Period. The ratios can be calculated by the following formulas:

Net Credit Purchases

(1) Creditor's Turnover Ratio =
Average Accounts Payable
Net Credit Purchases = Total Purchases - Cash Purchases
Opening Payable + Closing Payable
Average Accounts Payable =
2
Month (or) Days in a year
(2) Average Payment Period =
Creditors Turnover Ratio
(or)
Average Trade Creditors
= Net Credit Purchases
x 365

Significance: A high Creditor's Turnover Ratio signifies that the creditors are being paid promptly. A
lower ratio indicates that the payment of creditors are not paid in time. Also, high average payment period
highlight the unusual delay in payment and it affect the creditworthiness of the firm. A low average payment
period indicates enhancing the creditworthiness of the company.
Illustration: 26
From the following information calculate (1) Creditor's Turnover Ratio and (2) Average Payment
Period
Rs.
Total Purchase 3,00,000
Cash Purchases 1,75,000
Purchase Return 25,000
Sundry Creditors 1.1.2003 30,000
Sundry Creditors 31.12.2003 15,000
Bills Payable 1.1.2003 7,000
Bills Payable 31.12.2003 8,000

Solution:

Net Credit Purchases

(1) Creditor's Turnover Ratio = Average Accounts Payables
Net Credit Purchases = Total Purchases - (Cash Purchases + Purchase Return)
= Rs. 3,00,000 - (1,75,000 + 25,000)
= Rs. 1,00,000
Opening payable + Closing payable
Average Accounts Payable = 2
(30,000 + 7,000) + (15,000 + 8000)
= 2
270 A Textbook of Financial Cost and Management Accounting

60,000
= = Rs. 30,000
2
1,00,000
Creditor's Turnover Ratio = = 3.33 times
30,000
Month or Days in a year
(2) Average Payment Period =
Creditor's Turnover Ratio
12 months
= = 3.60 months
3.33
(or)
365 days
= =109.61 days
3.33
Alternatively
Average Trade Creditors
Average Payment Period = x 365
Net Credit Purchases
30,000
x 365
1,00,000
= 109.5 days
(4) Working Capital Thrnover Ratio
This ratio highlights the effective utilization of working capital with regard to sales. This ratio
represent the firm's liquidity position. It establishes relationship between cost of sales and networking
capital. This ratio is calculated as follows :
Net Sales
Working Capital Turnover Ratio =
Working Capital
Net Sales = Gross Sales - Sales Return
Work Capital = Current Assets - Current Liabilities
Significance: It is an index to know whether the working capital has been effectively utilized or not in
making sales. A higher working capital turnover ratio indicates efficient utilization of working capital, i.e., a
firm can repay its fixed liabilities out of its working capital. Also, a lower working capital turnover ratio shows
that the firm has to face the shortage of working capital to meet its day-to-day business activities unsatisfactorily.
Illustration: 27
Calculate Working Capital Turnover Ratio :
Current Assets Rs. 3,20,000
Current Liabilities Rs. 1,10,000
Gross Sales Rs. 4,00,000
Sales Return Rs. 20,000
Ratio Analysis 271

Solution:

Net Sales
Working Capital Turnover Ratio = Working Capital
Net Sales = Gross Sales - Sales Return
Working Capital = Rs. 4,00,000 - 20,000
Rs. 3,80,000
Working Capital = Current Assets - Current Liabilities
= Rs. 3,20,000 - 1,10,000
= Rs. 2,10,000
3,80,000
Working Capital Turnover Ratio =
2,10,000
= 1.80 times
IIIustration: 28
The following information is given about MIs Gowda Ltd. for the year ending Dec. 31't 2003 :
(a) Share Capital Rs. 8,40,000
(b) Bank Overdraft Rs. 50,000
(c) Working Capital Rs. 2,52,000
(d) Current Ratio = 2.5 :1
(e) Quick Ratio = 1.5 : 1
(t) Gross Profit Ratio = 20 % on sales
(g) Stock Turnover Ratio = 5 times
(h) Sales for 2003 Rs. 5,00,000
(i) Trade Debtors Rs. 70,000
(j) Opening Creditors Rs. 40,000
(k) Closing Creditors Rs. 30,000
(I) Closing Stock is Rs. 20,000 higher than the opening stock
Find Out
(a) Current Assets and Current Liabilities.
(b) Cost of goods sold, Average stock and Purchases.
(c) Creditor's Turnover Ratio.
(d) Creditor's Payment Period.
(e) Debtor's Turnover Period.
(t) Debtor's Collection Period.
(g) Working Capital Turnover Ratio.

Solution:
(a) Current Assets and Current Liabilities:
Working Capital = Current Assets - Current Liabilities
.. Rs. 2,52,000 = 2.5 - 1
1.5 = Rs. 2,52,000
2,52,000
1.5
= Rs. 1,68,000
Therefore
Current Assets = Rs. 1.68,000 x 2.5 = Rs. 4,20,000
Current Liabilities = Rs. 1,68.000 x 1 = Rs. 1,68,000
272 A Textbook of Financial Cost and Management Accounting

(b) Cost of goods sold, Average Stock and Purchases:

Cost of Goods Sold = Sales - Gross Profit
= Rs. 5,00,000 - 20 % on sales
= Rs. 5,00,000 - 1,00,000
= Rs. 4,00,000
Average Stock
Cost of Goods Sold
Stock Turnover Ratio
Average Stock
4,00,000
5 times =
Average Stock
4,00,000
Average Stock =
5
= Rs.80,000
Purchases
Cost of Goods Sold = Opening Stock + Purchases - Closing Stock
Purchases Cost of Goods Sold + Closing Stock
- Opening Stock
Opening Stock + Closing Stock
Average Stock =
2

Since closing stock is Rs. 20,000 higher than the opening stock

Opening Stock + ( Rs.20,000 + Opening Stock)

Rs.80,000 =
2
Rs. 1,60,000 = 2 Opening Stock + Rs.20,000
1,60,000 - 20,000 1,40,000
Opening Stock
2 2
= Rs.70,000
Closing Stock Rs. 70,000 + Rs. 20,000 = Rs. 90,000
Purchases = Rs. 4,00,000 + 90,000 - 70,000 = Rs. 4,20,000

(c) Creditor's Thrnover Ratio

Net Credit Purchases
Creditor's Turnover Ratio =
Average Trade Creditors
All Purchases taken as credit purchases
Opening Creditors + Closing Creditors
Average Trade Creditors =
2

Rs. 40,000 + Rs. 30,000

Average Trade Creditors =
2
Rs.70,000
=
2
= Rs.35,000
Ratio Analysis 273

(d) Creditor's Payment Period

Month or Days in a year
Creditor's Payment Period =
Creditor's Turnover Ratio

12 months
=
12
= 1 month
Alternatively
Average Trade Creditor's x No. of Working Days
Creditor's Payment Period =
Net Credit Purchases

35,000 x 365
= 4,20,000
= 30.41 days

(e) Debtor's Thrnover Ratio

Net Credit Sales
Debtor's Turnover Ratio =
Average Trade Debtor's

It is to be noted that credit sales, opening and closing receivables are not given in the problem, so the ratio may
be calculated as :
Total Sales
Debtor's Turnover Ratio =
Accounts Receivable or Trade Debtor's

Rs. 5,00,000
=
Rs. 70,000
= 7.14 times
(f) Debtors Collection Period
Month or Days in a year
Debtor's Collection Period =
Debtor's Turnover Ratio
12 months
= 7.14
= 1.68 months
Alternatively
Average Trade Debtors x No. of Working Days
Debtor's Collection Period =
Net Annual Sales

70,000 x 365
=
5,00,000
= 51.1 days
274 A Textbook of Financial Cost and Management Accounting
(g) Working Capital Thrnover Ratio
Cost of Goods Sold
Working Capital Turnover = Net Working Capital
Ratio
Rs. 4.00.000
=
Rs. 2.50,000
= 1.6 times
(5) Fixed Assets Thrnover Ratio
This ratio indicates the efficiency of assets management. Fixed Assets Turnover Ratio is used to
measure the utilization of fixed assets. This ratio establishes the relationship between cost of goods sold
and total fixed assets. Higher the ratio highlights a firm has successfully utilized the fixed assets. If the
ratio is depressed, it indicates the under utilization of fixed assets. The ratio may also be calculated as:

Cost of Goods Sold

Fixed Assets Turnover Ratio =
Total Fixed Assets
(or)
Sales
= Net Fixed Assets

Components of Fixed Assets (or) Non-Current Assets

(1) Goodwill
(2) Land and Building
(3) Plant and Machinery
(4) Furniture and Fittings
(5) Trade Mark
(6) Patent Rights and Livestock
(7) Long-Term Investment
(8) Debt Balance of Profit and Loss Account
(9) Discount on Issue of Shares
(10) Discount on Issue of Debenture
(11) Preliminary Expenses
(12) Other Deferred Expenses
(14) Government or Trust Securities
(15) Any other immovable Prosperities
Ratio Analysis 275

Illustration: 29
Find out Fixed Assets Turnover Ratio from the following information :
Total Fixed Assets = Rs. 6,00,000
Gross Profit = 20 % on sales
Net Sales = Rs. 8,00,000
Debenture = Rs. 2,00,000
Share Capital = Rs. 3,00,000

Solution:

Cost of Goods Sold

Fixed Asset Turnover Ratio =
Total Fixed Assets
Cost of Goods Sold = Sales - Gross Profit
= Rs. 8,00,000 - 20 % on sales
= Rs. 8,00,000 - 1,60,000 = Rs. 6,40,000
Rs. 6,40,000
Fixed Assets Turnover Ratio = Rs. 6,00,000
= 1.06 times
Alternatively
Sales
Fixed Assets Turnover Ratio =
Net Fixed Assets
Rs. 8,00,000
=
Rs. 6,00,000
= 1.33 times
Illustration: 30
From the following information find out Fixed Assets Turnover Ratio :
Opening Stock Rs. 40,000
Purchases Rs. 3,00,000
Closing Stock Rs. 60,000
Sales Rs. 5,00,000
Total Fixed Assets Rs. 6,25,000
Depreciation Rs. 25,000

Solution:

Cost of Goods Sold

Fixed Assets Turnover Ratio =
Total Fixed Assets
Cost of goods sold = Opening Stock + Purchases - Closing Stock
= Rs. 40,000 + 3,00,000 - 60,000
= Rs. 2,80,000
2,80,000
Fixed Assets Turnover Ratio = 6,25,000
= 0.448 times
276 A Textbook of Financial Cost and Management Accounting

Alternatively
Sales
Fixed Assets Turnover Ratio = Net Fixed Assets
Net Fixed Assets = Total Fixed Assets - Depreciation
= =
Rs. 6,25,000 - 25,000 Rs. 6,00,000
5,00,000
Fixed Assets Turnover Ratio =
6,00,000
= 0.83 times
Illustration: 31
Find out Fixed Assets Gross Profit and Cost of Sales from the following information :
Sales Rs. 5,00,000
Gross Profit Ratio 20 %
Fixed Assets Turnover Ratio (on cost of sales) 4 times

Solution:
Gross Profit = Sales x Gross Profit Ratio
= Rs. 5,00,000 x 20 %
20
= 5,00,000 x
100
= Rs. 1,00,000
Cost of Sales = Sales - Gross Profit
= Rs. 5,00,000 - 1,00 000 =Rs. 4,00,000
Cost of Sales
Fixed Assets Turnover = Fixed Assets
Rs. 4,00,000
4 = Fixed Assets
4,00,000
Fixed Assets = =Rs. 1,00,000
4

(6) Capital Turnover Ratio

This ratio measures the efficiency of capital utilization in the business. This ratio establishes the
relationship between cost of sales or sales and capital employed or shareholders' fund. This ratio may illso
be calculated as :

Cost of Sale~ Sales

(1) Capital Turnover Ratio = Capital Employed
(or)
C!lpital Employed
Capital Employed = Shareholders' Funds + Long-Term Loans
(or)
= Total Assets - Current Liabilities
Cost of Sales Sales
(2) Capital Turnover Ratio = Shareholders' Fund
(or)
Shareholders' Fund
Ratio Analysis 277
Components of Capital Employed (Shareholders' Fund + Long-Term Loans)
(1) Equity Share Capital
(2) Preference Share Capital
(3) Debentures
(4) Long-Tenn Loans
(5) Share Premium
(6) Credit Balance of Profit and Loss Account
(7) Capital Reserve
(8) General Reserve
(9) Provisions
(10) Appropriation of Profits
Illustration: 32
From the following infonnation find out (a) Cost of Sales (b) Capital Employed and (c) Capital
Turnover Ratio.
Rs.
Total Assets 10,00,000
Bills Payable 1,50,000
Sundry Creditors 75,000
Opening Stock 50,000
Purchases 3,00,000
Closing Stock 60,000

Solution:
(a) Cost of Sales = Opening Stock + Purchases - Closing Stock
= Rs. 5,00,000 + 4,00,000 - 60,000
= Rs. 3,90,000
(b) Capital Employed = Total Assets - Current Liabilities
= Rs. 10,00,000 - 2,25,000 = Rs. 7,75,000
Cost of Sales
(3) Capital Turnover Ratio = Capital Employed
3,90,000
=
7,75,000
= 0.50 times
Illustration: 33
Equity Share Capital Rs. 3,00,000
General Reserve Rs. 50,000
Preference Share Capital Rs. 2,00,000
Long-Term Loans Rs. 1,50,000
Profit and Loss Account Rs. 70,000
(Credit Balance)
Total Sales Rs. 10,00,000
Gross Profit Rs. 80,000
From the above information find out Capital Turnover Ratio
278 A Textbook of Financial Cost and Management Accounting

Solution:

Sales
Capital Turnover Ratio
Capital Employed
Capital Employed Shareholder fund + Long-Term Loans
= Equity Share Capital + General Reserve
+ Preference Share Capital + Long-Term Loans
+ Credit Balance of P & L Alc
Rs. 3,00,000 + 50,000 + 2,00,000 + 1,50,000 + 70,000
= Rs. 7,70,000
10,00,000
Capital Turnover Ratio =
7,70,000
1.29 times

Alternatively

Cost of Sales
Capital Turnover Ratio =
Capital Employed
Cost of Sales = Sales - Gross Profit
Rs. 10,00,000 - Rs. 80,000
Rs. 9,20,000
9,20,000
Capital Turnover Ratio
7,70,000
1.19 times

IV. SOLVENCY RATIOS

The term 'Solvency' generally refers to the capacity of the business to meet its short-term and long-
term obligations. Short-term obligations include creditors, bank loans and bills payable etc. Long-term
obligations consists of debenture, long-term loans and long-term creditors etc. Solvency Ratio indicates
the sound financial position of a concern to carryon its business smoothly and meet its all obligations.
Liquidity Ratios and Turnover Ratios concentrate on evaluating the short-term solvency of the concern
have already been explained. Now under this part of the chapter only the long-term solvency ratios are
dealt with. Some of the important ratios which are given below in order to determine the solvency of the
concern :
(1) Debt - Equity Ratio
(2) Proprietary Ratio
(3) Capital Gearing Ratio
(4) Debt Service Ratio or Interest Coverage Ratio
(1) Debt Equity Ratio

This ratio also termed as External - Internal Equity Ratio. This ratio is calculated to ascertain the
firm's obligations to creditors in relation to funds invested by the owners. The ideal Debt Equity Ratio is
1: 1. This ratio also indicates all external liabilities to owner recorded claims. It may be calculated as
Ratio Analysis 279

External Equities
(a) Debt - Equity Ratio = Internal Equities
(or)
Outsider's Funds
(b) Debt - Equity Ratio = Shareholders' Funds

The term External Equities refers to total outside liabilities and the term Internal Equities refers to all
claims of preference shareholders and equity shareholders' and reserve and surpluses.

Total Long-Term Dept

(c) Debt - Equity Ratio = Total Long-Term Funds
(or)
Total Long-Term Debt
(d) Debt - Equity Ratio = Shareholders' Funds

The term Total Long-Term Debt refers to outside debt including debenture and long-term loans raised
from banks.
Illustration: 34
From the following figures calculate Debt Equity Ratio :
Rs.
Preference Share Capital 1,50,000
Equity Share Capital 5,50,000
Capital Reserve 2,00,000
Profit and Loss Account 1,00,000
6 % Debenture 2,50,000
Sundry Creditors 1,20,000
Bills Payable 60,000
Provision for taxation 90,000
Outstanding Creditors 80,000
Solution:
External Equities
(a) Debt Equity Ratio = Internal Equities
External Equities = Debenture + Sundry Creditors
+ Bills Payable + Provision for taxation
+ Outstanding Creditors
= Rs. 2,50,000 + 1,20,000 + 60,000 + 90,000 + 80,000
= Rs.6,00,000
Internal Equities = Preference Share Capital + Equity Share Capital
+ Capital Reserve + Profit and Loss Alc
= Rs. 1,50,000 + 5,50,000 + 2,00,000 + 1,00.000
= Rs. 10,00,000
280 A Textbook of Financial Cost and Management Accounting

6,00,000
Debt Equity Ratio = 10,00,000
= 0.6 (or) 3 : 5

Total Long-Term Debt

(b) Dept Equity Ratio = Shareholders' Funds
Total Long-Term Debt = Rs. 2,50,000
Shareholders' Fund = Rs. 10,00,000
Rs. 2,50,000
Debt-Equity Ratio = Rs. 10,00,000
= 0.25
Total Long-term Debt
(c) Debt Equity Ratio ==
Total Long-term Funds
2,50,000
=
12,50,000
= 0.2
Outsider's Fund
(d) Debt Equity Ratio =
Shareholders' Fund
Outsider's Fund = Total Outside Liabilities
= Rs. 6,00, 000
6,00,000
Debt Equity Ratio =
10,00,000
= 0.6 (or) 3 : 5
Significance: This ratio indicates the proportion of owner's stake in the [Link]. Excessive liabilities
tend to cause insolvency. This ratio also tell the extent to which the firm depends upon outsiders for its existence.
(2) Proprietary Ratio
Proprietary Ratio is also known as Capital Ratio or Net Worth to Total Asset Ratio. This is one of the
variant of Debt-Equity Ratio. The term proprietary fund is called Net Worth. This ratio shows the
relationship between shareholders' fund and total assets. It may be calculated as :

Shareholders' Fund
Proprietary Ratio = Total Assets
Shareholders' Fund = Preference Share Capital + Equity Share Capital
+ All Reserves and Surplus
Total Assets = Tangible Assets + Non-Tangible Assets
+ Current Assets (or) All Assets including Goodwill
Significance : This ratio used to determine the financial stability of the concern in general.
Proprietary Ratio indicates the share of owners in the total assets of the company. It serves as an indicator
to the ~reditors who can find out the proportion of shareholders' funds in the total assets employed in the
business. A higher proprietary ratio indicates relatively little secure position in the event of solvency of a
concern. A lower ratio indicates greater risk to the creditors. A ratio below 0.5 is alarming for the creditors.
Ratio Analysis 281

Illustration: 35
From the following infonnations calculate the Proprietary Ratio :
Rs.
Preference Share Capital 2,00,000
Equity Share Capital 4,00,000
Capital Reserve 50,000
Profit and Loss Account 50,000
9% Debenture 2,00,000
Sundry Creditors 50,000
Bills Payable 50,000
Land and Building 2,00,000
Plant and Machinery 2,00,000
Goodwill 1,00,000
Investments 3,00,000
Solution:
Shareholders' Fund
Proprietary Ratio =
Total Assets
Shareholders' Fund = Preference Share Capital + Equity Share Capital
+ Capital Reserve + Profit and Loss Accol,lnt
= Rs. 2,00, 000 + 4,00,000 + 50,000 + 50,000
Rs.7,OO,OOO
Total Assets = Land and Building + Plant and Machinery
+ Goodwill + Investments
= Rs. 2,00,000 + 2,00,000 + 1,00,000 + 3,00,000
= Rs. 8,00,000
7,00,000
Proprietary Ratio =
8,00,000
= 87.5% (or) 0.87
(3) Capital Gearing Ratio
This ratio also called as Capitalization or Leverage Ratio. This is one of the Solvency Ratios. The
tenn capital gearing refers to describe the relationship between fixed interest and/or fixed dividend bearing
securities and the equity shareholders' fund. It can be calculated as shown below:

Equity Share Capital

Capital Gearing Ratio =
Fixed Interest Bearing Funds
Equity Share Capital = Equity Share Capital + Reserves and Surplus
Fixed Interest Bearing Funds = Debentures + Preference Share Capital
+ Other Long-Tenn Loans
A high capital gearing ratio indicates a company is having large funds bearing fixed interest and/or
fixed dividend as compared to equity share capital. A low capital gearing ratio represents preference share
capital and other fixed interest bearing loans are less than equity share capital.
282 A Textbook of Financial Cost and Management Accounting

Illustration: 36
From the following information, you are requited to find out Capital Gearing Ratio
Rs.
Preference Share Capital 5,00,000
Equity Share Capital 6,00,000
Capital Reserve 3,00,000
Profit and Loss Account 1,00,000
12% Debenture 3,00,000
Secured loan 1,00,000

Solution:

Equity Share Capital

Capital Gearing Ratio = Fixed Interest Bearing Funds
Equity Share Capital = Equity Share Capital + Capital Reserve
+ Profit and Loss Account
= Rs. 6,00,000 + 3,00,000 + 1,00,000
= Rs. 10,00,000
Fixed Interest Bearing Funds = Debenture + Preference Share Capital
+ Secured Loans
= Rs. 3,00,000 + 5,00,000 + 1,00,000
= Rs. 9,00,000
10,00,000
Capital Gearing Ratio ;::
9,00,000
= 10 : 9 (Low Gear)
(4) Debt Service Ratio
Debt Service Ratio is also termed as Interest Coverage Ratio or Fixed Charges Cover Ratio. This
ratio establishes the relationship between the amount of net profit before deduction of interest and tax and
the fixed interest charges. It is used as a yardstick for the lenders to know the business concern will be able
to pay its interest periodically. Debt Service Ratio is calculated with the help of the following formula :

Net Profit before Interest and Income Tax

Interest Coverage Ratio = Fixed Interest Charges
x 100

Illustration: 37
Calculate Interest Coverage Ratio :
Profit before Interest :: Rs. 7,00,000
Income Tax Paid = Rs. 50,000
Interest On Debenture = Rs. 3,00,000
Interest on Long-Term Loan = Rs. 1,00,000
Solution:

Net Profit before Interest and Income Tax

Interest Coverage Ratio = Fixed Interest Charges
x 100

Net Profit before Interest }

and Taxes = Rs. 7,00,000 + 50,000
= Rs. 7,50,000
Ratio Analysis 283

Fixed Interest Charges = Rs. 3,00,000 + 1,00,000

= Rs. 4,00,000
7,50,000
Interest Coverage Ratio = 4,00,000
x 100

= 187.5 % (or) 1.87 :1

Significance: Higher the ratio the more secure the debentureholders and other lenders would be with
respect to their periodical interest income. In other words, better is the position of long-term creditors and the
company's risk is lesser. A lower ratio indicates that the company is not in a position to pay the interest but
also to repay the principal loan on time.
V. OVERALL PROFITABILITY RATIO
This ratio used to measure the overall profitability of a firm on the extent of operating efficiency it
enjoys. This ratio establishes the relationship between profitability on sales and the profitability on
investment turnover. Overall all Profitability Ratio may be calculated in the following ways:

Net Profit Sales

Overall Profitability Ratio = Sales
x
Total Assets

DU Pont Control Chart (or) DU Pont Analysis

ROI indicates the efficiency of the concern which depends upon the working operations of the
concern. Net Profit Ratio and Capital Turnover Ratio, as often called is usually computed on the basis of
the chart represented by DU Pont. Thus it is known as "DU Pont Chart." This system of control was
applied for the first time by DU Pont company of the United States of America. The DU Pont chart helps
to the management to identify the areas of problems for the variations in the return on investment so that
actions may initiated to improve the performance. The following chart can explain the ROI effect by a
number of factors.
Return on Investment (ROI)
Net Profit
[ Capital Employed
J
~
~
Net Profit Ratio Capital Turnover Ratio
(Net Profit/Sales) (Sales/Capital Employed)

k
1
Operating Ratio
~
Fixed Asset Turnover Ratio
~
Working Capital
(Operating Cost/Sales) (Sales / Fixed Assets) Turnover Ratio
(Sales/Working Capital)
1
Cost of Goods Sold
r
Office &
~
Selling and
Administrative Expenses Distribution Expenses
1
Working Capital
(Current Assets - Current Liabilities)