MEANING OF KEY TERMS USED IN THE CHAPTER
1. Ratio It is an arithmetical expression of relationship between two
interdependent or related items.
2. Accounting Ratio Accounting Ratio means ratio calculated on the basis of
accounting information.
3. Pure Ratio It is a ratio expressed as quotient. For example, 2 : 1.
4. Percentage It is a ratio expressed in percentage. For example, 25%.
5. Times It is a ratio expressed in number of times. For example, 3 Times.
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6. Fraction It is a ratio expressed as fraction. For example, or .75.
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7. Liquidity Ratios These ratios measure the ability of the enterprise to meet its
short-term financial commitments. These include: Current Ratio
and Quick Ratio/Liquid Ratio/Acid Test Ratio.
8. Solvency Ratios These ratios measure long-term financial position of the enterprise.
These include: Debt to Equity Ratio; Total Assets to Debt Ratio;
Proprietary Ratio; Interest Coverage Ratio and Debt to Capital
Employed Ratio.
9. Activity or Turnover Ratios These ratios measure efficiency in use of assets of the enterprise
in generating sales. These include: Inventory Turnover Ratio;
Trade Receivables Turnover Ratio; Trade Payables Turnover
Ratio, Working Capital Turnover Ratio; Fixed Assets Turnover
Ratio and Net Assets Turnover Ratio.
10. Profitability Ratios These ratios show the profitability of the enterprise. These include:
Gross Profit Ratio; Operating Ratio; Operating Profit Ratio;
Net Profit Ratio and Return on Investment (ROI).
C H A P T E R S U M M A RY
• Accounting Ratio is a mathematical expression of the relationship between two related or interdependent
items or group of items shown in the financial statements.
• Ratio Analysis is the process of computing, determining and presenting the relationship of related or
interdependent items or group of items in the financial statements. It is an important technique of financial
analysis.
• Objectives of Ratio Analysis
1. To assess the earning capacity, financial soundness and operating efficiency of an enterprise.
2. To simplify the accounting information.
3. To help in comparative analysis.
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• Uses of Ratio Analysis: Ratio Analysis is useful in:
1. Analysis of financial statements.
2. Assessing the profitability of the business.
3. Assessing the liquidity or short-term solvency of the business.
4. Assessing the long-term solvency of the business.
5. Assessing the operating efficiency of the business.
6. Intra-firm and inter-firm comparison.
7. Locating the weak areas of the business.
• Limitations of Ratio Analysis
1. Qualitative Factors are Ignored: Ratio analysis is a technique of quantitative analysis and thus, ignores
qualitative factors, which may be important in decision-making.
2. Lack of Standard Ratio: There is almost no single standard ratio against which the actual ratio may be
measured and compared.
3. False Results if Based on Incorrect Information: Conclusions drawn may be misleading if ratios are based
on incorrect accounting information.
4. May not be Comparable: Ratios may not be comparable if different firms follow different accounting
policies and procedures.
• Classification of Accounting Ratios
1. Liquidity Ratios: (i) Current Ratio; and (ii) Quick Ratio.
2. Solvency Ratios: (i) Debt to Equity Ratio; (ii) Proprietary Ratio; (iii) Total Assets to Debt Ratio;
(iv) Interest Coverage Ratio; and (v) Debt to Capital Employed Ratio.
3. Activity Ratios: (i) Inventory Turnover Ratio; (ii) Trade Receivables Turnover Ratio; (iii) Trade Payables
Turnover Ratio; (iv) Working Capital Turnover Ratio; (v) Fixed Assets Turnover
Ratio and (vi) Net Assets Turnover Ratio.
4. Profitability Ratios: (i) Gross Profit Ratio; (ii) Operating Ratio; (iii) Operating Profit Ratio; (iv) Net Profit
Ratio; and (v) Return on Investment.
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Table Showing Summary of Accounting Ratios
Ratio Significance How Expressed Remarks
I. LIQUIDITY RATIOS
1. Current Ratio This ratio shows short-term financial soundness of the Pure Ratio Current Assets = Current Investments + Inventories (Excluding Stores
Current Assets business. Higher ratio means better capacity to meet its and Spares and Loose Tools) + Trade Receivables
=
Current Liabilities current obligation. The ideal Current Ratio is 2 : 1. (Net of Provision for Doubtful Debts) + Cash and
Cash Equivalents + Short-term Loans and Advances
+ Other Current Assets + Short-term Investments.
Current Liabilities = Short-term Borrowings + Trade Payables + Other
Current Liabilities + Short-term Provisions.
2. Liquid Ratio/Acid Test Ratio/ Liquid Ratio is a fairly stringent measure of liquidity. It is Pure Ratio Quick Assets = Current Assets – Inventories – Prepaid Expenses.
Quick Ratio based on those current assets which are highly liquid, i.e., Current Liabilities have same meaning as in Current Ratio.
can be converted into Cash and Cash Equivalents quickly. Note: Inventories and prepaid expenses are not considered as
Liquid Assets or Quick Assets
= Quick Ratio of 1 : 1 is considered as ideal. Higher the Quick Quick Assets.
Current Liabilities
Ratio better the short-term financial position.
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II. SOLVENCY RATIOS
1. Debt to Equity Ratio This ratio assesses the long-term financial position and Pure Ratio Debt = Long-term Borrowings, (i.e., debentures, mortgage loans,
soundness of enterprises. In general, lower the Debt to public deposits) + Long-term Provisions.
Debt
= Equity Ratio higher the degree of protection enjoyed by
Equity (Shareholders’ Funds) Equity (Shareholders’ Funds) = Share Capital + Reserves and Surplus.
the lenders. Or
Non-current Assets (Property, Plant and Equipment + Intangible Assets
+ Non-current (Trade) Investments + Long-term Loans and Advances) +
Working Capital – Non-current Liabilities (Long-term Borrowings + Long-
term Provisions).
Working Capital = Current Assets – Current Liabilities.
2. Total Asset to Debt Ratio This ratio measures the safety margin available to lenders Pure Ratio, Total Assets = Non-current Assets (Property, Plant and Equipment +
Total Assets of long-term debts. It measures the extent to which debt e.g., 2 : 1 Intangible Assets + Non-current Investments + Long-term Loans and
=
Debt is being covered by assets. Advances) + Current Assets [Current Investments + Inventories (including
Loose Tools and Stores and Spares) + Trade Receivables + Cash and Cash
Equivalents + Short-term Loans and Advances + Other Current Assets].
Debt = Long-term Borrowings + Long-term Provisions.
3. Proprietary Ratio This ratio shows the extent to which total assets have been Pure Ratio or % Shareholders’ Funds = Share Capital + Reserves and Surplus.
Shareholders ’ Funds or financed by the proprietor. Higher the ratio, higher the
Proprietors ’ Funds or Equity Total Assets has the same meaning as in Total Assets to Debt Ratio.
safety margin for unsecured lenders and creditors.
=
Total Assets
4. Interest Coverage Ratio This ratio shows how many times the interest charges are Times Profit before Interest and Tax = Profit after Tax + Tax + Interest.
Profit before Interest and Tax covered by the profits available to pay interest. Higher the
Interest on Long-term Debt ratio, more security for the lender is in respect of payment
of interest regularly.
5. Debt to Capital Employed Ratio This ratio shows the amount of Long-term Debts in Capital Pure Ratio Debt means Long-term Debts, i.e., Non-current Liabilities.
Employed. Low ratio means more security to lenders and Capital Employed = Shareholders’ Funds + Long-term Debts.
Long-term Debt
= high ratio means lesser security to lenders.
Capital Employed
III. ACTIVITY RATIOS/TURNOVER RATIOS
1. Inventory Turnover Ratio This ratio measures how fast Inventory is moving and Times Average Inventory
Cost of Revenue from generating sales. Higher the ratio, more efficient Opening Inventory + Closing Inventory
management of inventories and vice versa. =
Operations 2
=
Average Inventory
2. Trade Receivables Turnover Ratio This ratio shows efficiency in the collection of amount due Times Trade Receivables means debtors plus bills receivable.
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Credit Revenue from from trade receivables. Higher the ratio, better it is since Provision for Doubtful Debts is not deducted.
Operations it indicates that debts are being collected more quickly. Average Trade Receivables
= (Opening Debtors + Opening Bills Receivable) +
Average Trade Receivables
(Closing Deb btors + Closing Bills Receivable)
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3. Trade Payables Turnover Ratio It shows the number of times the creditors are turned over Times Trade Payables means creditors plus bills payable.
Net Credit Purchases in relation to purchases. A high turnover ratio or shorter Average Trade Payables
= payment period shows the availability of less credit or
Average Trade Payables (Opening Creditors + Opening Bills Payable) +
early payments.
(Closing Creditors + Closing Bills Payable)
=
2
4. Working Capital Turnover Ratio This ratio shows the number of times working capital has Times Working Capital = Current Assets – Current Liabilities.
Revenue from Operations been employed in the process of carrying on business.
= Higher the ratio, better the efficiency in the utilisation of
Working Capital
working capital.
5. Fixed Assets Turnover Ratio This ratio shows the efficiency with which the fixed assets Times Revenue from Operations means Gross Revenue less Sales Return, if any.
Revenue from Operations have been used in earning revenue from operations In terms of sales, it means Gross Sales less Sales Return, i.e., Net Sales.
= during the year. A high ratio means efficient utilisation of Net Fixed Assets means Fixed Assets (Cost) – Depreciation.
Fixed Assets (Net)
fixed assets while low ratio means inefficient utilisation
of fixed assets.
6 Net Assets or Capital EmployedTurnover Ratio This ratio shows the number of times Net Assets or Times Revenue from operations means Gross Revenue less Sales Return. In terms of sales,
Capital Employed is rotated or used in generating it means Gross Sales less Sales Return.
Revenue from Operations
= Revenue from Operations. Higher turnover ratio means Net Assets = Total Assets – Current Liabilities.
Capital Employed better and efficient utilisation of net assets or capital
employed and thus, higher profitability & liquidity.
IV. PROFITABILITY RATIOS
1. Gross Profit Ratio This ratio indicates the relationship between gross % Gross Profit = Revenue from Operations – Cost of Revenue from Operations.
Gross Profit profit and revenue from operations (Net sales). Higher Cost of Revenue from Operations
= × 100 the Ratio, lower the cost of goods sold. = Opening Inventory (excluding Stores and Spares and Loose Tools) + Net Purchases
Revenue from Operations + Direct Expenses – Closing Inventory (excluding Stores and Spares and Loose
Tools). Or
Cost of Materials Consumed + Purchases of Stock-in-Trade + Changes in
Inventories of Finished Goods, WIP and Stock-in-Trade + Direct Expenses.
If direct expenses are not given, assume them to be nil.
2. Operating Ratio This ratio is calculated to assess the operational % Cost of Revenue from Operations
efficiency of the business. A decline in the operating = Opening Inventory (excluding Stores and Spares and Loose Tools) + Net Purchases
Cost of Revenue from Operations
ratio, is better because it means higher margin, and + Direct Expenses – Closing Inventory (excluding Stores and Spares and Loose Tools).
+ Operating Expenses
100 thus, more profit. Or
Revenue frrom Operations Cost of Materials Consumed + Purchases of Stock-in-Trade + Changes in
Or Inventories of Finished Goods, WIP and Stock-in-Trade + Direct Expenses.
Or
Operating Cost
×100 Revenue from Operations – Gross Profit.
Revenue from Operations
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If Direct Expenses are not given, assume them to be nil.
Operating Expenses = Employees Benefit Expenses + Depreciation and
Amortisation Expenses + Other Expenses (Other than
Non-operating Expenses).
Revenue from Operations = Sales –Sales Return.
3. Operating Profit Ratio The objective of computing this ratio is to determine % Operating Profit
Operating Profit the operational efficiency of management. = Net Profit (Before Tax) + Non-operating Expenses – Non-operating Income.
= ×100 Or
Revenue from Operations
= Gross Profit + Other Operating Income – Other Operating Expenses.
Non-operating Expenses = Interest on Long-term Borrowings + Loss on Sale of
Fixed Assets or Non-current Assets.
Non-operating Income = Interest received on investments + Gain (Profit) on Sale
of Fixed Assets or Non-current Assets.
4. Net Profit Ratio It indicates overall efficiency of the business. Higher % Net Profit after Tax = Gross Profit + Other Income – Indirect Expenses – Tax.
Net Profit after Tax the net profit ratio, better the business.
= ×100
Revenue from Operations
5. Return on Investment or Return on It assesses the overall performance of the enterprise. Capital Employed: Liabilities Side Approach: Share Capital + Reserves and Surplus
% + Long-term Borrowings + Long-term Provisions.
Capital Employed It measures how efficiently the resources entrusted to
Profit before Interest, the business are used. Assets Side Approach: Non-Current Assets + Working Capital.
Tax and Dividend Working Capital = Current Assets – Current Liabilities.
= ×100
0 (Assume that all Non-current Investments are Trade Investments)
Capital Employed
(Interest on Non-trade Investments should be deducted from Profit before Interest,
Tax and Dividend.)