Understanding Computation of Liquidity Ratios

1. Current Ratio
Meaning: Current ratio shows the relationship between current assets and current liabilities. It
is calculated by dividing current assets by current liabilities on a particular date.
Formula:
Current Assets
Current Ratio=
Current Liabilities

Factors: The two terms used to calculate the ratio have been explained as under :
(a) Current Assets: Current investments (investment/trade investments normally means long
term investment. Short term investments or marketable securities should be included in
current investments)
1. Inventories (Including Raw Material. Work in Progress and finished goods. Excluding
loose tools and stores & spares)
2. Trade receivables
• B/R
• Sundry Debtors
• Less: Provision for doubtful debts
3. Cash and cash equivalents
4. Short-term loans and advances
5. Other current assets
• Prepaid Expenses
• Accrued Income
• Advance Payment for Tax
(b) Current Liabilities:
1. Short-term borrowings (including Bank Overdraft, cash credits, short term loans from
bank)
2. Trade payables (Bills Payables and sundry creditors)
3. Other Current Liabilities
• Current maturities of long-term debt
• Interest accrued but not due on borrowings
• Interest accrued and due on borrowings
• Income received in advance
• Unpaid dividends
• Calls in advance
4. Short-term Provision.
• Provision for Tax
 • Employee Provision
• Proposed Dividend
Objective: The objective of calculating current ratio is to access the ability of the enterprise to
meet the short-term obligations promptly.
Significance: Current ratio of 2 : 1 is generally considered to be acceptable. If the current ratio
is more than 2 : 1, it is beneficial to the short-term creditors. High ratio indicates that funds have
not been used efficiently. If the current ratio is less than 2 : 1, it indicates lack of liquidity and
shortage of working capital.
Note: Working Capital = Current Assets — Current Liabilities
2. Quick Ratio or Liquid Ratio or Acid Test Ratio
Meaning: Quick ratio is the relationship between liquid assets and current liabilities. Quick
ratio is computed by dividing liquid assets (or quick assets) by current liabilities.
Formula:
Liquid Assets/Quick Assets
Quick Ratio∨Liquid Ratio∨ Acid Test Ratio=
Current Liabilities
Factors: The two items used to calculate the ratio have been discussed as under:
(a) Liquid Assets: The term liquid assets implies all Current Assets — Inventories
— Other Current Assets (i.e. Prepaid Expenses + Payment of Advance Tax)
(b) Current Liabilities: It has the same meaning as used in current ratio.
Objective: The objective of calculating quick ratio is to ascertain the short-term liquidity
position of the enterprise. As liquidity implies the ability to convert current assets into cash.
Significance: Generally, a quick ratio of 1 : 1 or more is considered to be good for the reason
that it indicates availability of funds to meet the liabilities 100%.

Understanding Computation of Solvency Ratios

1. Dent to Equity Ratio
Meaning: This ratio indicates the relationship between long-term debts and the equity (or
Shareholders' Funds). As such this ratio is worked out by dividing long-term debts by
shareholders' funds, it is usually expressed as a proportion.
Formula:
Debt Long−term Debts
Debt Equity Ratio= ∨
Equity Shareholde r ' s Funds

Factors: The two terms used to calculate the ratio have been explained as follows:
(a) Debt: Long-term Borrowings (i.e. Debentures/Bonds, Long-term Loans etc.) and Long-
term Provisions (i.e. Provision for employee benefits, Provision for warranties etc.)
(b) Equity or Shareholders' Funds:
 (i) From Liabilities Side: Share capital (both preference as well as equity) +
Reserves and Surplus -Accumulated losses.
(ii) From Assets Side:
Assets - Outside Liabilities
Or
Non-current Assets + Current Assets - Current Liabilities - Non-Current
Liabilities
Or
Non-current Assets + Working Capital (i.e. Current Assets - Current Liabilities)
- Non-Current Liabilities
Or
Total Assets - Current Liabilities - Non-Current Liabilities

Where
(i) Non-Current Assets = Tangible Fixed Assets + Intangible Fixed Assets + Non-Current
Investment + Long-term Loans and Advances (i.e. Capital Advances + Securities
Deposit)
(ii) Non-Current Liabilities = Long-term Borrowings + Long-term Provisions
(iii) Current Assets and Current Liabilities as discussed in Current ratio.
Objective: The objective of debt equity ratio is to measure the degree of indebtedness of
a business enterprise. The ratio indicates the relative proportions of outsiders fund and
shareholders fund invested in an enterprise. It also indicates the extent to which the firm
depends upon outsiders for its existence.
Significance: The debt equity ratio of 2 : I is the norm which is accepted by financial
institutions for financing projects. It means debt could be twice the equity. If this ratio is
high. then risk is more in extending a loan.

2. Total Assets to Debt Ratio

Meaning: This ratio shows the relationship between total assets and the long-term debts of the
business enterprise. It is usually expressed as a pure ratio.
Total Assets
Formula: Total Assets ¿ Debt Ratio=
Long−term Debts∨Non−Current Liabilities

Factors: The two terms used to calculate the ratio have been explained as below:
(a) Total Assets includes Non-Current Assets and Current Assets.
(b) Long-term Debts have already been explained in the context of Debt equity ratio.
(c) Non-current assets already explained in the context of Debt Equity Ratio.
 Objective: The objective of computing total assets to debt ratio is to measure the proportion of
total assets financed by the long-term debts.
Significance: This ratio measures the proportion of total assets funded by long-term debt. A
higher ratio represents a larger safety margin for lenders while a lower ratio represents risky
financial position of business.

3. Proprietary Ratio
Meaning: This ratio indicates the relationship between Equity (or shareholders' funds) and
Total Assets and in computed by dividing the shareholders' funds (equity) by total assets. It is
usually expressed as a simple ratio. Shareholders’ Funds (Equity)
'
Shareholde r sFunds (Equity)
Formula: Proprietary Ratio=
Total Assets
Factors: Both shareholders’ funds and total assets terms have already been explained.
Objective: The objective of computing proprietary ratio is to measure the proportion of total
assets financed by shareholders' funds.
Significance: Normally, proprietary ratio attempts to indicate the part of total assets funded
through shareholders’ funds. The higher the ratio. the more profitable it is for the creditor, and
the lees. Management will have to depend on outside funds. If the ratio is low. the creditors can
be suspicious about the repayment of their debt.

4. Interest Coverage Ratio

Meaning: It is also known as debt service ratio or fixed charges coverage ratio. This ratio is
calculated by dividing profit before interest and tax by fixed interest charges. It is usually
expressed as number times.
Profit before Interest∧Tax
Formula: Interest Coverage Ratio= =...׿
¿ Interest Charges

Factors: The two variables used to calculate the ratio have been explained as follows:
(i) Profit before interest and tax = Profit after interest and tax + Interest on long-term
borrowings + Tax
(ii) Fixed interest charges means interest on long-term debts or borrowings.
Objective: The objective of computing interest coverage ratio is to measure the debt servicing
capacity of a firm so far as fixed interest on long-term debt is concerned.
Significance: A higher ratio indicates that the concern can meet its interest burden regularly
even if its earnings before interest and taxes is low and vice-versa. An interest coverage ratio of
6 or 7 times is considered better.
Understanding Computation of Activity Ratios
1. Inventory (Stock) Turnover Ratio
Meaning: This ratio shows the relationship between cost of revenue from operations (or cost of
goods sold) during a given period and average Inventory (stock) carried during the period.
Thus, inventory (stock) turnover is obtained by dividing the cost of Revenue from Operations
(cost of goods sold) by average inventory (stock).
¿
Formula: Inventory Turnover Ratio=Cost of Revenue ¿ Operations Average Inventory =...׿

Factors:
(a) Calculation of Cost of Revenue from Operations
Cost of Revenue from Operations = Opening Inventory + Net Purchases + Direct
Expenses
(Carriage, Wages, Freight etc.) — Closing Inventory
Or
Cost of Revenue from Operations = Revenue from Operations — Gross Profit
Or
Cost of Revenue from Operations = Cost of materials consumed + Purchases of Stock-
in-
trade + Change in Inventory (Finished Goods: Work in
Progress and Stock-in-trade) + Direct Expenses
(b) Calculation of Average Inventory:
Opening Inventory + Closing Inventory
Average Turnover=
2
Note: However, when figure of Cost of Revenue from Operations is not available, the Revenue
from Operations figure may be put in place of Cost of Revenue from Operations. Similarly, if
only closing inventory is given in the question, it may be treated as average inventory.
Objective: The objective of calculating inventory turnover ratio is to ascertain whether
investment in stock-in-trade is reasonable or not, i.e., only the required amount is invested in
stock-in-trade.
Significance: This ratio indicates the rate at which inventory of finished goods are converted
into revenue from operations (sales). It is also a measure of liquidity. It determines how many
times inventory is purchased or replaced during a year. The higher the ratio. the better it is for
the business, since it means that inventory is being sold quickly. Concerns having too high
inventory turnover ratio may be operating with low margin of profit. Low turnover of inventory
may be due to had buying. obsolete inventory and is a danger signal.
 Average Age of Inventory (or inventory Velocity): The inventory turnover ratio is normally
supplemented by average age of inventory. Inventory turnover ratio can also be converted into
number of day,' months/weeks.
365 days /12 months /52 weeks
Formula: Average Age of Inventory=
Inventory Turnover Ratio

2. Trade Receivables (Debtors) Turnover Ratio

Meaning: As debtors and bills receivable arise on account of credit revenue from operations
(credit sales), so it expresses the relationship between credit revenue from operations and
average trade receivables (i.e. Debtors + B/R) during the year.
Formula:
Trade Receivables Turnover Ratio=Credit Revenue ¿ Operations ¿ =
Average Trade Receivables (i. e . Debtors + B/ R)

Factors: The two terms used to calculate the ratio have been explained as follows:
(a) Credit Revenue from Operations = Revenue from Operations -Cash Revenue from
Operations
(b) Average Trade Receivables (i.e. Debtors + B/R)
Opening Trade Receivables+ ClosingTrade Receivables
¿
2
Notes:
(a) Debtors mean only trade debtors that arise on account of credit sale of goods. Debtors
arising otherwise than out of credit sale of goods arc not to be included in debtors, e.g.,
debtors arising out of credit sale of fixed assets are not included in debtors.
(b) If the amount of credit revenue from operations is not given in the question clearly, the
ratio may be calculated by taking the amount of revenue from operations.
(c) If the opening trade receivables are not given in the question, the ratio may he calculated
by taking the amount of closing trade receivables.
(d) Provisions for bad and doubtful debts should not be taken into account.
Objective: Trade Receivable Turnover Ratio shows how quickly trade receivables are
converted into cash and thus, it indicates the efficiency of staff entrusted with collection of
amounts from trade receivables.
Significance: This ratio throws light on credit and collection policies of the business and is thus
related to liquidity. The higher the ratio, the better it is, since it means speedier collection and
lesser amount being blocked up in debtors and vice-versa.

Average Collection Period (or Trade Receivables Velocity)

 Meaning: The Trade Receivables Ratio is usually supplemented by average collection period
(or trade receivables velocity). In other words, trade receivables turnover ratio can be converted
into number of days/months/weeks. This ratio indicates as to which trade receivables have been
collected on time.
365 days∨12 months∨52 weeks
Formula: Average Collection Period=
Trade Receivables Turnover Ratio

Objective: The actual collection period can he compared with the stated credit terms of the
business organisation.
Significance: If it is longer than stated credit terms, then this indicates some inefficiency in the
procedures for collecting debtors.

3. Trade Payables (Creditors) Turnover Ratio

Meaning: As trade payables arise on account of credit purchases, so it expresses relationship
between net credit purchases and trade payables (Creditors Bills Payable) during the year.
Formula:
Net Credit Purchases
Trade Payables Turnover Ratio= =…׿
Average Trade Receivables (Creditors+ B/ P)

Factors:
(a) Net Credit Purchases = Total Purchases - Cash Purchases - Purchase Returns Opening
Trade Payables + Closing Trade Payables
(b) Average Trade Payables (Trade Creditors + B/P) =
Opening Trade Payables+Closing Trade Payables
2
Notes:
(a) Trade Creditors should be taken before making any provision for discount on creditors.
(b) If the opening trade payables are not given in the question, the ratio may be calculated
by taking the amount of closing trade payables.
(c) If the amount of credit purchases is not given clearly, the ratio may be calculated by
taking the amount of total purchases.
Objective: The objective of calculating trade payables turnover ratio is to establish the number
of times the trade payables are turned over in relation to purchases.
Significance: Higher trade payables turnover is an indication of the fact that firm pays its
suppliers quickly which increases its credit worthiness and vice-versa.

Average Payment period (or Trade Payables Velocity)

 Meaning: The trade payables turnover ratio is usually followed by average payment period (or
trade payables velocity). This ratio indicates the extent to which the trade payables have been
paid in time.
365 days∨12 months∨52 weeks
Formula: Average Payment Period∨Trade PayablesVelocity=
Trade PayablesTurnover Ratio
Objective: By comparing average payment period with credit period allowed by the suppliers,
conclusions may be drawn.
Significance: Higher ratio means delayed payment to suppliers which is not a very good policy
as it may affect the reputation of the business. Lower ratio means credit allowed by the supplier
but is not enjoyed by the business.

4. Working Capital Turnover Ratio

Meaning: This ratio shows the relationship between the Revenue from Operations (net sales) of
the firm to its working capital. It is calculated by dividing Revenue from Operations (Net Sales)
by working capital.
¿
Formula: Working Capital Turnover Ratio=Revenue ¿ Operations WorkingCapital (CA−CL)

Factors:
(a) Revenue from Operations as discussed earlier.
(b) Working Capital = Current Assets - Current Liabilities
Objective: The objective of calculating working capital ratio is to ascertain whether or not
working capital has been effectively utilised in making revenue from operations.
Significance: This ratio indicates the efficiency or inefficiency in the utilisation of working
capital in making revenue from operations (sales). A high working capital turnover ratio shows
the efficient utilisation of working capital in generating revenue from operations (sales). A low
ratio, on the other hand, may indicate excess of working capital or working capital has not been
utilised efficiently.
Notes: If the amount of Revenue from operations is not given, the ratio may be calculated by
taking the cost of revenue from operations.
Understanding Computation of Profitability Ratios
1. Gross Profit Ratio
Meaning: This ratio expresses the relationship between gross profit and revenue from
operations (sales), It is usually expressed in percentage.
Gross Profit
Formula: Gross Profit Ratio= Operations ¿ x 100=... %
Revenue ¿
Factors:
 (a) Gross Profit = Revenue from Operations — Cost of Revenue from Operations as
discussed earlier.
(b) Revenue from Operations as discussed earlier.
Objective: Gross profit is a reliable guide to the adequacy of selling prices and efficiency of
trading activities. The gross profit should be adequate to cover the expenses, dividends and
certain reserves.
Significance: It indicates gross margin on goods sold. No ideal ratio is fixed but normally a
higher ratio is always considered good sign so as to cover not only the remaining operating
expenses, non-operating expenses etc. but also to allow proper returns to owners. A low ratio
may indicate unfavourable purchase and sales policy.

2. Operating Ratio
Meaning: This ratio expresses the relationship between cost of revenue from operations (cost of
goods, sold) and operating expenses on the one hand and Revenue from Operations on the other
hand.
Formula:
Operating Ratio=Cost of Revenue ¿ Operations+Operating Expenses ¿ Operations ¿ x 100=...%
Revenue ¿
Factors:
(a) Cost of Revenue from Operations as diseased earlier.
(b) Operating Expenses = Employee Benefit Expenses + Depreciation + Other Expenses
(i.e. Office and Administration Expenses + Selling and Distribution Expenses etc.)
Objective: The objective of operating ratio is to establish relationship between cost of revenue
from operations + operating expenses and revenue from operations for testing the operational
efficiency of the enterprise.

3. Operating Profit Ratio

Meaning: The operating profit ratio is calculated to establish relationship between operating
profit and Revenue from Operations. This ratio is also known as net operating ratio.
Operating Profit
Formula: Operating Profit Ratio= Operations ¿ x 100=... %
Revenue ¿

Factors:
(a) Operating Profit = Profit after Tax + Non-operating Expenses/Losses - Non-operating
Incomes (i.e. other incomes)
Operating Profit = Gross Profit + Other Operating Income – Other Operating Expenses
 (b) Non-operating Expenses = Finance costs (Interest on long-term borrowings) + Other
Non-
operating expenses (Loss on sale of Non-current assets)
(c) Non-operating Income = Interest received on investments + Dividend Income + Rental
Income + Profit on Sale of Non-current Assets
(d) Other Operating Income = Commission + Fees + Royalty
(e) Other Operating expenses as explained in the context of operating ratio.
(f) Revenue from Operations as discussed earlier.
Objective: Operating profit ratio is the test of the operational efficiency of the firm. It shows
the percentage that is absorbed by the operating profit.
Significance: Higher operating Profit ratio means better operational efficiency of the concern.
Note: Operating ratio and operating profit ratio are complementary to each other and thus, if
one each ratio is deducted from 100, other ratio is obtained. In the form of formula:
(i) Operating Profit Ratio = 100 - Operating Ratio = ........%
(ii) Operating Ratio = 100 - Operating Profit Ratio = .........%

4. Net Profit Ratio

Meaning: This ratio relates to net profit to revenue from operations (net sales). It is usually
expressed as percentage.
Profit after Tax
Formula: Net Profit Ratio= Operations ¿ x 100=...%
Revenue ¿
Factors:
(a) Profit after Tax = Gross Profit + Other Incomes — Indirect Expenses/Losses — Tax
(b) Revenue from Operations as discussed earlier.
Note: Profit after Tax is considered for computing Net Profit Ratio.
Objective: The objective of net profit ratio is to determine the overall operational efficiency of
the business.
Significance: A firm with a high net profit ratio is in an advantageous position to survive in
case of rising cost of production and falling selling prices. Where the net profit ratio is low, the
firm will find it difficult to withstand these types of adverse conditions.

5. Return on Investment (ROI) or Return on Capital Employed

Meaning: This is the most important test of profitability of a business. It measures the overall
efficiency of the business. As it reveals overall efficiency of the business. it assumes
significance from the point of view of investors.
It is ascertained by comparing profit earned and capital employed to earn that profit and is
expressed as percentage. It is also known as Rate of Return or Return on Capital Employed
(RoCE) or yield on capital.
Profit before Interest ,Tax∧Dividend (PBIT )
Formula: ROI= x 100=... %
Capital Employed
Factors:
(a) PBIT means interest, tax and dividend should not be deducted out of profit.
(b) Capital Employed may be calculated as follows
• Front Assets side = Non-current Assets + Working Capital
(i.e. Current Assets-Current Liabilities)
Or
Non-Current Assets + Current Assets - Current Liabilities
Or
Total Assets - Current Liabilities
where Non -current Assets = Tangible Fixed Assets + Intangible Fixed Assets +
Non-current Investments + Long-term Loans and Advances
Note:
1. It is assumed that all non-current Investments are Trade Investments.
2. If Non-trade Investments are given specifically, it will not be taken as a part of capital
employed. Similarly, interest on such Non-trade Investments should be deducted from
profit before interest. tax and dividend.
• From Liabilities side approach = Shareholders’ Funds (i.e. Share Capital +
Reserves and Surplus) + Non-current Liabilities (i.e. Long-term Borrowings +
Long-term Provisions)
Objectives: The objectives of calculating return on investment is to measure the earning power
of the net assets of the business.
Significance: This ratio indicates how well the management has utilised the funds employed by
owners and others. The higher the ROI, the more efficient the management is considered to be
in using the funds employed.