Chapter-5 Accounting Ratios
Accounting Ratio : It is an arithmetical relationship between two accounting variables.
Ratio Analysis : It is a technique of analysis of financial statements to conduct a
quantitative analysis of information in a company’s financial statements.
Expression of ration: Ratios are expressed in following four ways:
o Pure Ratio Like 2:1. All liquidity and solvency ratios are expressed in pure form.
o Percentage e.g. 15%. All profitability ratios are presented in percentage form.
o Times Like 4 times. All turnover ratios and Interest Coverage Ratio are presented in
this form.
o Fraction like 3/4.
Classification or Types of Ratios: [a] Liquidity Ratios [b] Solvency Ratios [d] Activity
Rations also known as turnover Ratios or Performance Ratios. [d] Profitability Rations
o IMPORTANT POINT [Note: For Calculation of ratios Formula must be written as it
carries marks]
1. Liquidity Ratios: These measure short term solvency, i.e. the firm’s ability to pay its
current dues. In Liquidity Ratios the following two ratios are included.
Current Ratio also called Working Capital Ratio.
Liquid Ratio also called Quick Ratio or Acid Test Ratio.
Current Ratio : It shows the relationship of current assets with current liabilities
Current Ratio = Current Assets / Current liabilities
o Current Assets : Current investments, Inventories, Trade receivables (Debtors and
Bills Receivables) after deducting any provision for Doubtful Debts), Cash and cash
equivalents, Short term loans and advances, Other current assets (Restricted to
prepaid expenses, accrued incomes and advance tax only)
o Current Liabilities: Short term borrowings, Trade payables (Creditors and Bills
Payable), Other current liabilities, Short terms provisions
o Significance : It assesses the ability of a business to pay its short term liability
on time.
o Ideal Ratio : 2:1 is considered as best.
A Low ratio indicates that the company cannot meet its short term liability
on time.
A High ratio indicates that funds have not been used efficiently and lying
idle.
Quick Ratio : It shows the relationship of quick assets with current liabilities.
Quick Ratio = Quick assets / Current liability
o Quick Assets = Current Assets – Inventory – Prepaid Expenses – Advance Tax
– Accrued Income or Quick Assets = Current Assets – Other Current Assets
o Significance : It assesses the ability of a business to pay its short term
liability promptly.
o Ideal Ratio : 1:1 is considered as best.
o It is better indicator of liquidity as some current assets are not easily
convertible into cash.
2. Solvency Ratio : Solvency ratios convey an enterprise’s ability to meet its long term
obligations as and when they becomes due.
Debt Equity Ratio: It show relationship between Debts (Long term Liabilities or Non
Current Liabilities) and Equity (Shareholders’ Funds).
Debt Equity Ratio = Debt / Equity
o Debts = Long-term borrowing + Long-term provisions
o Equity/Shareholders’ Funds = Share Capital + Reserves and Surplus – Non
– Trading Investments
o Equity/Shareholders’ Funds = Fixed Assets (Tangible and Intangible) +
Non Current Investment (Excluding Non Trading investment) +Long
Terms Loans and Advances + Current Assets – Current Liabilities – Long
–term borrowings – Long – term Provision
o Significance: It assesses the long term soundness of financial position
of a business.
o Ideal Ratio: 2:1 is considered as best but it should not be more than this.
Total Assets to Debt Ratio : It shows the relationship between Total Assets and
Debts.
o Total Assets To Debt Ratio = Total Assets / Debt
1|Ratio Analysis
o Total Assets = Fixed Assets (Tangible and Intangible) + Non Current
Investment (Excluding Non Trading Investment) + Long Term Loans and
Advances + Current Assets and Debts = Long-term borrowing + Long-
term provisions
o Significance: It measures the safety margin available to the providers
of long term loans.
o Ideal Ratio: No ideal ratio but a high ratio indicates higher safety to
lenders and low ratio represents risky position.
Proprietary Ratio: It shows the relationship between Proprietors’
Funds/shareholders’ Funds and Total Assets of the business.
o Proprietary Ratio = E q u i t y / T o t a l A s s e t s
o Total Assets = Fixed Assets (Tangible and Intangible) + Non Current
Investment (Excluding Non trading Investment) +long Term Loans and
Advances + Current Assets
o Significance: It measures the proportion of total assets financed by the
Proprietors of the business. It shows the safety margin available to the
lenders of the business as they can ascertain the portion of the
shareholders in the business.
o Ideal Ratio: No ideal ratio but a high ratio indicates higher safety to
lenders and law ratio represents risky position from lender’s point of
view.
Interest Coverage Ratio : This ratio establishes relationship between the Net Profit
before Interest & Tax and interest payable on long term debts (Fixed Interest
Charges)
o Interest Coverage Ratio = [Profit before tax / Total Interest]
o Since interest is a charge on profit, net profit taken to calculate this ratio is
before interest & tax.
o Objective & Significance-Objective is to ascertain the amount of profit
available to cover the interest charge. It determines ease with which a
company can pay interest expense on outstanding debt.
o Parties interested in this ratio are debenture holders and lenders of long
term credit.
o High Ratio is better for lenders as it indicates higher safety margin.
Activity Ratios/Turnover Ration/Performance Ratios : -These ratios measure the
efficiency of asset management and measure the effectiveness with which an
enterprise uses resources at its disposal. These show rotation of concerned item
within an accounting period. Important Turnover ratios are :
o Inventory Turnover Ratio : It is also called as Stock turnover ratio. This ratio is
a relationship between the Cost of goods sold i.e, Cost of Revenue form
Operations during a particular period of time and the Cost of average
inventory during a particular period.
It is expressed in number of times. Interest/Stock turnover Ratio = Cost
of revenue from operations / Avg inventory
Cost of Goods Sold = Opening Stock + Net Purchases + Direct Expenses
– Closing Stock OR = Sales/Revenue from Operations – Gross Profit
OR
Cost of Revenue from Operations = Cost of Material Consumed + Net
Purchases of Stock in Trade + Changes in inventories of Finished Goods,
Work in Progress and Stock-in-Trade + Direct Expenses
Cost of Material Consumed = Raw Material Purchased + Changes in
inventory of Raw Material
Changes in inventory = Opening Inventory – Closing Inventory
Avg inventory = [opening inventory + closing inventory] / 2
This ratio indicates whether investment in stock is within proper limit
or not.
This shows how quickly inventory is sold. Generally higher ratio is
considered better but very high ratio shows over trading and low ratio
means stock is piled up or over investment in stock.
o Debtors Turnover Ratio/Trade Receivables Turnover Ratio: It shows the
relationship between Net Credit Sales i.e., Net Credit Revenues from
Operations and Average Debtors/Average Trade Receivables (Debtors + Bills
Receivables).
2|Ratio Analysis
This ratio is expressed in TIMES.
Trade Receivable/Debtors turnover Ratio = Net credit sales of cost of
revenue from operations / Avg trade receivable
Net Credit Sales = Total Sales – Sales Return i.e., Returns inwards –
Cash Sales
Average Trade Receivable = [Opening T/r + Closing T/r] /2
Receivable are taken before deducting any Provision for Doubtful
Debts.
If details regarding cash and credit sales are not given then all the
sales are taken on credit basis.
If details regarding opening and closing values of trade receivable
are not given then closing trade receivables are used for calculation
of this ratio.
This ratio indicated the number of times the trade receivables are
turned in relation to credit sales over a year.
This shows how quickly cash is realized from trade receivables.
Generally higher is the ratio, the more efficient is the management of
the trade receivables.
o Creditors Turnover Ratio/Trade Payable Turnover Ratio: It shown the
relationship between Net Credit Purchases and Average Creditors/Average
Trade Payables (Creditors + Bills Payable). This ratio is expressed in TIMES.
Trade Payable/Creditors turnover Ratio = Net credit purchase / Average
Trade payable
Net Credit Purchases = Total Purchases – Purchases Return/Returns
Outwards Cash Purchases
Average Trade Receivable = [opening TR + closing TR] / 2
If details regarding cash and credit purchases are not given then all
the purchases are taken on credit basis.
If details regarding opening and closing values of trade payables are
not given then closing trade payables are used for calculation of this
ratio.
This ratio indicated the number of times the Trade Payables are turned
over in relation to credit purchases over a year.
This shows how quickly cash is paid to Trade Payables. Generally
lower ratio indicates that more credits are available for a longer period.
o Working Capital Turnover Ratio : It establishes the relationship between Net
Working Capital and Revenue from Operations i.e., Net Sales.
Working Capital Turnover Ratio = Revenue from operations / Net working
capital
Net Working Capital = Current Assets excluding Fictitious assets –
Current liabilities.
This ratio can also be calculated on the basis of the Cost of Revenue
from Operations i.e., Cost of Goods Sold.
This Ratio is calculated in Times.
This ratio indicated the number of times the working capital has been
turned over in relation to revenue form operations over a year.
Generally a higher ratio indicates efficient use of working capital.
Profitability Ratio:
These ratios are used to assess the profitability or earning capacity of
the business.
These ratios are very important as profitability is the measurement
of the overall performance and efficiency of the management.
Gross Profit Ratio
All Profitability ratios are shown in percentage form.
Gross Profit Ratio : It shows the relationship between Gross
Profits and Net Sales i.e., Net Revenue from Operation.
Gross Profit Ratio = [Gross profit / Net sales] x 100
This Ratio indicates the margin of gross profits available on
Revenue from Operations. Generally a higher ratio indicates
better profitability.
Operating Ratio:
It shows the relationship between Operating Cost and Net Sales
i.e., Net Revenue from Operations.
3|Ratio Analysis
Operating Ratio = [Gp / Net sales] x 100
Operating Cost = Cost of Revenue from Operations + Operating
Expenses
Operating Expenses = Office and Administration Expenses
+Selling and Distribution Expenses + Depreciation+ Bad debts +
Discount on Debtors + Interest on Short term loans.
OR
Operating Cost = Cost of Material Consumed +Net Purchases
of Stock in Trade + Changes in Inventories of Finished Goods,
Work in Progress and Stock-in-Trade + Direct Expenses =
Employees Benefit Expenses + Other Expenses such as
Office Administration Expenses + Selling and Distribution
Expenses + Depreciation + Bad debts + Discount on Debtors +
Interest on short term loans.
This ratio indicates the percentage of Operating costs to
Revenue form Operations Generally a lower Ratio indicates
better cost management and profitability.
Operating Profit Ratio : It shows the relationship between Operating
Profit and Net Sales i.e., Net Revenue form Operations.
o Operating profit Ratio = [Op / Net RoP] x 100
o Operating Profit = Net Revenue from Operations – Operating
Cost
Or
o Operating Profit = Gross Profit – Operating Expenses
Or
o Operating Profit = Net Profit + Non Operating Expenses –
Non Operating Income
o This ratio indicates the margin of operating profits available
on Revenue form Operations to cover non operating
expenses such as indirect Expenses and Financial Expenses.
o Generally a higher ratio indicates better profitability.
o Operating Ratio + Operating Profit Ratio =1
Net Profit Ratio : It shows the relationship between Net Profits
and Net Sales i.e., Net Revenue from Operations.
o Net profit Ratio = [Np / Net RoP] x 100
o Net Profit = Net Revenue from Operations –
Operating Cost – Non Operating expenses + Non
Operating Income
OR
o Net Profit = Gross Profit – Operating Expenses – Non
Operating Expenses + Non Operating Income
OR
o Net Profit = Operating Profit – Non Operating
Expenses + Non Operating Income Important
Points
o This ratio indicates the percentage of net profits
in relation to Revenue from Operations.
o Generally a higher ratio indicate better
profitability.
Return on Investment or Return on Capital Employed:
o It shows the relationship between Net profit
before interest, Tax and Divided and Capital
Employed of the business.
o Retrun on Investment (ROI) = [Np / Capital
employed] x 100
o Capital Employed = Share Capital + Reserves and
Surplus – Non Trading Investments + Non Current
Liabilities
OR
o Capital Employed = Shareholders’ Funds + Non Current
Liabilities By Assets Approach
4|Ratio Analysis
o This Ratio indicates the percentage of Net profits
before interest, tax and dividend in relation to Capital
Employed of the business.
o This Ratio is Considered as best measurement of the
overall performance of the enterprise.
o Generally a higher ratio indicates better profitability.
o As we are not including Non Trading Investments as
part of Capital Employed therefore Income from Non
Trading Investments will not be taken into account
for calculation of Net Profits.
5|Ratio Analysis