Financial ratios

Financial statements
• Financial statements are the basic and formal annual
reports through which the corporate management
communicates financial information to its owners and
various other external parties which include– investors,
tax authorities, government, employees, etc.
• These normally refer to
(a) The balance sheet (position statement) as at the end
of accounting period,
(b) The profit and loss account (income statement) of a
company.
(c) The cash flow statement is also taken as an integral
component of the financial statements of a company.
 Accounting Ratios
• Accounting ratios are an important tool of
financial statement analysis
• The data for accounting ratios is derived from
financial statements.
• Types of accounting ratio are as follows:
Liquidity Ratios
Solvency Ratios
Activity (or Turnover) Ratios
Profitability Ratios
 Use of accounting ratio
• Ratio analysis helps in:
To provide a deeper analysis of the profitability,
liquidity, solvency and efficiency levels in the
business
To provide information for making cross sectional
analysis by comparing the performance with the
best industry standards
 To make time series analysis useful for making
projections and estimates for the future.
 Liquidity Ratios
• Liquidity ratios are calculated to have
indications about the short term solvency of
the business, i.e. the firm’s ability to meet its
current obligations.

• These are analysed by looking at the amounts

of current assets and current liabilities in the
balance sheet.
 Current assets
• Liquid assets/ assets which can be easily
converted to cash.
• Examples (in decreasing order of liquidity):
 Cash
 Bank balance
 Inventory/ stock of goods
 Bills receivables/ outstanding receipts
 Advance (prepaid) payments
 Debtors (people to whom company has sold goods on
credit)
 Current liability
• Money/ goods taken on loan that must be
returned within one year
• Examples:
Bills payable
Outstanding (due) payments
Advance receipts
Bank overdraft
creditors (people from whom company has
bought goods on credit)
 Liquidity Ratios (contd)
• Working capital = current assets- current
liabilities
• Current Ratio = current assets/ current liabilities
• Quick ratio or acid test ratio = quick assets/
current liabilities.
Quick assets = current assets- inventory- prepaid
expenses
 Illustration 1
Rs. Rs.
• Calculate :
i. Working
Stock 50,000 Cash 30,000 capital
ii. current ratio
Debtors 40,000 Bills 40,000 iii. Quick ratio
payable
from the given
Bills 10,000 Bank 4,000 information.
receivable overdraft

Advance tax 4,000 creditors 60,000

 Illustration 1 solution
• Current Assets = Rs.50,000 + Rs.40,000 +
Rs.10,000 + Rs.4,000 + Rs.30,000
= Rs.1,34,000
• Current Liabilities= Rs.60,000 + Rs.40,000 +
Rs.4,000 = Rs. 1,04,000
i) working capital = 1,34,000-1,04,000 = Rs. 30,000
ii) Current Ratio = Rs.1,34,000 / Rs.1,04,000 =
1.29 : 1.
 Illustration 1 solution (contd)
Quick Assets = Current Assets – Stock – Advance
Tax
Quick Assets = Rs. 1,34,000 – (Rs. 50,000 + Rs.
4,000) = Rs. 80,000
Current Liabilities= Rs. 1,04,000
Quick ratio = Quick Assets / Current Liabilities =
Rs. 80,000 : Rs. 1,04,000 = 1:0.77
 Illustration 2
• X Ltd. has a current ratio of 3.5:1 and quick
ratio of 2:1. If excess of current assets over
quick assets represented by stock is Rs.
24,000, calculate current assets and current
liabilities.
 Illustration 2 solution
Current Ratio = 3.5:1
Quick Ratio = 2:1
Let Current Liabilities= x
Current Assets = 3.5x And Quick Assets = 2x
Stock = Current Assets – Quick Assets
So, 24,000 = 3.5x – 2x
24,000 = 1.5x
x = Rs.16,000 = current liabilities
Current Assets = 3.5x = 3.5 × Rs. 16,000
= Rs. 56,000.
 Illustration 3
• Calculate ‘Quick Ratio’ from the following
information: Current Liabilities= Rs. 50,000 ;
Current Assets= Rs. 80,000 ; Stock= Rs. 25,000;
Prepaid Expenses= Rs. 5,000.
 Illustration 3 Solution
• Quick Assets
= Current Assets – Closing Stock – Prepaid
Expenses
= Rs.80,000 – Rs.25,000 – Rs.5,000 = Rs. 50,000
Quick Ratio = Quick Assets : Current Liabilities
= Rs.50,000 : Rs.50,000 = 1 : 1.
 Illustration 4
• Calculate the current ratio from the following
information : Total Assets= Rs.3,00,000; Fixed
Assets= Rs.1,60,000; Long-term Liabilities
Rs.80,000 ;Investments= Rs.1,00,000 ;
Shareholders Fund=Rs.2,00,000.
 Illustration 4 Solution
Total Assets = Fixed Assets + Investments + Current Assets
=Rs. 3,00,000 = Rs. 1,60,000 + Rs. 1,00,000 + Current Assets
Current Assets = Rs. 3,00,000 – Rs. 2,60,000 = Rs. 40,000
Total Assets = Total Liabilities (including capital) =
Shareholders Funds + Long-term Liabilities + Current
Liabilities
= Rs. 3,00,000 = Rs. 2,00,000 + Rs. 80,000 + Current Liabilities
Current Liabilities = Rs. 3,00,000 – Rs. 2,80,000 = Rs. 20,000
Current Ratio = Current Assets : Current Liabilities = Rs.
40,000 : Rs. 20,000 = 2:1.
 Activity (or Turnover) Ratios

• The turnover ratios basically exhibit the activity levels

characterised by the capacity of the business to make more sales
or turnover.
• The activity ratios express the number of times assets employed,
or, for that matter, any constituent of assets, is turned into sales
during an accounting period. Higher turnover ratio means better
utilisation of assets and signifies improved efficiency and
profitability, and as such are known as efficiency ratios.
• The important activity ratios calculated under this category are :
[Link] Turn-over;
[Link] (Receivable) Turnover;
[Link] (Payable) Turnover;
[Link] (Net Assets) Turnover
[Link] Assets Turnover;
[Link] Capital Turnover.
 Stock Turnover Ratio
• Stock Turnover Ratio = Cost of Goods Sold/
Average Stock
Eg 5: From the following information, calculate
stock turnover ratio:
i. Opening Stock Rs. 18,000
ii. Wages Rs. 14,000
iii. Closing Stock Rs. 22,000
iv. Sales Rs. 80,000
v. Purchases Rs. 46,000
vi. Carriage Inwards Rs. 4,000
 Solution 5
• Cost of Goods Sold = Opening Stock + Purchases
+ Direct Expenses- Closing Stock
= Rs. 18,000 + Rs. 46,000 – Rs. 22,000 +(Rs. 14,000
+ Rs. 4,000)
= Rs. 60,000
Average Stock = (Opening Stock + Closing Stock)/2
= (Rs. 18,000 + Rs. 22,000)/2 = Rs. 20,000
Stock Turnover Ratio = Rs. 60,000/Rs. 20,000
= 3 Times.
 Debtors Turnover ratio
• Debtors Turnover ratio = Net Credit sales/
Average Accounts Receivable
• Where Average Account Receivable =
(Opening Debtors and Bills Receivable +
Closing Debtors and Bills Receivable)/2
 Illustration 6
• Calculate the Debtors Turnover Ratio from the
following information:
• Total sales= Rs. 4,00,000
• Cash sales = 20% of total sales
• Debtors on 1.1.2004 = Rs. 40,000
• Debtors on 31.12.2004 = Rs. 1,20,000
 Illustration 6 solution
• Average Debtors = (Rs. 40,000 + Rs.
1,20,000)/2 = Rs. 80,000
• Cash sales = 20% of Rs.4,00,000 =Rs. 80,000
• Net credit sales= Total sales – Cash sales =
Rs.4,00,000 – Rs.80,000 = Rs. 3,20,000
• Debtors Turnover Ratio = Net Credit sales/
Average Debtors = Rs. 3,20,000/Rs. 80,000 = 4
Times.
 Creditors Turnover ratio
• Creditors Turnover ratio = Net Credit
purchases/ Average accounts payable
• Where Average account payable = (Opening
Creditors and Bills Payable + Closing Creditors
and Bills Payable)/2
 Illustration 7
• Calculate the Creditor’s Turnover Ratio from
the following figures.
• Credit purchases during 2005 = Rs. 12,00,000
• (Creditors + Bills Payables) on 1.1.2005 = Rs.
4,00,000
• (Creditors + Bills Payables) on 31.12.2005= Rs.
2,00,000
 Illustration 7 solution
• Average Creditors = (Rs.4,00,000 +
Rs.2,00,000)/2 = Rs. 3,00,000
• Creditors Turnover Ratio = Net Credit
purchases/ Average accounts payable =
Rs.12,00,000/Rs.3,00,000 = 4 times.
 Solvency Ratios

• The persons who have advanced money to the

business on long-term basis are interested in safety of
their payment of interest periodically as well as the
repayment of principal amount at the end of the loan
period.
• Solvency ratios are calculated to determine the ability
of the business to service (repay) its debt in the long
run. The following ratios are normally computed for
evaluating solvency of the business.
[Link] equity ratio;
[Link] Assets to Debt Ratio;
[Link] Coverage Ratio.
Debt Equity Ratio (or Leverage ratio)
• From security point of view, capital structure
with less debt and more equity is considered
favourable as it reduces the chances of
bankruptcy. Normally, it is considered to be
safe if debt equity ratio is 2:1.
Debt-Equity ratio = Long-term Debt/ Shareholders
Fund
Where Shareholders Funds = Share Capital + Reserves
and Surplus
Long-term Funds = Debentures + Long-term Loan
 Illustration 8
Total liabilities = Rs. 5,00,000
Current liabilities = Rs. 1,00,000
Share capital = Rs. 3,50,000
Reserve and surplus = Rs. 1,50,000
Calculate debt equity ratio.
 Illustration 8 solution
Long-term Debt = Total External Liabilities –
Current Liabilities
= Rs. 5,00,000 – Rs. 1,00,000 = Rs. 4,00,000
Shareholders Funds = Share Capital + Reserves
and Surplus = Rs. 3,50,000 + Rs. 1,50,000
= Rs. 5,00,000.
Debt Equity Ratio = Rs. 4,00,000/Rs. 5,00,000
= 4:5.
 Some other solvency ratios
• Total assets to Debt Ratio = Total assets/Long-
term debt

• Interest Coverage Ratio = Net Profit before

Interest and Tax/ Interest on long term debt
 Illustration 9
From the following details, calculate interest
coverage ratio:
Net Profit after tax = Rs. 60,000; Interest on long
term debt =15%; Long-term Debt= 10,00,000;
and Tax Rate 40%.
 Illustration 9 solution
• Net Profit after Tax=Rs. 60,000
Tax Rate = 40%
Net Profit before tax=Net profit after tax*100/(100 – Tax rate)
= Rs. 60,000*100/(100 – 40)
= Rs. 1,00,000
• Interest on Long Term Debt = 15% of Rs. 10,00,000 = Rs.
1,50,000
• Net profit before interest and tax=Net profit before tax + Interest
= Rs. 1,00,000 + Rs. 1,50,000 = Rs. 2,50,000
• Interest Coverage Ratio = Net Profit before Interest and
Tax/Interest on long term debt
= Rs. 2,50,000/Rs. 1,50,000
= 1.67 times.
 Profitability Ratios

• The profitability or financial performance is mainly

summarised in Income statement. Profitability ratios are
calculated to analyse the earning capacity of the business
which is the outcome of utilisation of resources employed
in the business. The various ratios which are commonly
used to analyse the profitability of the business are:

[Link] Profit Ratio

[Link] Ratio
[Link] Profit Ratio
[Link] profit Ratio
[Link] on Investment (ROI)
 Gross Profit Ratio

• Gross profit ratio as a percentage of sales is

computed to have an idea about gross margin.
It is computed as follows:
• Gross Profit Ratio = (Gross Profit/Net Sales) ×
100
 Illustration 10
• Following information is available for the year
2005, calculate gross profit ratio:
i. Cash Sales= Rs. 25,000
ii. Credit sales= Rs. 75,000 :
iii. Cash purchases = Rs.13,000
iv. Credit purchases = Rs.60,000
v. Carriage Inwards = Rs. 2,000
vi. Decrease in stock = Rs. 10,000
vii. Wages= Rs. 5,000
 Illustration 10 solution
• Sales = Cash Sales + Credit Sales
= Rs.25,000 + Rs.75,000 = Rs. 1,00,000
• Purchases = Cash Purchases + Credit Purchases
= Rs.13,000 + Rs.60,000 = Rs. 73,000
• Cost of Sales = Purchases + (Opening Stock – Closing Stock)
+Direct Expenses
= Purchases + Decrease in stock + Direct Expenses
= Rs.73,000 + Rs.10,000 + (Rs.2,000 + Rs.5,000)
= Rs.90,000
• Gross Profit= Sales – Cost of Sales = Rs.1,00,000 - Rs.90,000
= Rs. 10,000
• Gross Profit Ratio = (Gross Profit/Net Sales) × 100
= Rs.10,000/Rs.1,00,000 × 100
= 10%.
 Net profit ratio
• Net Profit Ratio is based on all inclusive
concept of profit. It relates sales to net profit
after operational as well as non-operational
expenses and incomes. It is calculated as
under:
• Net Profit Ratio = (Net profit / Sales) × 100
• Generally, net profit refers to Profit after Tax
(PAT).
 Illustration 11

• Gross profit ratio of a company was 25%. Its

credit sales was Rs. 20,00,000 and its cash
sales was 10% of the total sales. If the indirect
expenses of the company were Rs. 50,000,
calculate its net profit ratio.
 Illustration 11 solution
Cash sales = 10% of total sales
Credit sales = 90% of total sales = Rs. 20,00,000
So total sales = 20,00,000 x 100/90
Hence, total sales are=Rs.22,22,222.22
Gross profit = .25 × 22,22,222 = Rs. 5,55,555
Net profit= Rs.5,55,555 – 50,000
= Rs.5,05,555
Net profit ratio= (Net profit/sales) × 100
= (Rs.5,05,555/Rs.22,22,222) × 100
= 22.75%.