Accounting

RATIOS
 RATIOS - INTRODUCTION

A ratio is a mathematical number calculated as a

reference
to relationship of two or more numbers and can be
expressed as a fraction, proportion, percentage,
and
a number of times.
Accounting ratio may be expressed as an
arithmatical
relationship between two accounting variables.
The technique of accounting ratios is used for
analysing
the information contained in nancial statements
for
 OBJECTIVES OF RATIO ANALYSIS

✔ To simplify the accounting information

✔ To determine the liquidity( short term and
long
term nancial obligations)
✔ To assess the operational e ciency of the
business
✔ To analyse the pro tability of the business
✔ To help in comparative analysis ( inter rm
and
 ADVANTAGES OF RATIO ANALYSIS

❖ Useful tool for analysis of nancial statements

❖ Simpli es accounting data
❖ Useful for forecasting
❖ Useful in inter rm and intra rm comparison
❖ Useful in locating the weak areas.
❖ Useful in assessing the operational e ciency of
business
LIMITATIONS OF RATIO ANALYSIS

▪ It can give false result

▪ Qualitative factors are ignored
▪ Lack of standard ratio
▪ May not be comparable
▪ Price level changes are not
considered
▪ Leads to window dressing
▪ Leads to personal bias
Pure Pure Times Percentage
 [Link] RATIOS

QUICK ASSETS = CURRENT ASSETS – INVENTORY –

PREPAID EXPENSES
 1. Current ratio/ Working capital ratio :
This ratio establishes the relationship between current assets and current
liabilities and is used to assess the short term financial position of the business
concern. Ideal ratio is 2:1.
Current Assets : Current Liabilities

A very high current ratio implies heavy investment in current assets which is not a
goodsign as it reflects under utilisation or improper utilisation of resources. A low
ratio endangers the business and puts it at risk of facing a situation where it
will not be able to pay its short-term debt on time - Significance

INCLUDED IN CURRENT ASSETS

INCLUDED IN CURRENT LIABILITIES
a. Current investments
b. Inventories a. Short term borrowings (bank overdraft)
(excluding loosetools, stores & spares) b. Trade payables
c . Trade receivables (B/P & Crs)
(B /R and Drs less provision) c. Other current liabilities (outstanding
d. Cash &cash equivalents expenses, calls in advance, received in
(cash in hand, cash at bank, cheques/drafts) advance)
e. Short term loans and advances d. Short term provisions
f. Other current assets
(prepaid expenses, interest receivable, accured
income)
 2. LIQUID RATIO/QUICK RATIO/ACID TEST RATIO

This ratio establishes relationship between liquid assets and

currentliabilities and is used to measure the firm’s ability to pay the claims
of creditors immediately. Ideal ratio is 1:1
Quick ratio = Quick Assets : Current Liabilities
While calculating quick assets we exclude the closing stock and prepaid expenses
from the current assets .

Significance :
A low ratio will be very risky and a high ratio suggests unnecessarily
deployment of resources in otherwise less profitable short-term investments.

• Current assets = Total assets – fixed assets – non current investment

• Current liabilities = Total debts – long term debts
• Liquid assets = Current assets – inventory-prepaid expenses
• Working capital = Current assets – current liabilities
• Current liabilities = Trade payables + other current liabilities
• Current liabilities = Total assets – capital employed
• Current assets = Capital employed + current liabilities – fixed assets
 SOLVENCY RATIOS
Solvency ratios are calculated to determine the ability of
the business to service its debt. In other words it shows
the rms ability to meet its long term obligations. They
are expressed in pure form.
The Solvency ratios are :
1. Debt-Equity Ratio
2. Proprietary Ratio
3. Total Assets to Debt Ratio
4. Interest Coverage Ratio
1. Debt-Equity Ratio
SIGNIFICANCE

The objective of debt to equity ratio is to measure the proportions

of external funds and shareholders funds invested in the company.
A high debt to equity means that the rm is depending more on
borrowings as to shareholders funds. So lenders are at higher risks
and have lower safety.
A low ratio means that the rm is depending more on
shareholders funds than borrowings. So lenders are at a lower risk
and have higher safety. A low ratio re ects more security.
So it is considered to be safe if debt equity ratio is 2:1.
2. Proprietary Ratio

Proprietory Ratio may be expressed either as ‘pure’ or

‘percentage’
Capital employed = Total Assets – Current Liabilities
 FORMULAES TO CALCULATE SHARE HOLDER FUND
I) LIABILITIES APPROACH: Share capital + Reserves & Surplus
II) ASSETS APPROACH :
Non current assets + Working capital ( CA –CL) – Non current
liabilities
▪ Non current assets = Tangible xed assets + Intangible assets + Non
current investments + Long term loans & advances
▪ Current assets = Current investments + Inventories +Trade receivables
+ Cash & cash equivalents + Short term loans & advances + Other
current assets
▪ Current liabilities = Short term borrowings + Trade payables + Other
current liabilities + Short term provisions
▪ Non current liabilities = Long term borrowing s + Long term provisions
SIGNIFICANCE

The objective of this ratio is to measure the proportion of

total assets nanced by proprietors funds.
A high ratio means adequate safety for unsecured lenders
and creditors
It also means improper mix of proprietors funds and loan
funds, which results in low return on investment.
A low ratio indicates greater risk to unsecured lenders
and creditors and the rm ge ing bene t of trading on
equity.
3. Total Assets to Debt Ratio

This ratio is expressed in ‘pure’

form
 FORMULAES :
TOTAL ASSETS INCLUDE :
* Non current assets = Fixed ( tangible + intangible) + Non current
investments + Long term loans & advances
* Current assets = Current investments + inventories ( including loose
tools & spare parts) + Trade receivables + Cash & cash equivalents +
Short term loans & advances + Other current assets
DEBT INCLUDE:
* Long term borrowings
* Long term provisions
SIGNIFICANCE
✔ The objective of this ratio is to establish relationship
between
total assets and long term debts of the rm. It measures
the
‘safety margin’ available to the lenders of the long term
debts.
It measures the extent to which debt is covered by the
assets of the rm.
✔ A high ratio means higher safety to lenders
✔ A low ratio means lower safety for lenders as the business
depends largely on the outside [Link], investment by the
proprietor is low.
4. Interest Coverage Ratio

This ratio is expressed in

times
SIGNIFICANCE

▪ This ratio is very useful to debenture holders and

lenders of
long term funds.
▪ The objective of this ratio is to ascertain the amount of
pro ts
available to cover interest on long term debt.
▪ A high ratio is be er for the lenders as it as shows
higher
margin to meet interest cost.
 ACTIVITY (OR TURNOVER) RATIO
These ratios indicate the speed at which, activities of the business
are being performed. So they are also called as “Performance ratios.
”These ratios measure the effectiveness with which the enterprise
uses its available resources. These ratios are expressed in times.
The activity ratios are ;
1. Inventory Turnover
2. Trade Receivables Turnover
3. Trade Payables Turnover
4. Working Capital Turnover.
 1. Inventory Turn-over Ratio

Significance :
▪ The objective of this ratio is to ascertain whether investment in
stock
has been judicious or not. It shows the number of times amount

invested in inventory is rotated.

▪ A high ratio shows that more sales are being produced by a
rupee of
investment in inventories. It shows overtrading and may result
in
working capital shortage.
▪ A low ratio means inefficient use of investment in inventories,
over
investment in inventory, accumulation of inventory etc.
FORMULAES :

I) COST OF REVENUE FROM OPERATIONS :

= REVENUE FROM OPERATIONS – GROSS PROFIT

(OR)
REVENUE FROM OPERATIONS + GROSS LOSS
(OR)
OPENING INVENTORY + NET PURCHASES + DIRECT EXPENSES –
CLOSING INVENTORY

II) AVERAGE INVENTORY :

= OPENING INVENTORY + CLOSING INVENTORY
--------------------------------------------------------
2
NOTE: IF TIMES WORD IS GIVEN THEN WE MULTPLY AND IF MORE
WORD IS GIVEN THEN WE ADD IN INVENTORY AS PER THE QUESTION
 2. Trade Receivables Turnover Ratio

Significance :
▪ This ratio indicates the number of times trade receivables are
turned
over in a year in relation to credit sales. It shows how quickly
trade
receivables are converted into cash and the efficiency in
collection of
amounts due against trade receivables.
▪ A high ratio is better since it shows that debts are collected
more
promptly.
▪ A lower ratio shows inefficiency in collection or increased
period
and more investment in debtors than required.
FORMULAES :
I) CREDIT REVENUE FROM OPERATIOINS :
= CREDIT SALES – SALES RETURN
(OR)
REVENUE FROM OPEATIONS –CASH REVENUE FROM
OPERATIONS

II) AVERAGE TRADE RECEIVABLES :

OPENING DRS + B/R + CLOSING DRS+ B/R
-------------------------------------------------------------
2

III) DEBT COLLECTION PERIOD :

365
------------------------
TRADE RECEIVABLES TURNOVER RATIO
(OR)
12
--------------
TRADE RECEIVABLES TURNOVER RATIO
 [Link] Payables Turnover Ratio

Significance :
▪ The objective of this ratio is to determine the efficiency with
which
the trade payables are managed and paid.
▪ A high ratio or shorter payment period shows the availability of
less
credit period or early payments. It indicates that the firm is not
availing full credit period and this boosts up credit worthiness
of the
firm.
▪ A low ratio indicates that creditors are not paid in time or
increased
credit period.
FORMULAES :

I) AVERAGE TRADE PAYABLES :

OPENING CRS + B/P + CLOSING CRS + B/P

------------------------------------------------------------
2

II) AVERAGE PAYMENT PERIOD :

AVERAGE TRADE PAYABLES X NO: OF MONTHS /

DAYS
NET CREDIT PURCHASES

(OR)

MONTHS OR DAYS IN A YEAR

-----------------------------------------
TRADE PAYABLES TURNOVER RATIO
4. Working capital Turnover Ratio
It shows the relationship between working capital and revenue from
operations. It shows the no .of times a unit of rupee invested in working
capital produces Sales.

Significance :
The objective of this ratio is to ascertain whether or not working
capital has been effectively used in generating revenue
A high ratio shows efficient use of working capital. It indicates
overtrading-working capital being inadequate for the scale of
operations
A low ratio shows inefficient use of working capital.

Working Capital Turnover Ratio = Revenue from

operations

Working capital

Note: working capital = current assets – current liabilities

 PROFITABILITY RATIOS
Efficiency in business is measured by profitability. “Profitability” refers
to financial performance of the business. These ratios are expressed
in percentage. The profitability ratios are :

i. Gross profit Ratio

ii. Operating Ratio
iii. Operating profit Ratio
iv. Net profit Ratio
v. Return on Investment Ratio
1. Gross Profit Ratio
Gross profit Ratio establishes the relationship between
gross profit and revenue from operations. This ratio shows
the profit margin on goods sold.

The main objective of computing this ratio is to determine

the efficiency with which
production and purchase/sales operations are carried on.

Higher Gross Profit Ratio is better as it leaves higher margin

to meet operating expenses and creation of reserves.
 2. Operating Ratio
Operating ratio establishes the relationship between operating cost
( cost of revenue from operations + operating expenses) and revenue from
operations.

The objective of computing this ratio is to assess the operational

efficiency
of the business.

Lower operating ratio is better because it leaves higher profit margin to

meet non operating expenses, to pay dividend etc.
A rise in the operating ratio indicates decline in efficiency.
 3. Operating Profit Ratio
Operating profit ratio measures the relationship between operating profit
and revenue from operations.

The objective of computing this ratio is to determine operational efficiency

of the business.

An increase in the ratio over the previous period shows improvement in

the
Operational efficiency of the business enterprise.
 4. Net Profit Ratio

Net profit ratio establishes the relationship between net profit and
revenue from operations. It relates revenue from operations to net
profit after operational as well as nonoperational expenses and
incomes.

Net profit is an indicator of overall efficiency of the business. Higher

the ratio, better the business. An increase in the ratio over the
previous period shows improvement in the operational efficiency and
decline means otherwise
 5. Return on Capital Employed or
Investment (ROCE or ROI)
ROI shows the relationship of profit (profit before interest and tax)with
capital employed. This ratio assesses overall performance of the
enterprise.

It measures how efficiently the resources of the business are used.

ROI is a fair measure of the profitability of any concern with the result
that the performance of different industries may be compared.
EFFECT OF RATIOS
UNDER VARIOUS
CASES
CASE 1
WHEN ONLY NUMERATOR THE RATIO INCREASES.
INCREASES.
 CASE 2
WHEN ONLY NUMERATOR THE RATIO
DECREASES. DECREASES.
 CASE 3
WHEN ONLY DENOMINATOR THE RATIO
INCREASES.
DECREASES.
 CASE 4
WHEN ONLY DENOMINATOR THE RATIO INCREASES.
DECREASES.
CASE 5
WHEN NUMERATOR THE RATIO INCREASES.
INCREASES WHILE

DENOMINATOR DECREASES

N
D
 CASE 6
WHEN NUMERATOR
THE RATIO
DECREASES WHILE DECREASES.
DENOMINATOR INCREASES

N
D
CASE 7
a. If the original ratio is
WHEN BOTH greater than 1, the ratio
NUMERATOR AND
DENOMINATOR
INCREASE BY THE b. If the original ratio is
SAME AMOUNT. less than 1, the ratio

c. If the original ratio is

=1
 CASE 8
a. If the original ratio is
WHEN BOTH greater than 1, the ratio

NUMERATOR AND
DENOMINATOR
DECREASE BY THE b. If the original ratio is
SAME AMOUNT. less than 1, the ratio

c. If the original ratio is

=1