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 financial statements for
assessing the solvency, efficiency and profitability of
the firms.
 OBJECTIVES OF RATIO
ANALYSIS

 To simplify the accounting information

 To determine the liquidity( short term and long
term financial obligations)
 To assess the operational efficiency of the
business
 To analyse the profitability of the business
 To help in comparative analysis ( inter firm and
intra firm comparisons)
 ADVANTAGES OF RATIO
ANALYSIS

 Useful tool for analysis of financial statements

 Simplifies accounting data
 Useful for forecasting
 Useful in inter firm and intra firm comparison
 Useful in locating the weak areas.
 Useful in assessing the operational efficiency 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
 Percentag
Pure Pure Times
e
 [Link] RATIOS

CURRENT • Current assets

RATIO • Current liabilities

LIQUID • Liquid or Quick Assets

RATIO • Current liabilities

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 a. Short term borrowings (bank

b. Inventories 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
(cash in hand, cash at bank, cheques/drafts) in 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 firms
ability to meet its long term obligations. They are expressed in
pure form.
The Solvency ratios are : Debt-Equity Ratio

1. Debt-Equity Ratio Proprietary Ratio

2. Proprietary Ratio
Solvency ratios
3. Total Assets to Debt Ratio Total Assets to
4. Interest Coverage Ratio Debt Ratio

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 firm 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 firm is depending more on shareholders

funds than borrowings. So lenders are at a lower risk and have higher safety.
A low ratio reflects 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 fixed 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 financed 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 firm getting benefit 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 firm. 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 firm.

 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 profits

available to cover interest on long term debt.

 A high ratio is better 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 Inventory Turnover
3. Trade Payables Turnover
4. Working Capital Turnover.
Trade Receivables
Turnover
ACTIVITY (OR
TURNOVER) RATIO
Trade Payables
Turnover

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.
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.
 [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.
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

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 OPERATING

PROFIT
ii. Operating Ratio
iii. Operating profit Ratio OPERATING NET PROFIT
iv. Net profit Ratio
v. Return on Investment Ratio

GROSS PROFITABIL RETURN ON

PROFIT ITY RATIOS INVESTMENT
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.
WHEN ONLY THE RATIO
NUMERATOR INCREASES.
INCREASES.
WHEN ONLY NUMERATOR THE RATIO DECREASES.
DECREASES.
WHEN ONLY THE RATIO DECREASES.
DENOMINATOR INCREASES.
WHEN ONLY THE RATIO
DENOMINATOR INCREASES.
DECREASES.
WHEN NUMERATOR THE RATIO
INCREASES WHILE INCREASES.
DENOMINATOR DECREASES

N
D
 WHEN NUMERATOR
THE RATIO DECREASES.
DECREASES WHILE

DENOMINATOR INCREASES

N
D
 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
 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