ACCOUNTING RATIOS

RATIO Significance Remarks

I. LIQUIDITY RATIOS :
1. CURRENT RATIO This ratio shows short-term financial Current Assets = Current
CURRENT ASSETS soundness of the Business. Higher Investments +Inventories
= ------------------------------- ratio means better capacity to meet (Excluding Stores Spares
its Current obligation. and Loose Tools) + Trade
CURRENT LIABILITIES
Receivables (Net of Prov
The ideal Current Ratio is 2:1 for D/ D) + Cash and Cash
Equivalents + Short-term
Loans and Advances +
Other Current Assets.

Current Liabilities = Short-

term Borrowings + Trade
Payables + Other Current
Liabilities + Short-term
Provisions.
2. LIQUID / QUICK / ACID Liquid Ratio is a fairly accurate
TEST RATIO: measure liquidity. It is based on Quick Assets=Current
LIQIUD ASSETS or QUICK those current assets which can be Assets – Inventories –
converted into Cash and Cash Prepaid Expenses
ASSETS
Equivalents quickly. Ideal Quick
= ------------------------------------ Ratio = 1:1 Note: Inventories and
CURRENT LIABILIITES prepaid expenses are not
Higher the Quick Ratio better the considered as Quick Assets.
short-term financial position.
II. SOLVENCY RATIO
3. Debt to Equity Ratio = This ratio assesses the long-term Debt = Long-term
financial soundness of enterprises. Borrowings, (i.e.,
Debt (LTB + LTP) In general lower the Debt to Equity debentures, mortgage,
Ratio higher the degree of public deposits, bank
Equity (Shareholders’funds) protection enjoyed by lender loans) + Long-term
Ideal debt Equity Ratio = 2:1 Provisions ( Provn for
Gratuity, leave encashment
etc.)

Shareholders’ Funds =
Share Capital + Reserves
and Surplus
4. Total Asset to Debt This ratio measures the safety Total Assets = Non-current
Ratio margin available to lenders of long- Assets (Tangible +
Total Assets term debts. It measures the extent Intangible + Non-current
to which debt is covered by assets. Investments + long-
= -----------------
term Loans and Advances)+
Debt Current Assets (including
 High ratio means higher safety for Stores and Spares and
lenders; a low ratio means lower Loose Tools)
safety for lenders.
Investment by the proprietor is low. Debt = Long term Debts
+Long term Provisions.
5. Proprietary Ratio This ratio shows the extent to which
total assets have been financed by Shareholders’ Funds=Share
the proprietor. Capital + Reserves and
Share holder’s Funds
Surplus
= --------------------------------
Higher the ratio, higher the margin
Total Assets for unsecured lenders and creditors.
But very high ratio means improper
debt to equity which results in lower
ROI.
A low Proprietary Ratio indicates
greater risk to unsecured lenders
and creditors the getting benefit of
trading on equity.
6. Interest Coverage Ratio This ratio shows how many times
Profit before Interest and Tax the interest charges are covered by Profit Before Interest and
= ------------------------------- the profits available to pay interest. Tax =Profit after Tax + Tax
Higher the ratio, more security for + Interest
Interest on Long-term
the lender’s in respect of payment
Debt
of interest.
(Times)
7.Debt to Capital Employed Like debt-equity ratio, it shows Capital employed =
Ratio proportion of long-term debts in Shareholders’ funds +
Long Term Debts capital employed. Low ratio providesLong-term debts (or Non-
security to lenders and high ratio current liabilities)
= --------------------------------------
helps management in trading on OR
Capital Employed (or Net equity. Capital employed = Net
Assets) assets = Total assets –
Current liabilities or =
Non-current assets + Net
working capital.
III. ACTIVITY RATIOS / TURNOVER RATIOS
8.Inventory Turnover Ratio This Ratio measures how fast Average Inventory
Cost of Revenue from Inventory is moving and
Operations generating sales. Opening Inventory +
Closing inventory
= --------------------------------
Higher the ratio, more efficient = ---------------------------------
Average Inventory management of inventories and 2
(Times) vice versa. Also refer formula no. 9,
10, 11 & 12.
9. Trade Receivables Turnover This ratio shows efficiency in the
Ratio collection of amount due from Trade Receivables =
trade receivables. Higher the ratio, (Debtors + Bills receivable)
better it is since it indicates that
 Credit Revenue from debts are being collected more Note- Provision for
Operations quickly. Doubtful Debts is not
deducted.
= ----------------------------------
Average Trade Receivables
Average Trade Receivables (Times) (Opening Debtors +
Opening B/R)+ (Closing
Debtors + Closing B/R)
= ----------------------------------
2
10.Trade Payables Turnover It shows the number of times the Trade Payables means
Ratio creditors are turned over in creditors plus bills payable.
Net Credit Purchases relation to purchases.
A high turnover ratio or shorter Average Trade Payables =
= ----------------------------------
payment period shows the (Opening Creditors +
Average Trade Payables availability of less credit or early Opening B/ P) +
payments. (closing Creditors +
Closing B/P)
(Times) = ----------------------------------
2
11.Net Assets Turnover Ratio It reflects relationship between
(or Capital Employed net revenue from operations and
net assets (capital employed) in
Turnover Ratio)
the business. Higher turnover
means better activity and
Net Revenue from Operations profitability.
Capital Employed ( Net Assets)
High turnover of net assets (or
capital employed) is a good sign
and implies efficient utilisation of
resources resulting in higher
liquidity and profitability in the
business.
12.Fixed Assets Turnover Ratio It reflects relationship between
net revenue from operations and
Net Revenue from Operations net fixed assets of the business.
Higher turnover means better
Net Fixed Assets activity and profitability.
: High turnover of fixed assets is a
good sign and implies efficient
utilisation of resources resulting in
higher liquidity and profitability in
the business
13.Working Capital Turnover This ratio shows the number of
Ratio times working capital has been Working Capital=Current
Revenue from Operations employed in the process of Assets – Current
carrying on business.
or CRFO
Liabilities
= ---------------------------------
 Working Capital Higher the ratio, better the
(Times) efficiency in the utilization of
working capital.
IV. PROFITABILITY RATIO
14.Gross Profit Ratio This Ratio indicates the relationship
Gross Profit x 100 between gross and net sales. Refer Additional formula =
= ---------------------------------- Higher the Ratio, lower the cost Is 8, 9 , 10 & 11
sold.
Revenue from Operations
(Percentage % )

15.Operating Ratio This Ratio is calculated to assess the

Cost of RFO + Operating operational efficiency of the Operating Expenses =
business. A decline in the operating Employees Benefit
Expenses
ratio is better as it means higher Expenses + Dep +
=--------------------------------X 100
margin, and more profit Amortisation + Other
Revenue from Operations Expenses (Other than Non-
(Percentage %) operating Expenses)

Refer Additional formula –

13 & 14
16.Operating Profit Ratio Operating Profit = NPBT +
The objective of computing this NOE - NOI
Operating Profit ratio is to determine operational
efficiency of management NOE = Interest on LTB +
= ----------------------------- x 100
Loss on Sale of FA
Revenue from Operations (Percentage %) & Invest.

NOI = Interest received

on investments + Profit
on Sale of FA & Invest.
17.Net Profit Ratio Indicates overall efficiency of the Net Profit before Tax =
NPBT business. Higher better the Gross Profit +
business Other Income –
= ---------------- X 100
Indirect Expenses
RFO
Net Profit after Tax =
OR (Percentage %) Gross Profit +
NPAT Other Income –
= ------------------- X100 Indirect Expenses -
RFO Tax

18.Return on Investment or It assesses the overall performance CAPITAL EMPLOYED:

Return on Capital Employed of the enterprise. It measures, how Liabilities Side Approach:
efficiently the resources entrusted Shareholder Funds + Long-
to the business are used term Borrowings + Long-
Profit before Interest, Tax
term Provisions
and Dividend Assets Side Approach:
= ---------------------------- X 100 (Percentage %) Non-Current Assets + WC.
Capital Employed
 ADDITIONAL FORMULAE
1. TOTAL ASSETS = TOTAL LIABILITES
2. TOTAL LIABILITIES = SHARE HOLDERS FUNDS + NON-CURRENT LIABILITIES + CURRENT
LIABILITIES
3. TOTAL ASSETS = NON-CURRENT ASSETS + NON-CURRENT INVESTMENTS + CURRENT
INVESTMENTS
4. TOTAL DEBTS = DEBTS (LTB +LTP) + CURRENT LIABILITES
5. TOTAL ASSETS = NON-CURRENT ASSETS + CURRENT ASSETS
6. EQUITY (SHF) = TOTAL ASSETS -TOTAL DEBTS
7. CAPITAL EMPLOYED (LIABILITIES APPROACH) = SHF + DEBT
(ASSETS APPROACH ) = NET FIXED ASSETS + WORKING CAPITAL
8. WORKING CAPITAL = CURRENT ASSETS - CURRENT LIABILITIES
9. COST OF REVENUE FROM OPERATIONS = (OPENING INVENTORY + NET PURCHASES + DIRECT
EXPENSE - CLOSING INVENTORY)
10. GROSS PROFIT = Revenue From Operation – COST OF RFO.
11. OPERATING RATIO (%) + OPERATING PROFIT RATIO {%) = 100
12. OPERATING COST =COST OF REVENUE FROM OPERATIONS + OPERATING EXPENSES.
13. OPERATING PROFIT = GROSS PROFIT + OTHER OPERATING INCOME – OTHER OPERATING
EXPENSES OR
OPERATING PROFIT = REVENUE FROM OPERATIONS – OPERATING COST.

MULTIPLE CHOICE QUESTIONS

1. Two basic measures of liquidity are:
(A) Inventory turnover and Current ratio
(B) Current ratio and Quick ratio
(C) Gross Profit ratio and Operating ratio
(D) Current ratio and average Collection period

2. Liquid Assets do not include:

(A) Bills Receivable (B) Debtors (C) Inventory (D) Bank Balance

3. A Company’s Quick Ratio is 1.5:1; Current Liabilities are Rs.2,00,000 and Inventory is Rs.1,80,000.Current
Ratio will be:
(A) 0.9:1 (B) 1.9 : 1 (C) 1.4:1 (D ) 2.4:1

4. Fixed Assets Rs.5,00,000; Current Assets Rs.3,00,000; Equity Share Capital Rs.4,00,000; Reserve
Rs.2,00,000;Long –term debts Rs.40,000.Proprietory Ratio will be:
(A) 75% (B) 80% (C) 125% (D) 133%

5. Equity Share Capital Rs.20,00,000; Reserves Rs.5,00,000; Debentures Rs.10,00,000; Current Liabilities
Rs.8,00,000. Debt-equity ratio will be:
(A) 0.4 : 1 (B) 0.32 : 1 (C) 0.72 : 1 (D) 0.5 : 1
6. Opening Inventory Rs.1,00,000; Closing Inventory Rs.1,50,000; Purchases Rs.6,00,000; Carriage Rs.25,000;
wages Rs.2,00,000. Inventory Turnover Ratio will be:
(A) 6.6 Times (B) 7.4 Times (C) 7 Times (D) 6.2 Times

7. A firm’s credit revenue from operations is Rs.3,60,000, cash revenue from operations is Rs.70,000. Cost of
revenue from operations is Rs.3,61,200. Its gross profit ratio will be:
(A) 11% (B) 15% (C) 18% (D) 16%

8. Given below are two statements, one labelled as Assertion (A) and the other labelled as Reason (R):
In the context of the above two statements, which of the following is correct:
Assertion (A): Purchase of Loose Tools against cash will reduce the current ratio.
 Reason: Loose Tools and Stores and spares are excluded from Current Assets becausethey are not
held for sale or conversion into cash.
(A) Both (A) and (R) are true and (R) is the correct explanation of (A).
(B) Both (A) and (R) are true and (R) is not the correct explanation of (A).
(C) (A) is true, but (R) is false
(D) (A) is false, but (R) is true.
9. Opening Inventory of a firm is ₹ 80,000. Cost of revenue from operation is ₹ 6,00,000. Inventory
Turnover Ratio is 5 times. Its closing inventory will be:
(A) ₹ 1,60,000 (B) ₹ 1,20,000 (C) ₹ 80,000 (D) ₹ 2,00,000
10. Given below are two statements, one labelled as Assertion (A) and the other labelled as Reason (R):
Assertion (A): Profitability ratios are calculated to analysis the earning capacity of the business.
Reason (R): Profitability ratios are calculated to determine the ability of the business to service its
debt in the long run.
In the context of the above two statements, which of the following is correct:
(A) Both Assertion (A) and Reason (R) are true and Reason (R) is the correct explanation of
Assertion (A).
(B) Both Assertion (A) and Reason (R) are true but Reason (R) is not the correct explanation of
Assertion (A).
(C) Assertion (A) is true but Reason (R) is false.
(D) Assertion (A) is false but Reason (R) is true
11. Assertion(A) : Debt means long term external liabilities
Reason (R) : Debt includes both long term and short term external liabilities
(a) Assertion and reason are correct but reason is not the correct explanation of assertion
(b) Both assertion and reason are correct but reason is the correct explanation of the assertion
(c) Only assertion is correct
(d) Both assertion and reason are incorrect
12. Assertion(A) : Long term financial position of a firm is assessed from liquidity ratios
Reason (R) : Liquidity ratio ie current ratio and quick ratio help in assessing long term financial
position of the firm.
(a) Assertion and reason are correct but reason is not the correct explanation of assertion
(b) Both assertion and reason are correct but reason is the correct explanation of the assertion
(c) Only assertion is correct
(d) Both assertion and reason are incorrect
SOLUTIONS:
1. B 2. D 3. D 4. A 5. A 6. D 7. D 8. A 9. A 10. C
11. C 12. D

3 OR 4 MARKS QUESTIONS
1. A company has a Current Ratio of 4:1 and Quick Ratio is 2.5:1. Assuming that the Inventories
are ₹ 22,500. Find out Total Current Assets and Current Liabilities.
SOLUTION :
Current ratio = 4:1; Quick Ratio = 2.5:1 Inventory = 4 - 2.5 = 1.5 (because Inventory = CA – LA)
If Inventory is 1.5, then Current Assets = 4
If Inventory = ₹ 22,500, then Current Assets = 4 x ₹ 22,500/1.5 = ₹ 60,000
and the Current Liabilities = ₹ 60,000/ 4 = ₹ 15,000.

2. Calculate the following ratios-

(A) Calculate Working Capital Turnover Ratio if Cost of Revenue from Operations is ₹ 8,40,000;
Gross Profit Ratio is 20% and excess of Current Assets over Current Liabilities is ₹ 3,50,000.
(B) From the following details, Calculate Interest Coverage Ratio.
 Net Profit After Tax ₹ 7,00,000 , 6% Debentures of ₹ 20,00,000 Tax Rate 30%
SOLUTION :
(A)Working Capital = Current Assets – Current Liabilities = ₹ 3,50,000 (Given)
1. Revenue from Operations (Sales) :
Gross Profit Ratio = 20 % of Revenue from Operations.
So Gross Profit Ratio on Cost of Revenue from Operations = 25%
Gross Profit = 8,40,000 X 25/100 = ₹ 2,10,000
Revenue from operation = Cost of Revenue from Operations+ Gross Profit
Revenue from operation = 8,40,000+2,10,000

2. Working Capital Turnover Ratio = Revenue from Operations/Working Capital

= 10,50,000/3,50,000 = 3 Times

(B)Net Profit Before Tax = ₹ 100 ; Tax Rate = 30 ; Net Profit after Tax = 70
Net Profit after Tax = ₹ 7,00,000
So Net Profit before Tax = ₹ 7,00,000 x 100/70 = ₹ 10,00,0000
Add : Interest on Debentures ₹ 20,00,000 x 6% = ₹ 1,20,000
Net Profit before Interest and Tax = ₹ 11,20,000
Interest Coverage Ratio = Net Profit before Interest and Tax/Interest on Long-term Debts
= ₹ 11,20,000/1,20,000 = 9.33 Times
3. (A) From the following, Calculate Inventory Turnover Ratio—
Net Revenue = ₹ 2, 00,000; Gross Profit = 25%,
Opening Inventory = ₹ 5000, Closing Inventory = ₹ 15,000
(B) Calculate Gross Profit and Revenue—
Average Inventory = ₹ 80,000; Inventory Turnover Ratio = 6 times
Selling price = 25% above cost.

SOLUTION:
(A) Inventory Turnover Ratio = Cost of Revenue from Operation/Average inventory
= ₹ 1, 50,000/ 10,000 = 15 Times.
Working:
Cost of Revenue= Revenue - Gross Profit
Cost of Revenue = ₹ 2, 00,000 – ₹ 50,000 = ₹ 1, 50,000
Average Inventory = (Opening Inventory + Closing Inventory) / 2
= (₹ 5,000+ ₹15,000) / 2 = ₹ 20,000/2 = ₹ 10,000
(B) Inventory Turnover Ratio =
Cost of Revenue/Average Inventory
6 = Cost of Revenue/ 80,000
Cost of Revenue = ₹ 80,000 x 6 = ₹ 4,80,000
Gross Profit = ₹ 4,80,000 x 25/100 = ₹ 1,20,000
Revenue = Cost of Revenue + Gross Profit
= ₹ 4, 80,000 + ₹ 1, 20,000 = ₹ 6, 00,000.

4. Suggestions would improve the ratio, which would reduce it, which would not change it?
(A) Purchased goods on credit for Rs 50,000 from Ramesh
(B) Purchase of goods from Rahul Rs 20,000 against cheque
(C) Sale of goods costing Rs 50,000 for Rs 60,000 on credit
(D) To sell a fixed asset at Rs 5,000 loss
(E) To borrow money on promissory note
(F) To give promissory note to a creditor
 SOLUTION:
(A) Reduce (B) No Change (C) Improve (D) Improve (E) Reduce (F) No Change

5. From the following information calculate total assets to debt ratio :

Long term borrowings Rs.300000 Long term provisions Rs 150000
Current liabilities Rs. 75000 Non current assets Rs.540000
Current assets Rs. 135000
SOLUTION:
Total assets to debt ratio = Total assets / long term debts
= 675000 / 450000 = 1.5:1

6. Closing Trade Payables Rs.90000, Net Purchases Rs.720000, Cash Purchases Rs.180000
Calculate the trade payable turnover ratio.
SOLUTION
Trade payable turnover ratio = Net credit purchase = 540000 = 6 times
Average trade payable 90000
7. From the given information, calculate : 3
(a) Quick Ratio
(b) Inventory Turnover Ratio
Current Assets 4,00,000 Inventory 1,00,000
Current Liabilities 2,00,000 Net Profit Before Tax 7,20,000
Revenue from Operations 10,00,000 Gross Profit Ratio 20%
SOLUTION:
(a) Quick Ratio= Quick Assets /Current Liabilities
Quick assets = Current Assets – Inventory
= 4,00,000 – 1,00,000 = ₹3,00,000
Quick Ratio = 3,00,000 = 1.5:1
2,00,000
(b) Inventory Turnover Ratio = Cost of Revenue from Operations /Average Inventory
Cost of Revenue from Operation = Revenue from Operations – Gross Profit
= 10,00,000 – 2,00,000 = ₹ 8,00,000
Inventory Turnover Ratio = 8,00,000/1,00,000 = 8 times
8. From the following information, calculate Return on Investment:
Particulars Rs.
Total Assets 22,00,000
10% Debentures 5,00,000
Current Liabilities 2,00,000
Net Profit After Tax 7,20,000
Tax 1,80,000
SOLUTION:
Return on Investment = Profit Before Interest and Tax x 100 / Capital Employed
Profit Before Interest and Tax = Net Profit After Tax + Tax + Interest on Debentures
= 7,20,000 + 1,80,000 + 50,000 = 9,50,000
Capital Employed = Total Assets – Current Liabilities
= 22,00,000 – 2,00,000 = 20,00,000
Return on Investment = 9,50,000 x 100 /20,00,000 = 47.5%