Accounting Ratio (vi) To provide information useful for making

Introduction estimates and preparing the plans for future.

1. Ratio It is an arithmetical expression of Advantages of Ratio Analysis
relationship between two related or interdependent (i) It is useful in analysis of financial statements.
items. (ii) Helps in simplifying accounting figures.
2. Accounting Ratios It is a mathematical (iii) Useful in judging the operating efficiency of
expression that shows the relationship between business.
various items or groups of items shown in financial (iv) Helps in identification of problem areas.
statements. When ratios are calculated on the (v) Helpful in comparative analysis.
basis of accounting information, they are called Limitations of Ratio Analysis
accounting ratios. (i) Accounting ratios ignore qualitative factors.
3. Ratio Analysis It is a technique which involves (ii) Absence of universally accepted terminology.
re-grouping of data by application of arithmetical (iii) Ratios are affected by window-dressing.
relationship. (iv) Effects of inherent limitations of accounting.
Objectives of Ratio Analysis (v) Misleading results in the absence of absolute
(i) To know the areas of an enterprise which need data.
more attention. (vi) Price level changes ignored.
(ii) To know about the potential areas which can be (vii) Affected by personal bias and ability of the
improved on. analyst.
(iii) Helpful in comparative analysis of the
performance.
(iv) Helpful in budgeting and forecasting.
(v) To provide analysis of the liquidity, solvency,
activity and profitability of an enterprise.
Classification of Accounting Ratio

Current Ratio Inventory/Stock Turnover Ratio

1. Liquidity
Ratio Liquid/Quick Ratio
Debtors or Receivables Turnover Ratio

Debt-Equity Ratio Creditors or Payable Turnover

Ratio

Total-Assets to 3. Activity Ratio

Debt Ratio
Fixed Assets Turnover Ratio
2.Solvency Proprietary Ratio
Ratio
Net Assets Turnover Ratio
Interest Coverage
Ratio
Working Capital Turnover Ratio
Debt to Capital
employed Ratio
 and spares)
Gross Profit Ratio
(c) Trade receivables (bills receivable and
sundry debtors less provision for doubtful
Operating Ratio debts)
(d) Cash and cash equivalents (cash in hand,
4.Profitability Operating Profit cash at bank, cheques/drafts in hand)
or Ratio (e) Short-term loans and advances
(f) Other current assets (prepaid expenses,
Income Ratio
Net Profit Ratio interest receivable, etc.)
Items Included in Current Liabilities
(a) Short-term borrowings
Return On
(b) Trade payables (bills payable and sundry
Investment R.O.I
creditors)
(c) Other current liabilities (current maturities
of long-term debts, interest, accrued but not
1.Liquidity Ratio. due on borrowings, interest accrued and due
Liquidity ratios measure the firm’s ability to fulfil its on borrowings, outstanding expenses,
short-term financial obligations. unclaimed dividend, calls-in-advance, etc)
a.Current Ratio (d) Short-term provisions
This ratio establishes relationship between current b. Liquid ratio/Quick ratio/Acid test ratio -
This ratio establishes relationship between
assets and current liabilities and is used to assess
liquid assets and current liabilities and is used
the short-term financial position of the business to measure the firm’s ability to pay the claims
concern. Current ratio of 2:1 is considered to be of creditors immediately. This ratio is a better
ideal. indicator of liquidity and 1 : 1 is considered to
be ideal.

Items Included in Current Assets

(a) Current investments
(b) Inventories (Excluding loose tools, stores
 2. Solvency (long-term solvency)
Items Included in Liquid/Quick Assets These are the ratios which assess the long-term
(i) Current investments. financial position of the enterprise. They assess the
(ii) Trade receivables (bill receivables, debtors ability to meet the long-term financial obligations of
less provisions for doubtful debts). the enterprise.
(iii) Cash and cash equivalents. a. a. Debt-Equity Ratio:- It establishes the
(iv) Short-term loans and advances. relationship between long-term debt (external
(v) Other current assets except prepaid expenses. equities) and the equity (internal equities) i.e.
Items excluded in liquid assets are inventories, shareholders’ funds. It is computed to ascertain
prepaid expenses. soundness of the long-term financial position of the
Current assets – inventories- prepaid firm.
expenses- Advanced Tax Generally, the ratio of 2 : 1 is considered as an
Items Included in Current Liabilities ideal.
(i) Short-term borrowings. 𝐷𝑒𝑏𝑡 𝑜𝑟 𝐿𝑜𝑛𝑔 𝑇𝑒𝑟𝑚 𝐷𝑒𝑏𝑡
(ii) Trade payables (bills payable and sundry 𝐸𝑞𝑢𝑖𝑡𝑦 𝑜𝑟 𝑆ℎ𝑎𝑟𝑒 ℎ𝑜𝑙𝑑𝑒𝑟𝑠 𝑓𝑢𝑛𝑑 𝑜𝑟 𝑁𝑒𝑡 𝑊𝑜𝑟𝑡ℎ
creditors). (i) Shareholders' Funds = (Equity Share Capital +
(iii) Other short-term liabilities. Preference Share Capital + or Net Worth or Internal
(iv) Short-term provisions. Equity Capital Reserve + Revenue Reserve +
Reserve for Contingencies + Retained Earnings +
Sinking Funds) - Fictitious* Assets.
*Fictitious Assets
Unamortised expenses and losses such as,
(i) Preliminary Expenses,
(ii) Underwriting Commission,
(iii) Discount on Issue of Shares, Expenses on Issue of Shares.
(iv) Accumulated Losses,
(v) Discount or Loss on Issue of Debentures,
(vi) Debit Balance of Statement of Profit & Loss etc.
 .
Shareholders' Fund is also called as Proprietor's Fund

(i) Debt = Long-term Borrowings + Long-term Provisions

Or
Debt Total External Liabilities - Current Liabilities
(ii) (a) Shareholders' Funds/Equity = Share Capital + Reserves and Surplus
[where, Share Capital = Equity Share Capital + Preference Share Or Capital]
(b) Shareholders' Funds/Equity = Non-current Assets + Working Capital - Non-
current Liabilities
Non-current Assets = Tangible Assets + Intangible Assets + Non-current Investments + Long-term
Loans and Advances
Working Capital = Current Assets - Current Liabilities
Non-current Liabilities = Long-term Borrowings + Long-term Provisions.

b. Total assets to debt ratio It establishes a Items Included in Total Assets

relationship between total assets and total long- Total Assets It includes
term debts. »Non-current Assets [Fixed assets (Tangible and
intangible assets) + Non-current Investments +
Long-term Loans and Advances
»Current Assets [Current investments + Inventories
(including spare parts and loose tools) + Trade
Receivables + Cash and Cash Equivalents + Short-
term Loans and Advances +Other Current Assets
Items Included in Long-term Debts payable on long-term debts. The ideal
(a) Long-term borrowings coverage ratio is 6 to 7 times.
(b) Long-term provisions
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑏𝑒𝑓𝑜𝑟𝑒 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑇𝑎𝑥
C. Proprietary ratio It establishes the 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑜𝑛 𝐿𝑜𝑛𝑔 𝑡𝑒𝑟𝑚 𝐷𝑒𝑏𝑡 𝑜𝑟 𝐹𝑖𝑥𝑒𝑑 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐶ℎ𝑎𝑟𝑔𝑒𝑠
relationship between proprietors’ funds and total e. Debt to Capital Employed Ratio
assets. This ratio establishes a relationship between Long
term Debts and Capital Employed. It is computed to
ascertain the long-term financial soundness
of the enterprise.
Proprietors’ Funds or Shareholders’ Funds 𝐿𝑜𝑛𝑔 𝑇𝑒𝑟𝑚 𝐷𝑒𝑏𝑡𝑠
Liabilities Approach:- Share Capital + Reserves
and Surplus 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑
or Long-term Debts include:
Assets Approach (1) 'Long-term Borrowings' and (ii) 'Long-term
*Non-current Assets (Tangible assets + Provisions'.
Intangible assets + Non-current trade (1) Long-term Borrowings are the borrowings
investments + Long-term loans and advances) + payable after 12 months from the date of Balance
Working Capital – Non-current Liabilities (Long- Sheet. These include the following:
term borrowings + Long-term provisions) Debentures, Bonds, Mortgage Loan, Bank Loan,
Total Assets Total assets include Loan from Financial Institutions, Public Deposits
» Non-current Assets [Fixed assets (Tangible etc.
and intangible assets) + Non-current Investments (ii) Long-term Provisions are the provisions
+ Long-term Loans and Advances payable after 12 months from the date of Balance
» Current Assets [Current investments + Sheet. These include the following:
Inventories (including spare parts and loose Provision for Employee Benefits such as
tools) + Trade Receivables + Cash and Cash Provision for Gratuity, Provision for Earned
Equivalents + Short-term Loans and Advances + Leave etc.
Other Current Assets]
D. Interest coverage ratio This ratio
expresses the relationship between net
profit before interest and tax and interest
Capital Employed: Capital Employed is computed
Investments (except non-trade Investments) +
following either Liabilities Side Approach or Assets
Long term Loans and Advances
Side Approach.
Working Capital = Current Assets - Current
Liabilities
First method (Liabilities Side Approach):
Current Assets = Current Investments + Inventories
Capital Employed Shareholder's Funds + Long
(including Loose Tools and Stores and Spares) +
term Debts
Trade Receivables + Cash and Cash Equivalents +
Shareholders Funds include Share Capital and
Short-term Loans and Advances + Other Current
Reserves and Surplus. (If there is a Debit Balance
Assets.
in Statement of Profit & Loss, it is deducted to
Notes:
calculate Shareholder's Funds)
(1) Unless specified, it is assumed that all Non
Long term Debts include Long-term Borrowings
Current Investments are Trade Investments and
and Long-term Provisions Following are deducted
hence will be included in Assets for calculating
to determine Capital Employed under this
Capital Employed.
approach:
(2) Whichever approach is followed (i,e., either
(i) Fictitious Assets such as Advertisement
Liabilities Side approach or Assets Side approach)
Suspense Account
the amount of capital employed will be same.
(ii) Non-trade Investments
3. Turnover or Performance or Activity
Second Method (Assets Side Approach): Ratios
Capital Employed= Non Current Assets + Working These ratios measure how efficiently a company is
Capital using its assets to generate sales.
Non Current Assets = Property, Plant and a. A. Stock turnover ratio or Inventory
Equipment and Intangible Assets + Non Current turnover ratio:- The ratio indicates the
number of times the stock is turned in sales
 during the accounting period, i.e. it
measures how fast the stock is moving
through the firm and generating sales.

c. C. Trade payables or Creditors turnover ratio:- It

indicates the speed with which the amount is being
paid to creditors. The higher the ratio, the better it is.

b. Trade Receivables or Debtors turnover

ratio:- It indicates economy and efficiency in the
In the absence of opening creditors and bills
collection of amount due from debtors.
payable, closing creditors and bills payable can be
used in the above formula. Also, if credit purchases
are not given, then all purchases are deemed to be
on credit.
d.
e.
f.
d. Fixed asset turnover ratio :- It measures the 4. Profitability Ratios
efficiency of the company’s net sales over its These ratios measure the profitability of a
net fixed assets. business assessing the and helps in overall
Fixed asset turnover ratio=
( )
efficiency of the business.
a. Gross profit ratio :- GP ratio is a profitability
ratio that deals with the relationship between
gross profit and the total net sales revenue. This
Net Fixed Assets = Fixed Assets – Depreciation + ratio is used to evaluate the operational
Intangible Assets performance of the business.
Fixed Assets = Land and Building,Plant &
Machinery , Furniture and fixtures, Computer
,Vehicles, Office Equipment etc.
Intangible Assets = Goodwill, Trade marks,
Patents, Copyright, Mining Rights, Licences,
Computer software.
e. Net Assets Turnover Ratio :-
The asset turnover ratio compares performance b. Operating ratio:- Operating ratio establishes
from the income statement with the company's the relationship between operating cost and
financial health on the balance sheet. revenue from operations i.e. net sales.
𝑪𝒐𝒔𝒕 𝒐𝒇 𝑹𝒆𝒗𝒆𝒏𝒖𝒆 𝒇𝒓𝒐𝒎 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒐𝒏 + 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑬𝒙𝒑𝒆𝒏𝒔𝒆𝒔 − 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑰𝒏𝒄𝒐𝒎𝒆
𝑹𝒆𝒗𝒆𝒏𝒖𝒆 𝒇𝒓𝒐𝒎 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒐𝒏

f. Working capital turnover ratio :- This ratio Operating Expenses = Employees Benefits Expenses +
shows the number of times the working capital has Other Expenses (Other than non-operating expenses)
+ Depreciation and Amortisation Expenses
been rotated in generating sales. or
Office expenses, administrative expenses, selling and
distribution expenses, employees benefit expenses,
depreciation and amortisation expenses.
c. Operating profit ratio:- Operating profit ratio Net profit = Revenue/Sales + Income from other
establishes the relationship between the sources – Cost of Goods Sold – Operating
operating profit and i.e. (revenue from Expenses – Other Expenses – Interest –
operations) net sales. Operating profit ratio is Depreciation – Taxes.
an indicator of operational efficiency of the Net Profit = Gross Profit + Indirect Income –
business. Indirect Expenses

e. Return on investment/Capital employed:- It

establishes the relationship between net profit
before interest, tax and preference dividend and
capital employed (equity + debts).

𝑵𝒆𝒕 𝑷𝒓𝒐𝒇𝒊𝒕 𝒃𝒆𝒇𝒐𝒓𝒆 𝑻𝒂𝒙, 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒂𝒏𝒅 𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅𝒔

𝑿𝟏𝟎𝟎
𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝑬𝒎𝒑𝒐𝒚𝒆𝒅
d. . Net Profit Ratio: This is a profitability ratio that
deals with the relationship between net profit after
tax and net sales. It is calculated by dividing the net
profit (after tax) by net sales.