Accounting Ratios
Topic - 1 | MEANING, OBJECTIVES & CLASSICFICATION
Study Material & Notes
Study Material & Notes for the Chapter 11
COMPANY – ACCOUNTING RATIOS
I. Meaning, Objectives & Classification of Accounting Ratios
A. Accounting Ratios – Meaning and Definition
- Ratio: A ratio is a relationship between two things expressed in numbers or amounts.
- Accounting Ratios: When ratios are calculated on the basis of accounting information, than these are called accounting ratios.
- Ratios Analysis: It is a technique of analysis of financial statements to conduct a quantitative analysis of information in a company’s financial statements.
- Expression of Accounting Ratio:
- Pure Ratio like 2:1. All liquidity and solvency ratios are expressed in pure form.
- Percentage like 15%. All profitability ratios are presented in percentage form.
- Times, rate or number like 4 times. All turnover ratios and Interest Coverage Ratio are presented in this form.
- Fraction like ¾
B. Accounting Ratios – Objectives/Uses/Advantages
- Simplify complex figures and establish relationships
- Ratios help in simplifying the complex accounting figures and bring out their relationships.
- They help summarise the financial information effectively and assess the managerial efficiency, firm’s credit worthiness, earning capacity, etc.
- Various Comparisons
- Ratios help comparisons with certain benchmarks to assess as to whether firm’s performance is better or otherwise.
- For this purpose, the profitability, liquidity, solvency, etc., of a business, may be compared:
- over a number of accounting periods with itself (Intra-firm Comparison/Time Series Analysis),
- with other business enterprises (Inter-firm Comparison/Cross-sectional Analysis)
with standards set for that firm/industry (comparison with standard (or industry expectations).
Helps to understand efficacy of decisions
The ratio analysis helps you to understand whether the business firm has taken the right kind of operating, investing and financing decisions. It indicates how far they have helped in improving the performance.
- Identification of problem areas
- Ratios help business in identifying the problem areas as well as the bright areas of the business. Problem areas would need more attention and bright areas will need polishing to get better results.
Topic - 2 | LIQUIDITY RATIOS
Study Material & Notes
Study Material & Notes for the Chapter 11
COMPANY – ACCOUNTING RATIOS
II. LIQUIDITY RATIOS
A. Meaning
- The term liquidity refers to the ability of the company to meet its current liabilities.
- Liquidity ratios are financial ratios that help in analyzing the ability of a business entity to meet its short-term obligations/liabilities.
- Liquidity ratios measure the firms’ ability to fulfil short term commitments out of its liquid assets
- These are analysed by looking at the amounts of current assets and current liabilities in the balance sheet.
- Higher ratio means better capacity to meet its current obligation.
B. Type
1. Current Ratio
2. Liquid Ratio
C. Current Ratio
a. Meaning
- The Current ratio measures the ability of a company to pay its current liabilities using its current assets.
- A higher Current ratio indicates that the company has sufficient current assets to meet its current liabilities.
b. Formula
- It is calculated by dividing Current Assets by Current Liabilities.
- Current Ratio = Current AssetsCurrent Liabilities
- Current Assets = Current Investments + Inventories (excluding stores & spares and Loose tools) + Trade Receivables (Net of provisions) + Cash & Cash equivalents + Short Term Loans & Advances + Other Current Assets
- Current Liabilities = Short Term Borrowings + Trade Payables + Other Current Liabilities + Short Term Provisions
- Working Capital = Current Assets – Current Liabilities
c. Important Considerations
- The ratio is expressed pure i.e. 2:1
- The ideal range for the Current ratio is 2:1
- A Current ratio of less than 1 indicates that the company may have difficulty meeting its current liabilities.
- Higher Current ratio means better capacity to meet its current obligations.
- Very high Current ratio shows funds idleness
D. Liquid Ratio
a. Meaning
- The Liquid ratio is a more stringent measure of liquidity. It measures the ability of a company to meet its current liabilities using its quick assets, which include cash, marketable securities, and accounts receivable.
- Its based on highly liquid assets that can be converted into cash quickly
- The Liquid ratio is also known as Quick ratio or Acid-test ratio.
b. Formula
- It is calculated by dividing Liquid Assets by Current Liabilities.
- Liquid Ratio = Liquid Assets/Current Liabilities
- Liquid Assets = Current Investments + Trade Receivables (Net of provisions) + Cash & Cash equivalents + Short Term Loans & Advances + Other Current Assets excluding Prepaid Expenses
- Current Liabilities = Short Term Borrowings + Trade Payables + Other Current Liabilities + Short Term Provisions
- Liquid Assets = Current Assets – Inventories – Prepaid Expenses
c. Important Considerations
- The ratio is expressed pure i.e. 2:1
- The ideal range for the Liquid ratio is 1.5 : 1
- A Liquid ratio less than 1 indicates that the company may have difficulty meeting its current liabilities even if all of its current assets are liquidated.
- Higher Liquid ratio means better capacity to meet its current obligations.
- Very high Liquid ratio shows funds idleness
Topic - 3 | SOLVENCY RATIOS
Study Material & Notes
Study Material & Notes for the Chapter 11
COMPANY – ACCOUNTING RATIOS
III. SOLVENCY RATIOS
A. Meaning
- The term ‘solvency’ refers to the ability of a concern to meet its long term obligations.
- The long-term liability of a firm is towards debenture holders, financial institutions providing medium and long term loans and public who made deposits
- The Solvency ratios indicate firm’s ability to meet Its interest payments and repayment schedules associated with its long term borrowings.
B. Type
1. Debt Equity Ratio
2. Total Assets to Debt Ratio
3. Proprietary Ratio
4. Interest Coverage Ratio
C. Debt Equity Ratio
a. Meaning
- It is calculated to know the relative claims of outsiders and the owners against the firm’s assets.
- This ratio establishes the relationship between the outsiders funds and the shareholders funds
b. Formula
- It is computed by dividing Long-term debts by Shareholders Funds
- Debt Equity Ratio = Long-term DebtsShareholders Funds
- Long Term Debts = Long Term Borrowings (i.e. debentures, mortgages, public deposits) + Long term provisions
- Shareholders Funds = Equity Share Capital + Preference Share Capital + Reserves & Surplus – Fictitious Assets
or
- Shareholders Funds = Non Current Assets (i.e. Tangible & Intangible assets, Non-current Investments + Long-term Loans & Advances) + Working Capital (i.e. Current Assets – Current Liabilities) Non-current Liabilities (i.e. Long-term Borrowings + Long-term Provisions)
c. Important Considerations
- The Debt Equity ratio is expressed pure i.e. 1:1
- The ideal range for the Debt Equity ratio is 2
- A lower Debt Equity ratio is preferred as it indicates less debt on a company’s balance sheet.
- The purpose of debt equity ratio is to derive an idea of the amount of capital supplied to the Organization by the Owners.
- This ratio is very useful to assess the soundness of long term financial position of the firm.
- It also indicates the extent to which the firm depends upon outsiders for its existence.
- A low debt equity ratio implies the use of more equity than debt.
D. Total Assets to Debt Ratio
a. Meaning
- Total Assets to Debt ratio measures the extent of the coverage of long-term debts by assets.
- This ratio measures safety margin available to lenders of long term debt
b. Formula
- It is computed by dividing Total Assets by Debt
- Total Assets to Debt Ratio = Total Assets/(Debt i.e Long-term Loans)
- Total Assets = Non-current assets + Current Assets
- Long Term Debts = Long Term Borrowings (i.e. debentures, mortgages, public deposits) + Long term provisions + Long-term liabilities
- Non-current assets (i.e. Tangible & intangible assets, non current investments + long term loans & advances)
- Current Assets (i.e. Current Investments + Inventories (excluding stores & spares and Loose tools) + Trade Receivables (Net) + Cash & Cash equivalents + Short Term Loans & Advances + Other Current Assets)
c. Important Considerations
- The Total Assets to Debt ratio is expressed pure i.e. 2:1
- This ratio measures the safety margin available to lenders of long-term debts. It measures the extent to which debt is being covered by assets
- A higher total assets to debt ratio is generally seen as a healthy sign of financial health, indicating that a company has sufficient assets to cover its debts.
- A lower ratio suggests a higher level of financial risk, as it indicates that a significant portion of assets is financed by debt.
- A declining ratio may indicate that a company is taking on more debt relative to its assets, which can be a warning sign.
E. Proprietary Ratio
a. Meaning
- Proprietary ratio establishes the relationship between Shareholders’ funds to Total assets of the firm
- Proprietary ratio throws light on the general financial position of the enterprise. Proprietary Ratio shows the extent to which total assets have been financed by proprietor
b. Formula
- It is computed by dividing Shareholder Funds by Total Assets
- Proprietary Ratio = Shareholders or Proprietary Funds/Total Assets
- Shareholders Funds = Equity Share Capital + Preference Share Capital + Reserves and Surplus
- Total Assets = Non Current Assets + Current Assets
- Non-current assets (i.e. Tangible & intangible assets, non current investments + long term loans & advances)
- Current Assets (i.e. Current Investments + Inventories (excluding stores & spares and Loose tools) + Trade Receivables (Net) + Cash & Cash equivalents + Short Term Loans & Advances + Other Current Assets)
c. Important Considerations
- The Proprietary ratio is expressed in fraction
- The ideal range for Proprietary ratio is 0.5
- A ratio below 0.50 may be alarming for the creditors since they may have to lose heavily in the event of company’s liquidation on account of heavy losses
- A high ratio shows that there is safety for creditors of all types hence a higher ratio is better for the Organization
- This ratio is of particular importance to the creditors who can ascertain the proportion of shareholders’ funds in the total assets employed in the firm.
- Higher proportion of shareholders funds in financing the assets is a positive feature as it provides security to creditors
F. Interest Coverage Ratio
a. Meaning
- It is a ratio which deals with the servicing of interest on loan.
- It is a measure of security of interest payable on long-term debts
- It expresses the relationship between profits available for payment of interest and the amount of interest payable.
- It is also known as debt service ratio or fixed charges coverage ratio
- Interest Coverage Ratio is computed to measure the debt servicing capacity of a firm so far as fixed interest on long-term debt is concerned.
b. Formula
- It is computed by dividing Net Profit before by Interest on Long-term debts
- Interest Coverage Ratio = (Net Profit before Interest and Tax) / (Interest on Long-term debts)
- Net Profit before Interest and Tax = Profit after Tax + Tax + Interest on long-term debts
- Interest on long-term debts = interest on debentures, loans long-term debts or borrowings.
c. Important Considerations
- The Interest coverage ratio is expressed in times
- The ideal interest coverage ratio is 6 to 7 times
- This ratio shows how many times the interest charges are covered by the profits available to pay interest
- Higher the ratio, more secure the lender is in respect of payment of interest regularly.
- A higher ratio indicates that the Organization can meet its interest burden regularly.
Topic - 4 | ACTIVITY RATIOS
Study Material & Notes
Study Material & Notes for the Chapter 11
COMPANY – ACCOUNTING RATIOS
IV. ACTIVITY RATIOS
A. Meaning
- Activity ratios measure the efficiency or effectiveness with which a firm manages its resources.
- These ratios are also called turnover ratios because they indicate the speed at which assets are converted or turned over in Revenue from operations (sales).
- Higher turnover ratio means better utilisation of assets and signifies improved efficiency and profitability
- These ratios are expressed as ‘times’ and should always be more than one. These ratios are also known as Turnover or Efficiency ratios.
B. Type
1. Inventory Turnover Ratio
2. Trade Receivables Turnover Ratio
3. Trade Payables Turnover Ratio
4. Working Capital Turnover Ratio
C. Inventory Turnover Ratio
a. Meaning
- It determines the number of times inventory is converted into revenue from operations during the accounting period under consideration
- It expresses the relationship between the cost of revenue from operations and average inventory.
- It determines how many times inventory is purchased or replaced during a year.
b. Formula
- It is computed by dividing Cost of Revenue from Operations by Average Inventory
- Inventory Turnover Ratio = Cost of Revenue from Operation/Average Inventory
(i) Cost of Revenue From Operations = Net Sales +/– Gross Profit/Loss
(ii) Average Inventory = (Opening Inventory+Closing Inventory)/2
(iii) Cost of Revenue From Operations = Opening Inventory + Purchases (net) + Direct Expenses – Closing Inventory
c. Important Considerations
- The Inventory Turnover ratio is expressed in times
- This ratio measures how fast Inventory is moving and generating sales.
- The objective of calculating inventory turnover ratio is to ascertain whether investment in stock in trade is reasonable or not, ie, only the required amount is invested in stock-in-trade.
- It throws light on utilisation of inventory of goods. High turnover is good but it must be carefully interpreted as it may be due to buying in small lots or selling quickly at low margin to realise cash.
- Low turnover of inventory may be due to bad buying, obsolete inventory, etc., and is a danger signal.
- When figure of Cost of Revenue from Operations is not available, the Revenue from Operations may be put in place of Cost of Revenue from Operations. Similarly, if only closing inventory is given in the question, it may be treated as average inventory.
D. Trade Receivables Turnover Ratio
a. Meaning
- The liquidity position of the firm depends upon the speed with which trade receivables are realised.
- This ratio indicates the number of times the receivables are turned over and converted into cash in an accounting period
- It expresses the relationship between credit revenue from operations and trade receivable.
b. Formula
- It is computed by dividing Credit Revenue from Operations by Average Trade Receivables
- Trade Receivables Turnover Ratio = Credit Revenue from Opertions/Average Trade Receivables
(i) Credit Revenue From Operations = Total Revenue From Operations – Cash Revenue from Operation
(ii) Average Trade Receivables = (Opening Trade Receivables+Closing Trade Receivables)/2
(iii) Trade Receivables = Debtors + Bills Receivables
Note: Provision for doubtful debts is not deducted
c. Important Considerations
- The Trade Receivables Turnover ratio is expressed in times
- This ratio shows efficiency in the collection of amount due from trade receivables.
- Higher the ratio, better it is since it indicates that debts are being collected more quickly.
- In general, a high ratio indicates the shorter collection period which implies prompt payment by debtor and a low ratio indicates a longer collection period which implies delayed payment for debtors.
- If Credit Sales is not specified, then total sales will be deemed as Credit Sales.
- If there is no mention of the opening trade receivables in the problem, then only closing trade receivables (debtors & bill receivables) we be considered as average trade receivables.
E. Average Collection Period
a. Meaning
- This ratio indicates in how many days receivables are getting collected by the Organization
- This is also known as Debt Collection Period or Credit period
b. Formula
- It is computed by dividing Number of days/weeks/months in a year by Trade Receivables Turnover ratio
c. Important Considerations
- The actual collection period can be compared with the stated terms of the organization
- If it is longer than stated credit terms, then this indicates inefficiency in the process of collecting debtors.
F. Trade Payables Turnover Ratio
a. Meaning
- Trade payables turnover ratio indicates the pattern of payment of trade payable.
- This ratio helps in finding out the exact time a firm is likely to take in repaying to its trade payables.
- As trade payable arise on account of credit purchases, it expresses relationship between credit purchases and trade payable.
b. Formula
- It is computed by dividing Net Credit Purchases by Average Trade Payables
- Trade Payables Turnover Ratio = Net Credit Purchases/Average Trade Payables
(i) Net Credit Purchases = Total Purchases – Purchase Returns – Cash Purchases
(ii) Average Trade Payables = Opening Trade Paybles+Closing Trade Paybles/2
(iii) Trade Payables = Creditors + Bills Payables
c. Important Considerations
- The Trade Payables Turnover ratio is expressed in times.
- This ratio shows the number of times the creditors are turned over in relation to purchases
- A high turnover ratio shows the availability of less credit or early payments, hence a low turnover ratio is beneficial for the organization.
- Trade Payables turnover ratio helps in judging the efficiency in getting the benefit of credit purchases offered by suppliers of goods. A high ratio indicates the shorter payment period and a low ratio indicates a longer payment period
- If Credit Purchases is not specified, then total purchases will be deemed as Credit Purchases.
- If there is no mention of the opening trade payables in the problem, then only closing trade payables (creditors & bill payables) we be considered as average trade payables.
G. Average Payment Period
a. Meaning
- This ratio helps in finding out the exact time a firm is likely to take in repaying to its trade payables
b. Formula
- It is computed by dividing Number of days/weeks/months in a year by Trade Payables Turnover ratio
- Average Payment Period = Number of days or weeks or months in a year/Trade Payables Turnover Ratio
c. Important Considerations
- The average payment period can be compared with credit period offered by the suppliers.
- If it is longer than stated credit terms, then this indicates inefficiency in the process of settlement of creditors which may affect organization availability to get purchases on credit in future.
- A shorter payment period shows, organization is availing less credit period or making early payments.
H. Working Capital Turnover Ratio
a. Meaning
- Working capital turnover ratio measures the efficiency at which the working capital is utilised for business operations
- This ratio shows the relationship between working capital and revenue from operations.
- It shows the number of times the working capital has been rotated in generating sales in a year.
b. Formula
- It is computed by dividing Revenue From Operations by Working Capital
- Working Capital Turnover Ratio = Revenue from Operations/Working Capital
- Working Capital = Current Assets – Current Liabilities
c. Important Considerations
- The Working Capital Turnover ratio is expressed in times
- This ratio shows the number of times working capital has been employed in the process of carrying on business
- The objective of calculating Working Capital Turnover Ratio is to ascertain whether or not working capital has been utilized effectively in making revenue from operations
- A higher ratio indicates efficient utilisation of working capital in generating sales and a low ratio indicates the working capital is not properly utilised.
Topic - 5 | PROFITABILITY RATIO
Study Material & Notes
Study Material & Notes for the Chapter 11
COMPANY – ACCOUNTING RATIOS
V. PROFITABILITY RATIOS
A. Meaning
- These ratios are called profitability ratios because it measure the profitability of a business and helps in assessing the overall efficiency of the business.
- Profitability ratios examine the earning capacity and current operating performance of the organization which is the outcome of utilization of resources employed in the business.
- These ratios are helpful for the management to take remedial measures if there is a declining trend. Higher turnover ratio means better utilisation of assets and signifies improved efficiency and profitability
- These ratios are expressed as ‘percentage’
B. Type
1. Gross Profit Ratio
2. Operating Profit Ratio
3. Operating Ratio
4. Net Profit Ratio
5. Return on Investment
C. Gross Profit Ratio
a. Meaning
- Gross profit ratio as a percentage of revenue from operations is computed to have an idea about gross margin
- It expresses the relationship of gross profit to revenue from operations (net sales). Gross profit ratio shows the margin of profit.
b. Formula
- It is computed by dividing Gross Profit by Revenue From Operations
- Gross Profit Ratio = (Gross Profit/Revenue from Operations) X 100
- Gross Profit = Revenue from Operations – Cost of Revenue from Operations
- Cost of Revenue from Operations = Opening Inventory (excluding Stores and Spares and Loose Tools) + Net Purchases + Direct Expenses – Closing Inventory (excluding Stores and Spares and Loose Tools)
- Cost of Revenue from Operations = Cost of Materials Consumed + Purchases of Stock-in-Trade + Changes in Inventories of Finished Goods, WIP and Stock-in-Trade + Direct Expenses.
c. Important Considerations
- The Gross Profit ratio is expressed in percentage form
- It indicates gross margin on products sold.
- It also indicates the margin available to cover operating expenses, non-operating expenses, etc.
- Change in gross profit ratio may be due to change in selling price or cost of revenue from operations or a combination of both.
- A higher ratio is always considered a good sign as it means lower cost of goods sold as well as good returns for the owners.
- A low ratio may indicate unfavourable purchase and sales policy.
D. Operating Ratio
a. Meaning
- Operating Ratio is calculated to assess the operational efficiency of the business.
- It establishes relationship between cost of operations and revenue from operation (net sales).
b. Formula
- It is computed by dividing Operating Cost by Revenue from Operations
- Operating Ratio = (Operating Cost/Revenue from Operations) X 100
- Operating Cost = Cost of Revenue from Operations + Operating Expenses
- Cost of Revenue from Operations = Opening Inventory (excluding Stores and Spares and Loose Tools) + Net Purchases + Direct Expenses – Closing Inventory (excluding Stores and Spares and Loose Tools)
- Operating Expenses = Employees benefit expenses + expenses directly related to business (Office & administrative, selling & distribution, depreciation & amortisation)
c. Important Considerations
- The Operating ratio is expressed in percentage form
- This ratio is calculated to assess the operational efficiency of the business.
- A lower operating ratio is considered a healthy sign as it means higher margin, and thus, more profit
- It is very useful for inter-firm and intra-firm comparisons
E. Operating Profit Ratio
a. Meaning
- Operating Profit Ratio is calculated to assess the operating margin.
- It establishes relationship between operating profit and revenue from operation (net sales).
b. Formula
- It is computed by dividing Operating Profit by Revenue from Operations
- Operating Profit Ratio = (Operating Profit/Revenue from Operations) X 100
- Operating Profit = Gross Profit + Operating Income – Operating Expenses
- Operating Profit = Net Profit before tax + Non-operating Expenses – Non-operating Income
- Non-operating Expenses = Interest on Long-term Borrowings + Loss on Sale of Fixed Assets + Loss by theft/fire + Charity/Donation
- Non-operating Income = Interest received on investments + Profit on Sale of Fixed Assets + Interest/dividend received + Insurance Claim received
c. Important Considerations
- The Operating Profit ratio is expressed in percentage form
- This ratio is calculated to assess the operational efficiency of the business.
- Higher the ratio, the better is the profitability of the business
- It is very useful for inter-firm and intra-firm comparisons
d. Operating Ratio and Operating Profit Ratio
- Operating Ratio = Operating Cost / Revenue from Operations
- Operating Profit Ratio = Operating Profit / Revenue from Operations
- Operating Cost + Operating Profit = Revenue from Operations
- Operating Ratio + Operating Profit Ratio = (Operating Cost / Revenue from Operations) + (Operating Profit / Revenue from Operations)
- Operating Ratio + Operating Profit Ratio = Operating Cost + Operating Profit / Revenue from Operations
- Operating Ratio + Operating Profit Ratio = Revenue from Operations / Revenue from Operations
- Operating ratio and Operating profit ratio are complementary to each other and thus, if one each ratio Is deducted from 100, other ratio is obtained. In the form of formula :
- Operating Profit Ratio + Operating Ratio = 100
- Operating Profit Ratio = 100 – Operating Ratio
- Operating Ratio = 100 – Operating Profit Ratio
F. Net Profit Ratio
a. Meaning
- Net profit ratio is based on all inclusive concept of profit
- It relates revenue from operations to net profit after operational as well as non-operational expenses and incomes.
- Net profit ratio determines overall efficiency of the business.
- It expresses the relationship of Net profit to Revenue from operations (net sales).
b. Formula
- It is computed by dividing Profit after Tax by Revenue From Operations
- Net Profit Ratio = (Profit after Tax / Revenue from Operations) X 100
- Profit after Tax = Gross Profit + Operating Income + Non-operating Income – Operating Expenses – Non-operating expenses – Tax
c. Important Considerations
- The Net Profit ratio is expressed in percentage form
- It reflects the overall efficiency of the business, assumes great significance from the point of view of investors.
- A firm with a high net profit ratio is in an advantageous position to survive in case of rising cost of production and falling selling prices.
- Where the net profit ratio is low, the firm will find it difficult to withstand these types of adverse conditions.
G. Return on Investment
a. Meaning
- This ratio indicates how efficiently the management has utilised the funds employed by owners and lenders.
- It assesses the overall performance of the enterprise. It measures, how efficiently the resources entrusted to the business are used.
- It establishes the relationship between Net profit before interest, tax & dividend to Capital Employed (equity & debts).
b. Formula
- It is computed by dividing Profit before Interest Tax and Dividend by Capital Employed
- Return on Investments = (Profit before Interest, tax and Dividend / Capital Employed) X 100
- Capital Employed (Liabilities Approach): Share Capital + Reserves and Surplus + Long-term Borrowings + Long-term Provisions
- Capital Employed (Assets Approach): Non-Current Assets (Tangible Assets + Intangible Assets) + Non-current Investments + Long-term Loans and Advances) + Working Capital.
c. Important Considerations
- The Return on Investments ratio is expressed in percentage form
- The objective of calculating return on investment is to measure the earning power of the net assets of the business.
- This ratio is very important from Investors’ point of view in assessing whether their investment in the firm generates a reasonable return or not.
- The higher the Return on Investments, the more efficient the management is considered to be in using the funds employed.
- For inter-firm comparison, return on capital employed funds is considered a good measure of profitability