E- ACCOUNTING GURUKULAM: ACCOUNTING RATIOS

ACCOUNTING RATIOS

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 ratios represent relationship between two accounting numbers.

Objectives of Ratio Analysis

1. To know the areas of the business which need more attention;

2. To know about the potential areas which can be improved.

3. To provide a deeper analysis of the profitability, liquidity, solvency and efficiency levels in the business;

4. To provide information for making cross sectional analysis by comparing the performance with the best industry standards; and

5. To provide information derived from financial statements useful for making projections and estimates for the future

Advantages of Ratio Analysis

Types of Ratios

LIQUIDITY RATIOS

Liquidity ratios are calculated to measure the short-term solvency of the business. The two ratios included in this category are Current Ratio and Liquidity Ratio.

Current Ratio

Current ratio is the proportion of current assets to current liabilities.

Current Ratio =

Current assets include current investments, inventories, trade receivables (debtors and bills receivables), cash and cash equivalents, short-term loans and advances and other current assets such as prepaid expenses, advance tax and accrued income, etc.

Current liabilities include short-term borrowings, trade payables (creditors and bills payables), other current liabilities and short-term provisions.

A very high current ratio implies heavy investment and A low ratio endangers the business and puts it at risk.

Quick Ratio

It is the ratio of quick (or liquid) asset to current liabilities. It is also known as Acid-Test Ratio.

Quick Ratio =

While calculating quick assets we exclude the inventories at the end and other current assets such as prepaid expenses, advance tax, charges and expenses, etc. from the current assets.

A1:1 ratio will be safe , low ratio will be very risky.

SOLVENCY RATIOS

Solvency ratios are calculated to determine the ability of the business to service its debt. The Solvency ratios are ;

1. Debt-Equity Ratio;

2. Debt to Capital Employed Ratio;

3. Proprietary Ratio;

4. Total Assets to Debt Ratio;

5. Interest Coverage Ratio.

Debt-Equity Ratio

Debt-Equity Ratio measures the relationship between long-term debt and equity. Normally 2:1 is a good debt-equity ratio.

Debt-Equity Ratio =

Debt to Capital Employed Ratio

It refers to the ratio of long-term debt to the total of external and internal funds (capital employed or net assets).

Debt to Capital Employed Ratio =

Low ratio provides security to creditors and high ratio helps management in trading on equity.

Proprietary Ratio

Proprietary ratio expresses relationship of proprietor’s (shareholders) funds to net assets.

Proprietary ratio =

Total Assets to Debt Ratio

This ratio measures the extent of the coverage of long-term debts by assets.

Total Assets to Debt Ratio =

The higher ratio indicates that assets have been mainly financed by owners funds and the long-term is adequately covered by assets.

Interest Coverage Ratio

It is a ratio which deals with the servicing of interest on loan. A higher ratio ensures safety of interest on debts

Interest Coverage Ratio =

ACTIVITY (OR TURNOVER) RATIO

These ratios indicate the speed at which, activities of the business are being

performed. The activity ratios are ;

1. Inventory Turnover

2. Trade Receivable Turnover

3. Trade Payable Turnover

4. Investment (Net Assets) Turnover

5. Fixed Assets Turnover

6. Working Capital Turnover.

Inventory Turn-over Ratio

It determines the number of times inventory is converted in to revenue from operations. Lower ratio is danger and higher ratio is good.

Inventory Turn-over Ratio =

Trade Receivables Turnover Ratio

It expresses the relationship between credit revenue from operations and trade

receivable. Higher turnover means speedy collection from trade receivable.

Trade Receivables Turnover Ratio =

Trade Payable Turnover Ratio

Trade Payables turnover ratio indicates the pattern of payment of trade payable. Lower ratio means credit allowed by the supplier is for a long period.

Trade Payable Turnover Ratio =

Net Assets/Capital Employed Turnover Ratio

It reflects relationship between net assets/capital employed and revenue from

operations in the business. Higher turnover means better activity and profitability.

Net Assets/Capital Employed Turnover Ratio =

Fixed Assets Turnover Ratio

Fixed asset turnover Ratio =

Working Capital Turnover Ratio

Working Capital Turnover Ratio =

PROFITABILITY RATIOS

Profitability ratios are calculated to analyse the earning capacity of the business. The profitability ratios are ;

1. Gross Profit Ratio

2. Operating Ratio

3. Operating Profit Ratio

4. Net profit Ratio

5. Return on Investment (ROI) or Return on Capital Employed (ROCE)

6. Return on Net Worth (RONW)

7. Earnings per Share

8. Book Value per Share

9. Dividend Payout Ratio

10. Price Earning Ratio.

Gross Profit Ratio

Gross profit ratio as a percentage of revenue from operations is computed to find out gross margin. Higher gross profit ratio is always a good sign.

Gross Profit Ratio =

Operating Ratio

It is computed to analyse cost of operation in relation to revenue from operations.

Operating Ratio =

Operating Profit Ratio

It is calculated to reveal operating margin. Lower operating ratio is a very healthy sign.

Operating Profit Ratio = 100 – Operating Ratio

Operating Profit Ratio =

Net Profit Ratio

It relates revenue from operations to net profit after operational as well as non-operational expenses and incomes.

Net Profit Ratio =

Return on Capital Employed or Investment (ROCE or ROI)

It explains the overall utilisation of funds by a business enterprise.

Return on Capital Employed =

Return on Shareholders’ Funds

It is in assessing whether the shareholder’s investment in the firm generates a reasonable return or not. It should be higher than the return on investment.

Return on Shareholders’ Funds =