Institute of Commerce And Taxes

# A/326, SAHEED NAGAR, BBSR MOB: 9861545426

Management Accounting [+3 COMM]
Q1. Define Ratio Analysis. Discuss various importance’s and limitations of accounting ratios.
Ratios are relationship of various items of financial statements in arithmetical terms.
Ratio analysis is referred to as the study or analysis of the line items present in the financial statements
of the company. It can be used to check various factors of a business such as profitability, liquidity,
solvency and efficiency of the company or the business.
Ratio analysis is mainly performed by external analysts as financial statements are the primary source
of information for external analysts.
There are a lot of financial ratios which are used for ratio analysis. The groups of ratios are as follows:
1. Liquidity Ratios: Liquidity ratios are helpful in determining the ability of the company to meet its
debt obligations by using the current assets. At times of financial crisis, the company can utilise the
assets and sell them for obtaining cash, which can be used for paying off the debts.
Some of the most commonly used liquidity ratios are quick ratio, current ratio, cash ratio, etc.
The liquidity ratios are used mostly by creditors, suppliers and any kind of financial institutions such as
banks, money lending firms, etc for determining the capacity of the company to pay off its obligations
as and when they become due in the current accounting period.
2. Solvency Ratios: Solvency ratios are used for determining the viability of a company in the long
term or in other words, it is used to determine the long term viability of an organisation.
Solvency ratios calculate the debt levels of a company in relation to its assets, annual earnings and
equity. Some of the important solvency ratios that are used in accounting are debt ratio, debt to capital
ratio, interest coverage ratio, etc.
Solvency ratios are used by government agencies, institutional investors, banks, etc to determine the
solvency of a company.
3. Activity Ratio: Activity ratios are used to measure the efficiency of the business activities. It
determines how the business is using its available resources to generate maximum possible revenue.
These ratios are also known as efficiency ratios. These ratios hold special significance for business in
a way that whenever there is an improvement in these ratios, the company is able to generate revenue
and profits much efficiently.
Some of the examples of activity or efficiency ratios are asset turnover ratio, inventory turnover ratio,
etc.
4. Profitability ratios: The purpose of profitability ratios is to determine the ability of a company to
earn profits when compared to their expenses. A better profitability ratio shown by a business as
compared to its previous accounting period shows that business is performing well.
The profitability ratio can also be used to compare the financial performance of a similar firm, i.e it can
be used for analysing competitor performance.
Some of the most used profitability ratios are return on capital employed, gross profit ratio, net profit
ratio, etc.
5. Coverage Ratios: Shows the equation between profit in hand and the claims of outside
stakeholders. These are stakeholders that are required by the law to be paid, even in case of
liquidation. So these types of ratios ensure that there is enough to cover these payments to such
outsiders. Some examples of coverage ratios are Dividend Payout Ratio, Debt Service ratio etc.
Importance / Significance :
i) Useful in financial position analysis: Ratio analysis makes the financial data more meaningful
for the management by which it can acquire more financial assistance from different Banks and
other creditors in form of their investments. Similarly, the analyst can determine the improvement
or deterioration in the financial position of the concern through the Ratios.
ii) It helps in decision making: The management cannot make a sound decision for the enterprise
from the financial statement as it lacks meaningful conclusion. So through ratio analysis the
management can make proper planning and forecasting as a guide for the future.
iii) It helps in comparison and control: Through Ratios, comparison can be made between different
departments in order to evaluate their performance. If deviations are found then corrective
measures can be taken to exercise effective control.
iv) Utility to Government: Govt. is interested to know the overall strength of the enterprise which are
calculated through ratio analysis. So, the Govt. can frame the future policies for the country as a
whole after getting the industrial information from various enterprise.
Limitations:
i) It gives false results if based on unreliable data: Ratio analysis of accounting data can be
correctly made if the figures in the financial statement are correctly obtained. It means sometimes
the facts and figures in the financial statement are affected by window dressing which means
showing the position better than the actual. For example, if the value of inventory is inflated or
depreciation is not charged, then profitability of the concern may be misleading even in the ratio
analysis. Hence the analyst cannot interpret the financial data and figures if there is lack of
reliability of facts.
ii) Variation in accounting methods: The results of two firms can be compared through ratio
analysis only when they follow same accounting methods while recording. But in actual practice it
becomes difficult for comparison as different firms follow different accounting principles. For
example different methods of the charging depreciation and valuation of stock in financial
statement leads to wrong interpretation in the ratio analysis.
iii) No common standard: It is very difficult to fix and determine a common standard for comparison
of data of two equal firms. Because circumstances differ from concern to concern and the nature
of each industry is different. For example, different firms in order to calculate profitability ratio, may
take the profit before charging interest and tax or profit before tax but after interest or profit after
interest and tax. So, there may be changed results obtained through ratio analysis. Hence, in order
to make the profitability ratio more comparable it is necessary to adopt some accepted accounting
standards to make correct interpretation of ratios.
iv) No use for unrelated figures:
The ratio analysis may be made even for two unrelated or insignificant figures which may not give
a clear interpretation. For example, the ratio between sales and investment in Govt. securities may
mislead the interpretation. So, ratios should be calculated on the basis of cause and effect
relationship. Hence an analyst should be clear about the cause and effect before calculating a ratio
between two figures.
Advantages of Ratio Analysis are as follows:
• Helps in forecasting and planning by performing trend analysis.
• Helps in estimating budget for the firm by analysing previous trends.
• It helps in determining how efficiently a firm or an organisation is operating.
• It provides significant information to users of accounting information regarding the performance of
the business.
• It helps in comparison of two or more firms.
• It helps in determining both liquidity and long term solvency of the firm.
Disadvantages of Ratio Analysis are as follows:
• Financial statements seem to be complicated.
• Several organisations work in various enterprises each possessing different environmental positions
such as market structure, regulation, etc., Such factors are important that a comparison of 2
organisations from varied industries might be ambiguous.
• Financial accounting data is influenced by views and hypotheses. Accounting criteria provide
different accounting methods, which reduces comparability and thus ratio analysis is less helpful in
such circumstances.
• Ratio analysis illustrates the associations between prior data while users are more concerned about
current and future data.
Q2. Classify accounting ratios that are helpful to management.
Following are the ratios:
Financial ratios / Balance sheet / Position statement ratio :
These ratios are calculated to judge the financial position of the concern from short term and long term
point of view and hence these are grouped into three groups.
a) Liquidity Ratios b) Current Assets Movement / Turnover Ratio c) Stability Ratios
a) Liquidity Ratios (Short term Financial Position):-These ratios are calculated to measure the
liquidity position or the strength of the concern in meeting its current obligations. It can easily
compare short term obligations and the short term or current resources available to meet those.
Normally, Current assets and Current liabilities are considered in these ratios.
i) Current ratio / working capital ratio : It is a ratio of current assets to current liabilities which
represents the firms capacity to pay current liabilities through its current assets. For this reason,
current assets include cash, Bank balance, short term investment, B/R, Debtors, loans & Advance
given, closing stock, prepaid expenses. Similarly, current liabilities include, sundry creditors, B/P,
outstanding expenses, un-expired incomes, Bank overdraft, Income Tax payable and dividend
payable.
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐀𝐬𝐬𝐞𝐭𝐬
Hence Current Ratio = 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬
Interpretation : Generally 2 :1 is considered ideal for a concern as a Banker’s Rule of thumb. The
idea behind this rule of double the current assets over current liabilities is to face the delays and
losses in the realization of current assets.
ii) Liquidity / Quick / Acid test ratio : Quick or liquid ratio shows the ability of a firm to meet its
immediate current liabilities with its most liquid or quick assets. The Rule of Thumb for the liquid
assets to liquid liabilities is 1:1. Liquid assets, which are readily converted into cash and include cash
and Bank balance, sundry debtors, B/R, short term investment excluding inventories and prepaid
expenses. Similarly, liquid liabilities include all current liabilities except bank overdraft. It is Acid test
ratio as it clearly indicates the soundness of financial position.
𝐋𝐢𝐪𝐮𝐢𝐝 𝐀𝐬𝐬𝐞𝐭𝐬
Liquid ratio = 𝐋𝐢𝐪𝐮𝐢𝐝 𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬 (𝐄𝐱𝐩𝐭.𝐁𝐎𝐃)
Interpretation :
A high acid test ratio indicates the capacity of the firm to meet the current liability is better and a low
ratio tells the liquidity is not good. Sometimes a high quick ratio may not be good enough if there are
slow realizable debtors than a low quick ratio.
iii) Absolute liquid / cash ratio/ super quick ratio : Generally, the assets like B/R and debtors are
more liquid and realizable than the inventories. But there may be chance of delay in its immediate
realization into cash. So, absolute liquid ratio includes the assets like cash in hand, cast at bank,
readily realizable securities excluding debtors, B/R and inventories.
𝐂𝐚𝐬𝐡 & 𝐵𝑎𝑛𝑘 𝑏𝑎𝑙𝑎𝑛𝑐𝑒+𝑠ℎ𝑜𝑟𝑡 𝑡𝑒𝑟𝑚 𝑠𝑒𝑐𝑢𝑖𝑡𝑖𝑒𝑠
So absolute liquid ratio = 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬
The rule of thumb of this ratio is 1:2 and it tells the balance of cash is sufficient for the current
liabilities as all creditors don’t demand their dues at the same time.
b) Current assets movement / Efficiency/ Activity / (Short term financial position ) Turnover
Ratio :
These ratios can exactly express the effective utilization of various assets in a concern to promote
sales and profits. It means the enterprise must make good plans for the efficient use of assets to
increase the overall efficiency. These ratios are otherwise known as turnover ratio as it indicates the
usability and execution of assets for developing sales. The higher efficiency ratio reflects greater
utilization of asset where as a lower ratio indicates under utilization of resources.
i) Inventory or stock turnover ratio / stock velocity :- This ratio represents the rate or percentage
at which the inventory is converted into sales during a year. It means if there is higher turnover of
inventory during a year then it leads to more profit and then the efficiency of the management can
be well judged. This ratio reflects a relationship between cost of goods sold during a period and the
average amount of inventory in that period. If there is higher ratio, then it is to be felt that finished
stocks are rapidly turned over or sold. But a low turnover indicates overstocking of stock, more space
& rent and more wastage etc.
𝐂𝐨𝐬𝐭 𝐨𝐟 𝐠𝐨𝐨𝐝𝐬 𝐬𝐨𝐥𝐝
Stock turnover ratio = 𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐬𝐭𝐨𝐜𝐤 𝐝𝐮𝐫𝐢𝐧𝐠 𝐚 𝐩𝐞𝐫𝐢𝐨𝐝
Cost of goods sold = Sales – Gross profit
Or = opening stock + Purchases + Manufacturing expenses – Closing stock
𝐎𝐩𝐞𝐧𝐢𝐧𝐠 𝐬𝐭𝐨𝐜𝐤+𝐂𝐥𝐨𝐬𝐢𝐧𝐠 𝐬𝐭𝐨𝐜𝐤
Similarly, Average stock = 𝟐
For example if the cost of goods sold is Rs.8,00,000 and the average stock is Rs. 2,00,000 then
stock turnover ratio will be 4times.
𝐃𝐚𝐲𝐬 𝐢𝐧 𝐚 𝐲𝐞𝐚𝐫
Again inventory conversion period = 𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 𝐭𝐮𝐫𝐧𝐨𝐯𝐞𝐫 𝐫𝐚𝐭𝐢𝐨
ii)
a) Debtors / receivable turnover ratio / debtors velocity : It indicates the number of times of debt
collection of a firm in each year. It means this ratio tells the collectability of debtors and bills
receivable and represents how the credit policy of the enterprise is being managed. If the ratio is
higher than the management of debtors is more efficient and lower ratio tells inefficient management
of debtors.
𝐍𝐞𝐭 𝐜𝐫𝐞𝐝𝐢𝐭 𝐬𝐚𝐥𝐞𝐬 𝐑𝐬.𝟓,𝟎𝟎,𝟎𝟎𝟎
So debtors turnover ratio : = = 10 times
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐝𝐞𝐛𝐭𝐨𝐫𝐬 𝟓𝟎,𝟎𝟎𝟎
𝐎𝐩𝐞𝐧𝐢𝐧𝐠 𝐝𝐞𝐛𝐭𝐨𝐫𝐬+𝐜𝐥𝐨𝐬𝐢𝐧𝐠 𝐝𝐞𝐛𝐭𝐨𝐫𝐬
Average debtors = 𝟐
Again debtors mean sundry debtors and bills receivable. But the gross value of debtors should be taken
into calculation without deducting the provision for Bad & doubtful debt. Similarly, if the amount of credit
sales, opening and closing debtors is not given, then
𝐓𝐨𝐭𝐚𝐥 𝐒𝐚𝐥𝐞𝐬
D. T. Ratio = 𝐃𝐞𝐛𝐭𝐨𝐫𝐬 & 𝐵/𝑅
b) Average collection period ratio: This ratio represents the average number of days at which the firm
can collect and realize the amount of debtors and B/R. higher ratio of it tells more chances of bad
debt and a lower ratio tells less chance of bad debt. So it tells the speed at which debtors and B/R
are collected.
𝟑𝟔𝟓 𝐃𝐚𝐲𝐬 𝟑𝟔𝟓 𝐃𝐚𝐲𝐬
Average collection period = = 𝟏𝟎 𝐭𝐢𝐦𝐞𝐬 = 36.5 days
𝐃𝐞𝐛𝐭𝐨𝐫𝐬 𝐭𝐮𝐫𝐧𝐨𝐯𝐞𝐫 𝐫𝐚𝐭𝐢𝐨
𝐚𝐯𝐞𝐫𝐚𝐠𝐞 𝐝𝐞𝐛𝐭𝐨𝐫𝐬
Or 𝐧𝐞𝐭 𝐜𝐫𝐞𝐝𝐢𝐭 𝐬𝐚𝐥𝐞𝐬
x No. of days in a period
iii)
a) Creditors / Payable turnover ratio : This ratio tells the average credit period enjoyed by a firm
before paying to the creditors. It means the creditors can also know how much time the firm is taking
for final payment to them for the credit purchase of goods.
𝐍𝐞𝐭 𝐜𝐫𝐞𝐝𝐢𝐭 𝐩𝐮𝐫𝐜𝐡𝐚𝐬𝐞𝐬 𝐑𝐬.𝟐,𝟎𝟎,𝟎𝟎𝟎
So creditors turnover ratio = = = 4 times
𝐚𝐯𝐞𝐫𝐚𝐠𝐞 𝐜𝐫𝐞𝐝𝐢𝐭𝐨𝐬+𝐁/𝐏 𝟓𝟎,𝟎𝟎𝟎
If the amount of credit purchase, creditors at the beginning and end is not given, then the total purchase
and the balance of creditors including B/P are taken into calculation.
A high ratio is better for the firm as creditors are not paid in time and a low ratio is not favorable for the
firm as the firm is not taking full advantage of credit period.
b) Average payment period ratio : It tells the average payment period or the speed at which
payments are made to creditors for credit purchase. It means the average days taken by the firm to
 pay its creditors. A higher ratio indicates that the liquidity position is bad and a lower ratio tells the
liquidity position of firm is better.
𝟑𝟔𝟓 𝐃𝐚𝐲𝐬 𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐜𝐫𝐞𝐝𝐢𝐭𝐨𝐫𝐬
Average payment period = or x 365 days
𝐂𝐫𝐞𝐝𝐢𝐭𝐨𝐫𝐬 𝐭𝐮𝐫𝐧𝐨𝐯𝐞𝐫 𝐫𝐚𝐭𝐢𝐨 𝐂𝐫𝐞𝐝𝐢𝐭 𝐩𝐮𝐫𝐜𝐡𝐚𝐬𝐞
iv) Sales to working capital / working capital turnover ratio : This ratio indicates the effective
utilization of working capital in a firm during a year according to the increase or decrease in sales.
A higher ratio indicates efficient utilization of lower working capital with greater profits. A lower ratio
indicates inefficient utilization of working capital.
𝐂𝐨𝐬𝐭 𝐨𝐟 𝐬𝐚𝐥𝐞𝐬
So, working capital turnover ratio = 𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐰𝐨𝐫𝐤𝐢𝐧𝐠 𝐜𝐚𝐩𝐢𝐭𝐚𝐥
𝐎𝐩𝐞𝐧𝐢𝐧𝐠 𝐰𝐨𝐫𝐤𝐢𝐧𝐠 𝐜𝐚𝐩𝐢𝐭𝐚𝐥+𝐂𝐥𝐨𝐬𝐢𝐧𝐠 𝐰𝐨𝐫𝐤𝐢𝐧𝐠 𝐜𝐚𝐩𝐢𝐭𝐚𝐥
Average working capital = 𝟐
If cost of sales and opening working capital are not given, then
𝐒𝐚𝐥𝐞𝐬
Working capital turnover ratio = 𝐍𝐞𝐭 𝐰𝐨𝐫𝐤𝐢𝐧𝐠 𝐜𝐚𝐩𝐢𝐭𝐚𝐥 𝐚𝐭 𝐭𝐡𝐞 𝐞𝐧𝐝
(Current assets – Current liabilities)
c) Long term financial position / stability / coverage ratio / long term solvency ratio :-
This ratio indicates the long term solvency or the ability of a firm to meet its long term payments like
debentures, interest and installment in time. Through this ratio, the long term creditors can exactly
know the repayment of interest, principal in time with the security of their loans.
i) Debt equity ratio / External – Internal equity ratio : This ratio indicates the proportion of external
debts or outsiders funds and the Internal equities or shareholders funds invested in the company to
measure the long term financial policy.
𝐋𝐨𝐧𝐠 𝐭𝐞𝐫𝐦 𝐝𝐞𝐛𝐭𝐬 𝐨𝐫 𝐨𝐮𝐭𝐬𝐢𝐝𝐞𝐫𝐬 𝐟𝐮𝐧𝐝𝐬
So Debt Equity Ratio = 𝐒𝐡𝐚𝐫𝐞𝐡𝐨𝐥𝐝𝐞𝐫𝐬 𝐟𝐮𝐧𝐝𝐬
Shareholders’ funds include preference share capital equity share capital, credit balance of P/L a/c,
capital reserve, revenue reserve, sinking fund less fictitious assets. Here long term debt also includes
the short term debt like current liabilities. A low ratio is favourable for long term creditors as it provides
safety to them, but it is not better for shareholders. Rule of thumb us 2 : 1 for creditors and 2 :3 for
shareholders. In other words a high ratio means that the creditors have invested more than the owners
and they may suffer in times of distress than the owners. So the creditors prefer low equity ratio. But
the owners prefer a high ratio as this will give them better returns with smaller capital contribution.
ii) Funded debt to total capitalization ratio : This ratio indicates the proportion between long term
funds raised from outsiders and total capital including long term funds available in the business to
meet those. So funded debt includes debentures, mortgage, loans, bonds and other long term
loans. Similarly, total capital includes equity share capital, pref. share capital, reserve, surplus and
debentures, mortgage loans, bonds and other long term loans. Hence, funded debt is that part of
total capitalization which is financed by outsiders.
𝐅𝐮𝐧𝐝𝐞𝐝 𝐝𝐞𝐛𝐭
So, funded debt to total capitalization ratio = 𝐓𝐨𝐭𝐚𝐥 𝐜𝐚𝐩𝐢𝐭𝐚𝐥𝐢𝐬𝐚𝐭𝐢𝐨𝐧
X100
Smaller ratio will be better for the enterprise up to 50% to 55%.
iii) Proprietary / Equity ratio: This ratio indicates the relation between shareholders funds and total
tangible assets otherwise known as net worth to total assets ratio. The share holders funds include
equity share capital, preference share capital, profit, reserve and surplus excluding accumulated
losses like net loss.
𝐒𝐡𝐚𝐫𝐞𝐡𝐨𝐥𝐝𝐞𝐫𝐬 ′ 𝐟𝐮𝐧𝐝𝐬
Equity ratio = 𝐓𝐨𝐭𝐚𝐥 𝐭𝐚𝐧𝐠𝐢𝐛𝐥𝐞 𝐚𝐬𝐬𝐞𝐭𝐬
Higher is the ratio better will be for the business.
iv) Total liabilities to total assets / solvency ratio: This ratio measures the relationship between
𝐓𝐨𝐭𝐚𝐥 𝐥𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬 𝐭𝐨 𝐨𝐮𝐭𝐬𝐢𝐝𝐞𝐫𝐬
total liabilities and total assets of the business. Solvency ratio = 𝐓𝐨𝐭𝐚𝐥 𝐚𝐬𝐬𝐞𝐭𝐬
Lower ratio is better for the business as the business is capable to pay its outside liabilities from the
total assets and the long term solvency is stable.
v) Fixed assets to net worth / fixed assets to proprietor’s funds: This ratio explains whether the firm
has raised adequate long term funds to meet its fixed assets requirements. It gives an idea that
what extent of capital has been used in purchasing fixed assets. The ideal ratio is less than one
that is 67.
𝐅𝐢𝐱𝐞𝐝 𝐚𝐬𝐞𝐭𝐬 𝐥𝐞𝐬𝐬 𝐝𝐞𝐩𝐫𝐞𝐜𝐢𝐚𝐭𝐢𝐨𝐧
Fixed assets to net worth ratio = 𝐒𝐡𝐚𝐫𝐞𝐡𝐨𝐥𝐝𝐞𝐫𝐬′ 𝐟𝐮𝐧𝐝𝐬
vi) Shareholders’ funds include share capital, reserve, surplus. In other words, if the ratio is less than
100%, then it indicates that shareholders funds is more than total fixed assets but if more than
100%, then the owners funds are not sufficient to finance the fixed assets.
vii) Fixed assets to total long term funds / Fixed assets ratio :
𝐅𝐢𝐱𝐞𝐝 𝐚𝐬𝐬𝐞𝐭𝐬 𝐥𝐞𝐬𝐬 𝐝𝐞𝐩𝐫𝐞𝐜𝐢𝐚𝐭𝐢𝐨𝐧
Fixed assets ratio = 𝐓𝐨𝐭𝐚𝐥 𝐥𝐨𝐧𝐠 𝐭𝐞𝐫𝐦 𝐟𝐮𝐧𝐝𝐬
Here long term funds include shareholders funds and long term loans and borrowings. This ratio
tells the extent of fixed assets financed by long term funds. Generally fixed assets should be equal
with total long term funds and hence the ratio should be 100%. But if the fixed assets exceeds the
total long term funds then a part of working capital is used which is not a good policy.
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐚𝐬𝐬𝐞𝐭𝐬
viii) Current assets to proprietors’ funds ratio = 𝐱𝟏𝟎𝟎
𝐒𝐡𝐚𝐫𝐞𝐡𝐨𝐥𝐝𝐞𝐫𝐬 𝐟𝐮𝐧𝐝𝐬
This ratio indication the extent of proprietors funds invested in current assets.
2. (A) General profitability ratios : These ratios are calculated to measure the overall efficiency of a
business as profit is the engine that drives the business. It is helpful to the investors, creditors, workers
and the management as it represents the worth of investment, margin of safety and the source of
benefits respectively. Generally these ratios are calculated through trading, profit and loss a/c and
expressed in percentage.
i. Gross profit ratio : This ratio tells the relationship of gross margin or profit on trading to net sales.
𝐆𝐫𝐨𝐬𝐬 𝐩𝐫𝐨𝐟𝐢𝐭 𝐒𝐚𝐥𝐞𝐬− 𝐂𝐨𝐬𝐭 𝐨𝐟 𝐠𝐨𝐨𝐝𝐬 𝐬𝐨𝐥𝐝
So, Gross profit ratio = 𝐱𝟏𝟎𝟎 Or 𝐱𝟏𝟎𝟎
𝐍𝐞𝐭 𝐬𝐚𝐥𝐞𝐬 𝐍𝐞𝐭 𝐬𝐚𝐥𝐞𝐬
Interpretation: Higher ratio is better as it covers fixed expenses dividends and reserves. But a
low ratio is unfavorable as it indicates high cost of goods sold, reduction in selling price or more
investment on fixed assets instead of raw materials. Sometimes this ratio may be wrongly
obtained due to over valuation of closing stock or undervaluation of opening stock.
ii. Opening ratio : This ratio indicates the proportion of cost of goods sold and other operating
expenses to net sales. Here operating expenses include all administrative, selling and distribution
expenses excluding non operating incomes and expenses like interest and dividend received on
investment, interest paid on loans and debentures, profit or loss on sale of fixed assets. So,
𝐂𝐨𝐬𝐭 𝐨𝐟 𝐠𝐨𝐨𝐝𝐬 𝐬𝐨𝐥𝐝+𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐞𝐱𝐩𝐞𝐧𝐬𝐞𝐬
operating ratio = 𝐱𝟏𝟎𝟎
𝐍𝐞𝐭 𝐬𝐚𝐥𝐞𝐬
Cost of goods sold = Opening stock + Purchase + Direct expenses + Manufacture expenses
– Closing stock Or Sales – Gross profit
Interpretation : Lower operating ratio is better for the business as it provides sufficient profit for
the payment of interest, dividend, tax and reserve etc. But higher ratio is unfavorable as it provides
less profit.
iii. Operating profit ratio : This ratio indicates the relationship between operating profit and sales.
𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐩𝐫𝐨𝐟𝐢𝐭
So, operating profit ratio = 𝐱𝟏𝟎𝟎
𝐍𝐞𝐭 𝐬𝐚𝐥𝐞𝐬
Again operating profit = (Net sales – Operating cost)
Operating cost = cost of goods sold + Operating expenses)
Or Operating profit = (Net profit + Non-operating expenses – Non-operating incomes)
Or Operating profit ratio = 100 – Operating ratio
Higher ratio is better as it provides more profit after meeting all operating cost.
iv. Expenses ratio : This ratio tells the relationship between various expenses to sales. The lower
ratio indicates greater profitability and higher ratio tells lower profitability.
𝐌𝐚𝐭𝐞𝐫𝐢𝐚𝐥 𝐜𝐨𝐧𝐬𝐮𝐦𝐞𝐝
a) Material consumed ratio = 𝐱𝟏𝟎𝟎
𝐍𝐞𝐭 𝐬𝐚𝐥𝐞𝐬
 𝐋𝐚𝐛𝐨𝐮𝐫 𝐜𝐨𝐬𝐭+𝐌𝐚𝐧𝐮𝐟𝐚𝐜𝐭𝐮𝐫𝐢𝐧𝐠 𝐞𝐱𝐩𝐞𝐧𝐬𝐞𝐬
b) Conversion cost ratio = 𝐱𝟏𝟎𝟎
𝐍𝐞𝐭 𝐬𝐚𝐥𝐞𝐬
𝐀𝐝𝐦𝐢𝐧𝐢𝐬𝐭𝐫𝐚𝐭𝐢𝐯𝐞 𝐞𝐱𝐩𝐞𝐧𝐬𝐞𝐬
c) Administrative expenses ratio = 𝐱𝟏𝟎𝟎
𝐍𝐞𝐭 𝐬𝐚𝐥𝐞𝐬
𝐒𝐞𝐥𝐥𝐢𝐧𝐠 & 𝐷𝑖𝑠𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠
d) Selling & Distribution expenses ratio = 𝐱𝟏𝟎𝟎
𝐍𝐞𝐭 𝐬𝐚𝐥𝐞𝐬
𝐍𝐨𝐧−𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐞𝐱𝐩𝐞𝐧𝐬𝐞𝐬
e) Non-operating expenses ratio = 𝐱𝟏𝟎𝟎
𝐒𝐚𝐥𝐞𝐬
v. Net profit ratio : This ratio indicates the relationship between net profit after tax and net sales to
know overall profitability of the business. It is helpful to the proprietors and investors as it reveals
the real profitability of a concern.
𝐍𝐞𝐭 𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐩𝐫𝐨𝐟𝐢𝐭 𝐚𝐟𝐭𝐞𝐫 𝐭𝐚𝐱
So, net profit ratio = 𝐱𝟏𝟎𝟎
𝐍𝐞𝐭 𝐬𝐚𝐥𝐞𝐬
Here operating profit excludes non operating incomes and expenses. Higher ratio indicates better
profitability.
B) Overall profitability ratios :
i) Return on shareholders’ funds / Net worth ratio :- The ratio of net profit after interest and tax to
the shareholders’ funds represents the degree of profitability achieved by the management. Here
shareholders’ funds include preference share capital, equity share capital, reserve & surplus
excluding net loss. So higher ratio is better for the business as it can attract more shareholders to
invest funds.
𝐍𝐞𝐭 𝐩𝐫𝐨𝐟𝐢𝐭 𝐚𝐟𝐭𝐞𝐫 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 & 𝑡𝑎𝑥
Return on shareholders’ funds = 𝐱𝟏𝟎𝟎
𝐒𝐡𝐚𝐫𝐞𝐡𝐨𝐥𝐝𝐞𝐫𝐬 ′ 𝐟𝐮𝐧𝐝𝐬
ii) Return on equity shareholders’ funds : This ratio measures the percentage of net profit earned
on equity shareholders’ funds. Generally the performance of a company can be really judged from
the return on equity capital. Here equity shareholders funds include equity share capital (paid up),
reserve & surplus, credit balance of profit and loss a/c, share premium excluding net loss. Higher
ratio is better for the equity shareholders point of view. Return of equity shareholders fund =
𝐍𝐞𝐭 𝐩𝐫𝐨𝐟𝐢𝐭 𝐚𝐟𝐭𝐞𝐫 𝐭𝐚𝐱,𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐚𝐧𝐝 𝐩𝐫𝐞𝐟𝐞𝐫𝐞𝐧𝐜𝐞 𝐝𝐢𝐯𝐢𝐝𝐞𝐧𝐝
𝐱𝟏𝟎𝟎
𝐄𝐪𝐮𝐢𝐭𝐲 𝐬𝐡𝐚𝐫𝐞𝐬𝐡𝐨𝐥𝐝𝐞𝐫𝐬𝐬 ′ 𝐟𝐮𝐧𝐝𝐬
iii) Earnings per share (EPS) : This ratio determines the earning per equity share and estimates
the company’s capacity to pay dividend to its equity share holders.
𝐍𝐞𝐭 𝐩𝐫𝐨𝐟𝐢𝐭 𝐚𝐟𝐭𝐞𝐫 𝐭𝐚𝐱 𝐚𝐧𝐝 𝐩𝐫𝐞𝐟𝐞𝐫𝐞𝐧𝐜𝐞 𝐝𝐢𝐯𝐢𝐝𝐞𝐧𝐝
So, earning per share = 𝐱𝟏𝟎𝟎
𝐍𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐞𝐪𝐮𝐢𝐭𝐲 𝐬𝐡𝐚𝐫𝐞𝐬
iv) Return on capital employed : This ratio tells the earning capacity of the capital employed in
the business. It means it reflects the overall profitability of the firm in return of capital used.
Hence, higher return is favourable for the firm. So return on capital employed =
𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐩𝐫𝐨𝐟𝐢𝐭 𝐛𝐞𝐟𝐨𝐫𝐞 𝐭𝐚𝐱 𝐚𝐧𝐝 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭
𝐱𝟏𝟎𝟎
𝐂𝐚𝐩𝐢𝐭𝐚𝐥 𝐞𝐦𝐩𝐥𝐨𝐲𝐞𝐝
Here capital employed = Equity share capital + preference share capital + profit + reserve &
surplus + long term liabilities – net loss
Or tangible fixed and intangible assets + current assets – current liabilities
v) Capital turnover / sales to capital employed ratio : This ratio tells the effectiveness of the
capital employed which can increase the sales and profit. So it shows the relationship between
cost of goods sold and the capital employed. Hence higher ratio is better as there is more sales
𝐂𝐨𝐬𝐭 𝐨𝐟 𝐠𝐨𝐨𝐝𝐬 𝐬𝐨𝐥𝐝 𝐨𝐫 𝐬𝐚𝐥𝐞𝐬
and more profit. Capital turnover ratio = 𝐂𝐚𝐩𝐢𝐭𝐚𝐥 𝐞𝐦𝐩𝐥𝐨𝐲𝐞𝐝
Capital employed = shareholders’ funds + long term liabilities.