Accounting Ratios

Ratio is an arithmetical expression of relationship between two

interdependent or related items. Ratios when calculated on the basis of
accounting information are called Accounting Ratios.

Objectives
1. To simplify the accounting information.
2. To determine liquidity, i.e., Short-term solvency (Ability of the
enterprise to meet its short-term financial obligations) and
Long-term solvency (Ability of the enterprise to pay its long-
term liabilities) of the business.
3. To assess the operating efficiency of the business.
4. To analyse the profitability of the business.
5. To help in comparative analysis, i.e., inter-firm and intra-firm
comparisons.
Advantages

1. Useful Tool for Analysis of Financial Statements

Accounting ratios are useful for understanding the financial position
and financial performance of an enterprise. Bankers, investors,
creditors, etc., all analyse Balance Sheet and Statement of Profit &
Loss using ratios.

2. Simplifies Accounting Data

Accounting ratio simplifies, summarises and systematises accounting
data and making it understandable. Its main contribution lies in
communicating precisely the interrelationships which exist between
various elements of financial statements.

3. Useful in Assessing the Operating Efficiency of

Business
Operating efficiency can be assessed with the help of ratio analysis.
Activity Ratios are aimed to evaluate the performance of the enterprise
in utilising the resources.

4. Useful for Forecasting

Accounting ratios are helpful in business planning and forecasting.
The trend of ratios is analysed and used as a guide for future planning

5. Useful in Locating the Weak Areas

Accounting ratios assist in locating the weak areas of the business
even though the overall performance may be good. The management
can then pay attention to the weaknesses and take remedial actions.

6. Useful in Inter-firm and Intra-firm Comparison

A firm may compare its performance with that of other firms or with
the industry standards in general (Inter-firm Comparison or Cross-
sectional Analysis). If the performance of different units belonging to
the same firm is to be compared (Intra-firm Comparison or Time-
series Analysis). Accounting ratios make the comparison simple.
Limitations

1. False Result
Accounting ratios are calculated from the financial statements,
therefore, the reliability of ratio and its analysis depends on the
correctness of the financial statements. If the financial statements are
not true and fair, the analysis will give a false picture of the affairs.

2. Qualitative Factors are not considered

Ratio analysis is a technique of quantitative analysis. It ignores
qualitative factors, which may be important in decision-making.

3. Lack of Standard Ratios

There is no single standard ratio against which accounting ratio can be
compared.

4. May not be Comparable

Accounting ratios may not be comparable if different firms follow
different accounting policies and procedures.

5. Price Level Changes are not considered

Change in price level affects the comparability of the ratios. But price
level changes are not considered in accounting variables from which
ratios are computed. This limits the utility of accounting ratios.

6. Window Dressing
Accounting ratios may be affected by window dressing. Manipulation
of books of account is a way to conceal vital facts and present the
financial position better than what it actually is. On account of such a
situation, presence of particular ratio may not be a definite indicator of
good or bad management.

7. Personal Bias
Personal judgments play an important role in preparing financial
statements and, therefore, the accounting ratios are also not free from
this limitation. The ratios have to be interpreted but different people
may interpret the same ratio in different ways.
 Liquidity Ratio
(Ability to meet short term financial obligations)

1. Current Ratio = Current Assets

Current Liabilities
 Ideal Ratio = 2:1

2. Liquid Ratio/ Liquid Assets

Acid Test Ratio/ =
Current Liabilities
Quick Ratio
 Ideal Ratio = 1:1

 Liquid Assets = Current Assets – Inventories – Prepaid Expenses

 Working Capital = Current Assets – Current Liabilities

 While calculating Current Ratio, ‘Loose Tools’ and ‘Stores and Spares’ are to
be excluded.
Balance Sheet
Shareholder’s Fund Non-Current Assets
- Share Capital Equity
Capital - Reserves & Surplus
Employed
Debt Non- Current Liabilities Current Assets
Total
Current Liabilities Debt

 Total Debt = (Short Term + Long Term)Debt

 Total Debt = (Current + Non-Current)Liabilities
 Capital Employed = Shareholder’s Fund + Non-Current Liabilities
 Both are Pure Ratio
 Solvency Ratio
(Ability to meet long term financial obligations)

Debt
1. Debt to Equity Ratio =
Equity
 Ideal Ratio = 2:1

2. Total Assets to Debt Ratio = Total Assets

Debt

Shareholder’s Fund
3. Proprietary Ratio = Total Assets

Debt
4. Debt to Capital Employed Ratio = Capital Employed

5. Interest Coverage Net Profit before Interest and Taxes

=
Ratio Interest on Debt

 1, 2 and 4 are Pure Ratio

 3 is Pure Ratio or %
 5 is in Times
 Activity/Turnover Ratio
(Efficiency in utilisation of resources)

1. Inventory Cost of Revenue from Operations (COGS)

=
Turnover Ratio Average Inventory
 COGS = Opening Stock + Net Purchases + Direct Expenses
- Closing Stock
OR
 COGS = Revenue from Operations (Net Sales) – Gross Profit
 Average Inventory = (Opening + Closing)Inventory
2

2. Trade Receivables Net Credit Sales

=
Turnover Ratio Average Trade Receivables
Debtors Debtors
 Average Trade Receivables = Opening + + Closing +
Bills Bills
Receivables Receivables

3. Trade Payables = Net Credit Purchases

Turnover Ratio Average Trade Payables
Creditors Creditors
 Average Trade Receivables = Opening + + Closing +
Bills Bills
Payables Payables

2
4. Working Capital Revenue from Operations (Net Sales)
=
Turnover Ratio Working Capital
 If Net Sales not given, use COGS (Cost of Revenue of Operations)

5. Fixed Assets Revenue from Operations (Net Sales)

=
Turnover Ratio Net Fixed Assets
(Fixed Assets – Depreciation)

6. Net Assets/ Revenue from Operations (Net Sales)

Capital Employed = Capital Employed
Turnover Ratio
 All are in Times
 Profitability Ratio (%)
(Profitability of firm)
Trading A/c Profit & Loss A/c
To Op. Stock By Sales To Operating Expenses By Gross Profit
To Purchases Less : Sales Return - Taxes By Operating Income
Less : Purchase By Cl. Stock - Salaries - Commission
Return - Rent Received
To Direct Expenses - Advertisement - Discount Received
To Gross Profit - Deprecation
- Carriage Outward
Operating - Bad Debts
To Non-Operating Expenses By Non-Operating Income
Profit
- Interest Paid - Interest Received
- Dividend Paid - Dividend Received
- Loss on Sale of F.A. - Rent Received
- Charity - Profit on Sale of F.A.
- Loss by Fire/Theft
To Net Profit

1. Gross Profit Ratio = Gross Profit

X 100
Revenue from Operations
Net Profit after Tax
2. Net Profit Ratio = X 100
Revenue from Operations
Operating Profit
3. Operating Profit Ratio = X 100
Revenue from Operations
 Operating Profit = Gross Profit + Operating (Income – Expenses)
 Net Profit = Gross Profit + Operating (Income – Expenses)
+ Non-Operating (Income – Expenses)
Operating Cost
4. Operating Ratio = X 100
Revenue from Operations
 Operating Cost = COGS + Operating Expenses Office & Admin
Selling & Distribution
 Operating Profit Ratio + Operating Ratio = 100%

5. Return on Investment Net Profit before

(ROI)/ Return on Interest & Taxes 100
= X
Capital Employed Ratio Capital Employed

Interest 8% Bank Loan 2,00,000

Liability
10% Debentures 5,00,000

 Profit before Interest and Taxes

Less : Interest
Profit before Taxes
Less: Taxes
Profit after Interest and Taxes