Accounting for Business(30201)

Welcome in Lecture Series for

Accounting for Business
by
Dr. Rajesh Sinha
Meaning of Ratios
A ratio is defined as “the indicated quotient of two mathematical
expressions and as the relationship between two or more things.” Here
ratio means financial ratio or accounting ratio which is a mathematical
expression of the relationship between accounting figures.
Therefore accounting ratio is….
A relationship expressed in mathematical terms;
Between two individual figures or group of figures;
Connected with each other in some logical manner; and
Selected from financial statements of the concern
TYPES OF RATIOS
Liquidity Ratios
Liquidity or short-term solvency means ability of the business to pay
its short term liabilities.
Inability to pay-off short-term liabilities affects its credibility as well
as its credit rating. Continuous default on the part of the business leads
to commercial bankruptcy.
Short-term lenders and creditors of a business are very much
interested to know its state of liquidity because of their financial stake.
Both lack of sufficient liquidity and excess liquidity is bad for the
organization.
Types:
a) Current Ratio. b) Quick Ratio or Acid test Ratio. c) Cash Ratio or
Absolute Liquidity Ratio. d) Net Working Capital Ratio.
Current Ratio
The main question this ratio addresses is: "Does your business have
enough current assets to meet the payment schedule of its current debts
with a margin of safety for possible losses in current assets?“
Formula: Curent Ratio
Where,
Current Assets = Inventories + Sundry Debtors + Cash and Bank
Balances + Receivables/ Accruals + Loans and Advances + Disposable
Investments + Any other current assets.
Current Liabilities = Creditors for goods and services + Short term
Loans + Bank Overdraft + Cash Credit + Outstanding Expenses +
Provision for Taxation + Proposed Dividend + Unclaimed Dividend +
Any other current liabilities.
Quick Ratio or Acid test Ratio
The Quick Ratio is a much more conservative measure of short-term
liquidity than the Current Ratio. It helps answer the question: "If all
sales revenues should disappear, could my business meet its current
obligations with the readily convertible quick funds on hand?“
Formula: Quick Ratio =
Where,
Quick Assets = Current Assets − Inventories − Prepaid expenses
Current Liabilities = As mentioned under Current Ratio.
Cash Ratio/ Absolute Liquidity Ratio
The cash ratio measures the absolute liquidity of the business. This ratio
considers only the absolute liquidity available with the firm.

Formula: Cash Ratio =

Working Capital Ratio

1. Gross working capital = Total of Current asset
2. Net working capital = Current asset-Current Liabilities
Example of Liquidity Ratio
Q1. Following information is taken from the balance sheet of ABC ltd.
Inventory: 5000
Salary outstanding: 3000
Marketable securities: 4000
Trade payables: 8000
Proposed dividend: 2000
Prepaid rent: 500
overdraft: 4000
Advance tax: 3000
Cash and bank: 6000
Receivables: 4000
Calculate: a) current ratio; b) Quick ratio; c) cash ratio/Liquid ratio
Answer

Total Current Assets = 5000 + 4000 + 500 + 3000 + 6000 + 4000 = 22500
Total Current Liabilities = 3000 + 8000 + 2000 + 4000 = 17000

Current ratio: 1.32

Quick Ratio: 1
Absolute liquid ratio: 0.59
Q2. X Ltd., has a current ratio of 3.5:1 and quick ratio of 2:1. If excess
of current assets over quick assets represented by inventories is Rs.
24,000, calculate current assets and current liabilities.

Q3. Calculate the current ratio from the following information:

Total assets = Rs. 3,00,000
Non-current liabilities = Rs. 80,000
Shareholders’ Funds = Rs. 2,00,000
Non-Current Assets:
Fixed assets = Rs. 1,60,000
Non-current Investments = Rs. 1,00,000
Q2. X Ltd., has a current ratio of 3.5:1 and quick ratio of 2:1. If excess
of current assets over quick assets represented by inventories is Rs.
24,000, calculate current assets and current liabilities.
Current Assets (CA): Rs. 56,000; Current Liabilities (CL): Rs. 16,000

Q3. Calculate the current ratio from the following information:

Total assets = Rs. 3,00,000
Non-current liabilities = Rs. 80,000
Shareholders’ Funds = Rs. 2,00,000
Non-Current Assets:
Fixed assets = Rs. 1,60,000
Non-current Investments = Rs. 1,00,000
CA-Rs.40,000; CL-20000: Current ratio: 2:1
Long-term Solvency Ratios /Leverage Ratios
The leverage ratios may be defined as those financial ratios which
measure the long term stability and structure of the firm.
These ratios indicate the mix of funds provided by owners and lenders
and assure the lenders of the long term funds with regard to:

(i) Periodic payment of interest during the period of the loan and

(ii) Repayment of principal amount on maturity.

 it includes capital structure ratio and coverage ratio

Types of leverage ratio

Capital Structure Ratios Coverage Ratios

(a) Equity Ratio (a) Debt-Service Coverage Ratio
(b) Debt to Equity Ratio (DSCR)
(c) Debt to Total Assets Ratio (b) Interest Coverage Ratio
(d) Capital Gearing Ratio (c) Preference Dividend Coverage
Ratio
(e) Proprietary Ratio
(d) Fixed Charges Coverage Ratio
Equity Ratio: This ratio indicates proportion of owners’ fund to total fund invested in the business.
Traditionally, it is believed that higher the proportion of owners’ fund lower is the degree of risk.

Equity Ratio =

Debt to Equity Ratio: This ratio is very often referred in capital structure decision as well as in the
legislation dealing with the capital structure decisions (i.e. issue of shares and debentures). Debt
equity ratio is the indicator of firm’s financial leverage.

Debt to Equity Ratio = or

Shareholders equity = equity share capital+ preferential share capital+ reserve and surplus

Total out side liability = long term liabilities + current liabilities

Capital Gearing Ratio: capital gearing ratio is calculated to show the proportion of fixed
Cost (interest or dividend) bearing capital to funds belonging to equity shareholders i.e.
equity funds or net worth.

Capital gearing ratio =

Proprietary ratio: It indicates the proportion of total assets financed by shareholders.

Proprietary ratio =

*Proprietary fund =Shareholders fund

Interest coverage ratio: 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 reveals the number of times interest on long-term debts is covered by the profits available for interest. A
higher ratio ensures safety of interest on debts.

Formula:
Interest coverage ratio =

Example: Net Profit after tax Rs. 60,000; 15% Long-term debt 10,00,000; and Tax rate 40%. Calculate
Interest coverage ratio.

ANS: 1.67
Using the following information calculate:
a) Debt to total asset ratio; b) Equity ratio; c) Debt equity ratio; d) Capital
gearing ratio
Activity Ratios/ Efficiency Ratios/ Performance Ratios/ Turnover Ratios

 These ratios are employed to evaluate the efficiency with which the firm manages and utilises its assets.
 For this reason, they are often called ‘Asset management ratios’. These ratios usually indicate the frequency
of sales with respect to its assets.
 These assets may be capital assets or working capital or average inventory

Types of Activity Ratios:

(a) Total Assets Turnover Ratio
(b) Fixed Assets Turnover Ratio
(c) Capital Turnover Ratio
(d) Current Assets Turnover Ratio
(e) Working Capital Turnover Ratio
-Inventory/ Stock Turnover Ratio
-Receivables (Debtors) Turnover Ratio
-Payables (Creditors) Turnover Ratio.
Assets turnover ratios
Total Asset Turnover Ratio: This ratio measures the efficiency with which the firm uses its
total assets. This ratio is computed as:
=

Fixed Assets Turnover Ratio: It measures the efficiency with which the firm uses its fixed
assets.
=

Capital Turnover Ratio/ Net Asset Turnover Ratio:

=

Current Assets Turnover Ratio: It measures the efficiency using the current assets by the
firm.
=
Inventory/ Stock Turnover Ratio: The relationship between the cost of goods sold
during the year and average inventory held during the year.
It measures the efficiency with which a firm utilizes or manages its inventory. It is
calculated as follows:

Where, average inventory = opening inventory+ closing inventory / 2

Example: A trader carries an average inventory of Rs. 40,000. His inventory turnover
ratio is 8 times. If he sells goods at a profit of 20% on Revenue from operations, find out
the gross profit.
Inventory Turnover Ratio= Cost of Goods Sold (COGS)​/Average Inventory
8 = COGS/40000
COGS = 320000
Profit on sales = 20%
Therefore, sales-sales 20% = 320000 (COGS)
Or, sales x 80/100 = 320000
Or, sales = 320000* 100/80 = 400000
Gross profit = 20% of 400000 = 80000.
Receivables (Debtors) Turnover Ratio: In case firm sells goods on credit, the
realization of sales revenue is delayed and the receivables are created. The cash is
realised from these receivables later on.
The speed/velocity with which these receivables are collected affects the liquidity
position of the firm.

DTR =

Receivables (Debtors’) Velocity/Average collection period: The average

collection period measures the average number of days it takes to collect an account
receivable.

Average collection period =

Payables Turnover Ratio: This ratio is calculated on the same lines as receivable
turnover ratio is calculated.
This ratio shows the velocity/speed of payables payment by the firm. It is calculated
as follows:

PTR =

Payable Velocity/ Average payment period: calculates no. of credit periods or

days.

Average payment period =

2. Calculate the Trade receivables turnover ratio from the following
information:
Total Revenue from operations Rs. 4,00,000
Cash Revenue from operations 20% of Total Revenue from operations
Trade receivables as at 1.4.2014
40,000
Trade receivables as at 31.3.2015
1,20,000

ANS: Credit sales -320000; Average trade receivables -80000; TRTR= 4

i. Revenue from Operations = Rs. 30,00,000
Total Assets = 8,00,000 + 5,00,000 + 2,00,000 + 1,00,000 + 1,80,000 + 1,10,000 + 80,000 + 30,000
= Rs. 20,00,000

Total Current Liabilities = 1,40,000 + 50,000 + 10,000 = Rs. 2,00,000

Net Assets=Total Assets− Current Liabilities=20,00,000−2,00,000=Rs.18,00,000

Net Assets Turnover Ratio= 30,00,000/18,00,000​=1.67 times

ii. Total Fixed Assets = 8,00,000 + 5,00,000 + 2,00,000 + 1,00,000 = Rs. 16,00,000
Fixed Assets Turnover Ratio= 30,00,000/16,00,000​=1.875 times

iii. Total Current Assets = 1,80,000 + 1,10,000 + 80,000 + 30,000 = Rs. 4,00,000
Working Capital=CA− CL=4,00,000−2,00,000=Rs.2,00,000
Working Capital Turnover Ratio= 30,00,000/2,00,000​=15 times