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RATIOS

MEANING
A ratio shows the relationship between two numbers. Accounting ratio shows the relationship between
two accounting figures. Ratio analysis is the process of computing and presenting the relationships
between the items in the financial statement. It is an important tool of financial analysis, because it helps
to study the financial performance and position of a concern.

Classification of ratios based on function


1. Liquidity Ratios: show the relationship between the current assets and current liabilities of the concern.
Examples are Liquid ratio and Current ratio.
2. Leverage Ratios: show the relationship between proprietor’s funds and debts used in financing the
assets of the concern. Examples are Capital gearing ratio, Debt-Equity ratio and Proprietary ratio. These
are also known as Solvency ratios.
3. Activity Ratios (also known as Turnover ratios or Productivity ratios) show the relationship between
the sales and the assets. Examples are Stock turnover ratio, Debtors turnover ratio etc.
4. Profitability ratio show the relationship between Profits and sales; for example, Operating ratio, gross
profit ratio, Operating net profit ratio, Expenses ratios etc.; or Profits and investments; for example,
Return Return on capital employed., Return on investments, Return on equity capital etc.
5. Coverage ratios show the relationship between the profit on one hand and the claims of outsiders
(dividend, interest etc.) to be paid out of such profits. Examples are Dividend payout ratio and Debt
services ratio.

Profit and loss account Ratio:


GROSS PROFIT RATIO
Meaning
This ratio compares gross profit with net sales. It is usually expressed in the form of percentage.
Formula
Gross profit = Gross Profit x 100
Net Sales
Function/Purpose
Gross profit is a profitability ratio, which shows the relationship between profits and sales. This ratio
helps to judge (i) how efficient the concern is in managing its production, purchase, selling and
inventory; (ii) how good its control is over the direct costs; (iii) how productive the concern is; and (iv)
how much amount is left to meet other expenses and earn net profit.

OPERATING RATIO
Meaning
Operating ratio expresses the relationship between total operating costs and net sales. It is expressed by
way of percentage .
Formula
Operating Ratio = Cost of Goods Sold + Operating Expenses x 100
Net Sales

Function/Purpose
Operating ratio indicates cost of operations. Its purpose is to measure and to ascertain the efficiency of
the management as regards operations. This ratio helps to judge (i) how efficient the concern is in
controlling its costs of production, administration, selling expenses; and (iv) how much amount out of
sales revenue is used up in carrying out the operations of the concern.

EXPENSES RATIO
Meaning
This ratio expresses the relationship between each item of expenditure and sales. It is expressed as a
percentage. Total of all Expenses ratios will be equal to operating ratio.
Formula
Expense Ratio = Expenditure x 100
Net Sales

e.g.

Cost of goods Sold ( Factory cost) = COGS × 100


Net sales

Administrative Expenses Ratio = Administrative Expenses x 100


Net Sales

Finance expenses= Finance expenses *100


Net sales
Selling Expenses Ratio = Selling Expenses x 100
Net Sales

OPERATING PROFIT RATIO

Meaning
Operating profit ratio indicates the relationship between Operating profit and the sales.
Formula
Operating Profit = Operating Profit x 100 =
Net Sales

Components
Operating profit [OP] =
1. Gross Profit
2. Less: Operating expense [OE]
Function/Purpose
Operating profit ratio is a profitability ratio, which shows the relationship between profits and sales.
It indicates profits from operations. This ratio helps to judge (i) how efficient the concern is in
managing
all its operations of production, purchase, inventory, administration, selling, distribution etc.; and (ii)
how much amount is left to meet non-operating expenses and earn net profits.

NET PROFIT RATIO

Meaning
Net profit ratio indicates the relationship between net profit and the sales. It is usually
expressed in the form of a percentage.

Net Profit = Net Profit x 100


Net Sales

Balance Sheet Ratio

CURRENT RATIO
Meaning
This ratio compares the current assets with the current liabilities. It is expressed in the form of a pure
ratio e.g. 2:1
Formula
Current Ratio = Current Assets = CA
Current Liabilities CL

Function/Purpose
Current ratio is a liquidity/solvency ratio which indicates the ability of the concern to meet its short-term
liabilities. It measures the short term solvency of the concern. It is used by a creditor to judge the safely
margin available and to decide the amount and the terms of the credit. The standard ratio is 2: 1.

LIQUID RATIO
Meaning
Liquid ratio compares the quick assets with the quick liabilities. It is measures the immediate
solvency position of the company. It is also known as Quick ratio or Acid test ratio.
Formula
Liquid ratio = Quick Assets = QA
Quick Liabilities QL
Note: QA=Current Assets less Closing Stock less Prepayment
QL=Current Liabilities less Bank Overdraft less income received in advance
Note 1: Stock is excluded because it is uncertain as to when and how much it will realize.
Prepayment (pre-paid expenses, advances etc) are excluded because they cannot be converted into
cash.
Note 2: Bank overdraft is excluded because it is almost with bank and not required to be paid back
is full as long as the concern exists.

STOCK TO WORKING CAPITAL RATIO


Meaning
Formula:
Stock *100
Working capital
This ratio shows the relationship between the closing stock and the working capital. It helps to judge the
quantum of inventories in relation to the working capital of the business. It is expressed as a percentage.
It is also known as Inventory Working Capital Ratio.
If the stock to working capital is 70%. It means 70% of the working capital is blocked in assets and 30%
is blocked in other current assets.

PROPRIETORY RATIO
Meaning
Proprietory ratio compares proprietor’s funds with total assets. It is usually expressed in the form of
percentage.
Formula
Proprietory Ratio = Proprietors’ Funds or Shareholder’s Equity X 100 = PF X 100
Total Assets TA
Components
Proprietor’s Funds [PF] will include
1. Paid up Equity capital (EC)
2. Reserves & Surplus (RS) including capital reserves, revenue reserves, P & L a/c Cr.
Balance.

Less: Accumulated losses (i.e. P & L a/c Dr. Balance)


Less: Fictitious Assets like Miscellaneous Expenditure not written off.
3. Paid up Preference Capital (PC)
Thus, PF = EC + RS + PC –Misc Exp
Function/Purpose
Proprietory ratio is a solvency ratio which indicates (i) the long term solvency; and (ii) the extent
of funds invested by the owners in relation to total funds employed in the business (i.e.
capitalization).

DEBT – EQUITY RATIO


Meaning
This ratio compares the long-term debt with shareholders’ funds. It is usually expressed as a pure
ratio.
Formula

Debt = Borrowed Funds = BF


Equity Proprietors’ Funds PF

Purpose/Function

Debt –equity ratio is a solvency ratio which indicates the proportion of debt and equity in financing of
the assets of the concern. Debt-equity ratio shows the (i) margin of safety for long term creditors; and
(ii) the balance between debt and equity (i.e. capitalization). If the debt equity ratio is 2.5: 1, it indicates
that for every 2.5 obtained from debt, the company has obtained Re 1 from the shareholder

CAPITAL GEARING RATIO


Meaning
The Capital Gearing ratio shows the relationship between two types of capital viz (i) Funds not bearing
fixed rate of interest and dividend- Equity capital including reserves less fictitious asset . and (ii) . Funds
and dividend bearing fixed rate of interest Preference capital and Long Term Borrowing. This is also
known as ‘Capital Structure ratio’. When the ratio is more than 1, the company is said to highly geared
and when the ratio is less than 1 the company lowly geared.
Formula= Funds bearing fixed rate of interest and dividend
Funds not bearing fixed rate of interest and dividend
Preference Share capital + Debenture + Long term Bank loan + Public deposit
Equity share capital + Reserves and Surplus – Misc expenditure

Combined Ratio:

RETURN ON CAPITAL EMPLOYED


Meaning

This ratio measures the relationship between net profit (before interest and tax) and the
capital employed to earn it. It is expressed as a percentage . This ratio is also known as
‘Return on Investment’ [ROI]

Formula
Return on Capital Employed = Profit (before Interest, Tax) x 100
Capital Employed
Components
Profit (before Interest, Tax) [PBIT] =
1. Profit before interest on long term borrowing tax & dividends.
2. Less abnormal, non-recurring items.

Capital Employed (CE) =


1 Equity capital
2. Add. Preference capital + Reserves & Surplus
3. Add. Long term Borrowings (Terms loans + Debentures)
4. Less : Fictitious assets like Miscellaneous Expenses not written off
5. Less : Profit & loss A/c. Dr. Balance (loss).
Note : Capital employed may be taken to mean Assets Employed, in which case,

Capital Employed [CE] can also be computed as


1. Fixed Assets (Less depreciation) ( including investments)
2. Add : Current Assets
3. Less : Current Liabilities
4. Exclude Fictitious assets.

Function / Purpose
Return on capital employed ratio is a profitability ratio, which shows the relationship
between profits and investments. Its purpose is to measure the overall profitability from the
total funds made available by the owners and lenders. This ratio helps to judge how
efficient the concern is in managing the funds at its disposal.

RETURN ON PROPRIETORS’ FUNDS


Meaning
This ratio measures the relationship between net profit (after interest and tax) and the
proprietors’ capital. It is usually expressed as a percentage. It is also known as Return on
Proprietor’s Equity or Return on Net Worth

Formula

Return on Proprietor’s Funds = Net Profit (after Tax) x 100 = NPAT x 100
Proprietor’s Funds PF

RETURN ON EQUITY SHAREHOLDER FUND


Meaning

This ratio measures the relationship between net profit (after interest, tax and preference
dividend) and the equity shareholders funds. It is usually expressed as a percentage.
Formula

Return on Equity Capital = NPAT – Prefrence dividend X 100 =


Equity Shareholder’s Funds

Components :

Equity shareholders’ Funds [EF] =


Equity capital [EC]
Reserves and Surplus [RS]
Less: Fictitious assets like Miscellaneous Expenses not written off
Less: Profit& Loss A/c Dr. Balance(loss)

DEBTORS TURNOVER

Meaning

This ratio shows the relationship between net credit sales and average trade debtors .It is
expressed as a times. Actual debtors turnover ratio of 6 times indicates that debtors
turnover 6 times during the year

Formula

Debtors Turnover = Net Credit Sales


Avg Accounts Receivable + Avg Bills receivable

Debtors Velocity (Debt Collection Period)

Debtors velocity means the period (months or days) taken by the debtors for settlement of
their bills. It shows the number of days for which credit sales remain outstanding
= 365 days/ 12 months
Debtors Turnover Ratio

Function / Purpose
Debtors turnover ratio is a turnover ratio, which shows the relationship between credit
sales and debtors. Its purpose is to (I) calculate the speed with which debtors get settled
on an average during the year; (ii) calculate the debtors velocity to indicate the period of
credit allowed to average debtor; and (iii) judge how efficiently the debtors are managed.

CREDITORS TURNOVER RATIO

Meaning
Creditors turnover ratio shows the relationship between the net credit purchases and the
average trade creditors. Actual debtors turnover ratio of 6 times indicates that debtors
turnover 6 times during the year
Formula

Creditors Turnover = Credit Purchases = Net Credit Purchases


Accounts Payable Avg Creditors + Avg Bills Payable

Creditors Velocity (Debt Payment Period)

Creditors velocity means the period (months or days) taken by the concern to pay off its
creditors.

Credit Period Enjoyed = 365 days or 12 months


Creditors Turnover

Function / Purpose

Creditors turnover ratio is a turnover ratio, which shows the relationship between credit
purchases and creditors. Its purpose is to (i) calculate the speed with which creditors are
paid off on an average during the year; (ii) calculate the creditors velocity to indicate he
period taken by the average creditor to be paid off; and (iii) judge how efficiently the
creditors are managed.

STOCK TURNOVER RATIO


Stock turnover ratio shows the relationship between the cost of goods sold and the
average stock. This ratio is normally expressed as a ‘rate’

Formula

A. Stock Turnover Ratio = Cost of Goods Sold


Average Stock
Function/ Purpose
Stock turnover ratio is an activity ratio, which shows the relationship between sales and
stock. Its purpose is to (i) calculate the speed at which stock is being turned over into
sales; (ii) calculate the stock velocity to indicate he period taken by the average stock to
be sold out; and (iii) judge how efficiently the stocks are managed and utilized to
generate sales.

Actual Ratio
For example, a Stock turnover ratio of 8, indicates that the stock is being turned into sales
8 times during the year. The Inventory cycle makes 8 rounds during the year. It also helps
to work out the Stock Holding Period (stock velocity). If the Stock turnover is 8 times,
the Stock Holding Period is 1.5 months (12 months / Stock turnover ratio = 12 / 8). This
indicates that it takes 1.5 months for the stock to be sold out. Stock velocity shows the
duration of the inventory cycle.
Interest Coverage Ratio:

This ratio indicates sufficiency or deficiency of earnings to pay interest falling due within
the period covered under profits.

Interest coverage Ratio= NPBIT


Interest

DEBT SERVICE COVERAGE RATIO

Note : Debt Service Coverage Ratio (which deals with the capacity to pay interest as well
as loan installment) is different from Debt Service Ratio

Meaning
Debt Service Coverage Ratio shows the relationship between net profits and interest +
installments payable on loans. It is expressed as a pure number. Debt Service means the
payment of interest + installments on loans. Coverage means the availability of profits for
debt servicing.

Formula
Debt Service Coverage Ratio = Net profit + Depreciation + Interest on Term loan
Interest + Installment due on loans

Function / Purpose
Debt Service Coverage Ratio (DSCR) is a type of coverage ratio. A coverage ratio shows
the relationship between the profit and the claims of outsiders to be paid out of such profits.
The purpose of DSCR is to measure the debt-servicing capacity of the company.

DIVIDEND PAYOUT RATIO

Meaning
Dividend Payout Ratio shows the relationship between the dividend paid to equity
shareholders out of the profits available to the equity shareholders. It shows how much
percentage of earnings are given as dividend

Formula
Dividend payout ratio = Dividend per share x 100
Earning per share

EARNING PER SHARE:

EPS= NPAT- Preference dividend


No of Equity shares
Earning per share is most widely used financial data. Higher the ratio indicates that the
company may pay dividend at a higher rate. It shows how much percentage of earnings
are given as dividend

Price –Earning ratio (P/E ratio) : This ratio is the market price of shares expressed as
multiple of Earning per share:

P/E ratio: Market price per share


Earnings per share

This ratio indicates the market price is how many times as the earning, A higher P/E ratio
is good. Investor should invest in the company having low P/E ratio

Dividend yield ratio Market price per share


Earning per share

It means the dividend is how percentage of market price per share

ADVANTAGES OF RATIO ANALYSIS


Advantages :

• Useful in analysis of financial statements. Ratio analysis is the most


important tool available for analysing the financial statements i.e. Profit
and Loss Account and Balance Sheet. Such analysis is made not only by
the management but also by outside parties like bankers, creditors, investors
etc.
• Useful in improving future performance. Ratio analysis indicates
the weak spots of the business. This helps management in overcoming
such weaknesses and improving the overall performance of the business in
future.
• Useful in inter-firm comparison. Comparison of the performance of one
firm with another can be made only when absolute data is converted into
comparable ratios. If A firm is earning a net profit of Rs. 50,000 while
another firm B is earning Rs. 1.00,000, it does not necessarily mean that
firm B is better off unless this profit figure is converted into a ratio and then
compared.
• Useful in judging the efficiency of a business. As stated earlier,
accounting ratios help in judging the efficiency of a business. Liquidity,
solvency, profitability etc. of a business can be easily evaluated with the
help of various accounting ratios like current ratio, liquid ratio, debt-
equity ratio, net profit ratio, etc. Such an evaluation enables the
management to judge the operating efficiency of the various aspects of
the business.
• Useful in simplifying accounting figures. Complex accounting data
presented in Profit and Loss Account and Balance Sheet is simplified,
summarised and systematised with the help of ratio analysis so as to
make it easily understandable. For example, gross profit ratio, net
profit ratio, operating ratio etc. give a more easily understandable picture
of the profitability of a business than the
• Absolute figures.

Limitations of Ratio Analysis


Ratio analysis is a very useful technique. But one should be aware of its
limitations as well. The following limitations should be kept in mind white making
use of ratio analysis in interpreting the financial statements.
1. Reliability of ratios depends upon the correctness of the basic data.
Ratios obviously will be only as reliable as the basic data on which they
are based. If the balance sheet or profit and loss account figures are
themselves unreliable, it will be a mistake to put any reliance on the ratios
worked out on the basis of that Balance Sheet or Profit and Loss Account.
1. An individual ratio may by itself be meaningless. Except in a few cases,
an accounting ratio may by itself be meaningless and acquires significance only
when compared with relevant ratios of other firms or of the previous years. In fact,
ratios yield their best advantage on comparison with other similar firms; also if
ratios for a year are compared with ratios in the previous years, it will be a useful
exercise. Comparison is the essential requirement for using ratios for interpreting a
given situation in a firm or industry.
2. Ratios are not always comparable. When the ratios of two firms are being
compared, it should be remembered that different firms may follow different
accounting practices. For example, one firm may charge depreciation on
straight line basis and the other on diminishing value. Similarly, different firms
may adopt different methods of stock valuation. Such differences will not
make some of the accounting ratios strictly comparable. However, use of
accounting standards makes ratio comparable.
1. Ratios sometimes give a misleading picture. One company produces
500 units in one year and 1,000 units the next year; the progress is
100%. Another firm produces 4,000 units in one year and 5,000 in the
next year, the progress is 25%. The second firm will appear to be less
active than the first firm, if only the rate of increase or ratio is
compared. It will be much more useful if absolute figures are also
compared along with rate of increase—unless the firms being compared are
equal in all respects. In fact, one should be extremely careful while
comparing the results of one firm with those of another firm if the two
figures differ in any significant manner, say in size, location, degree
of automation or mechanisation.
2. Ratios ignore qualitative factors. Ratios are as a matter of fact, tools
of quantitative analysis. It ignores qualitative factors which sometimes are
equally or rather more important than the quantitative factors. As a result of
this, conclusions from ratio analysis may be distorted. For example,
despite the fact that credit may be granted to a customer on the basis of
information regarding the financial position of business as disclosed by
certain ratios, but the grant of credit ultimately depends upon the credit
standing, reputation and managerial ability of the customer, which
cannot be expressed in the form of ratios.
3. Change in price levels makes ratio analysis ineffective. Changes in
price levels often make comparison of figures for a number of years
difficult. For example, the ratio of sales to fixed assets in 2003 would be
much higher than in 1995 due to rising prices because fixed assets are
stilt being expressed on the basis of cost incurred a number of years ago
while sates are being expressed at their current prices.
2. There is no single standard for comparison. Ratios of a company have
meaning only when they are compared with some standard ratios. Circumstances
differ from firm to firm and the nature of each industry is different. Therefore, the
standards will differ for each industry and the circumstances of each firm will
have to be kept in mind. It is difficult to find out a proper basis of comparison.
Therefore, the performance of one industry may not be properly comparable
with that of another. Usually it is recommended that ratios should be compared
with the average of the industry. But the industry averages are not easily available.

3. Ratios based on past financial statements are no indicators of


future. Accounting ratios are calculated on the basis of financial
statements of past years. Ratios thus indicate what has happened in
the past. Since past is quite different from what is likely to happen
in future, it is difficult to use ratios for forecasting purposes. The financial
analyst is more interested in what will happen in future. The management of
a company has information about the company's future plans and, policies
and is, therefore, able to predict future to a certain extent. But an
outsider analyst has to rely only on the past ratios which may not
necessarily reflect the firms future financial position and performance.

COMPUTATION OF RATIOS

Q1) Following is the Balance Sheet of Ranbaxy ltd. as on 31st March 2007. You are
required to convert the same in Vertical formats and. calculate the following ratios: 1)
Current Ratio 2) Liquid Ratio, 3) Stock to Working Capital Ratio, 4) Proprietory Ratio, 5)
Capital Gearing Ratio, 6) Debt Equity Ratio
Liabilities Rs. Assets Rs.
Equity Share Capital (Rs. 10 2,00,000 Land & Bldg at WDV 1,00,000
each) Plant & Mach at WDV 1,20,000
10% Preference Share Capital 1,00,000 Long Term Investments 90,000
General Reserve 2,00,000 Capital WIP 75,000
12% Debentures 1,00,000 Inventories 2,00,000
Accounts Payable 1,60,000 Book Debts (last year Rs. 2,00,000
Bank Overdraft 1,00,000 1,80,000)
Acceptances given 75,000 Current Investments 50,000
Income received in Advance 25,000 Prepaid Exp 10,000
Provision for Taxation 40,000 Cash at Bank 40,000
Advance Tax 30,000
Bills Receivable 75,000
Underwriting Commission 10,000
( To the extent not w/off)
10,00,000 10,00,000

Q.2) The following is the Profit & Loss A/c. of Reliance ltd. for the year ended 31st
March 2007. You are required to convert the same in a suitable form for analysis and
calculate the following ratios:
1) Gross Profit Ratio, 2) Operating Ratio, 3) Operating Expense Ratio, 4) Operating
Profit Ratio; 5) Net Profit Ratio.
Particulars Rs. Particulars Rs.
To Opening Stock 1,50,000 By Sales (10% cash) 20,00,000
To Purchases 10,50,000 Less: Returns 2,00,000
To Factory Expenses 4,50,000 18,00,000
To Gross Profit 3,50,000 By Closing Stock 2,00,000
20,00,000 20,00,000

To Administrative Expenses 1,20,000 By Gross Profit 3,50,000


To Rent 30,000 By Bad Debts Recovery 50,000
To Interest paid on Debentures 12,000 By Dividend/ Int. received 25,000
To Selling Expenses 15,000 By Miscellaneous Income 75,000
To Bad debts 10,000
To Depreciation 30,000
To Loss by fire 40,000
To Provision for Tax 1,21,500
To Net Profit 1,21,500
5,00,000 5,00,000
To Proposed Equity Dividend 50,000 By Net Profit 1,21,500
To Dividend on Preference 10,000
Share
To Transfer to General Reserve 61,500
1,21,500 1,21,500
The Companies shares are quoted on stock exchange at Rs 44.60

From the financial statements given above (Q.1 & Q.2) you are required to calculate the
following ratios:

Overall Profitability Ratios: 1) Return on Capital Employed, 2) Return on Shareholders


fund, 3) Return on Equity Shareholders fund.

Turnover Ratios: 1) Stock Turnover ratio, 2) Debtors Turnover ratio & Debtors Velocity,
3) Creditors Turnover ratio & Creditors Velocity, 4) Fixed Asset Turnover Ratio, 5) Total
Asset Turnover ratio .6) Working Capital Turnover ratio.
Ratios related to Equity Shares: 1) Earning Per Share (EPS), 2) Price Earning Ratio
(P/E ratio), 3) Dividend Per Share (DPS), 4) Dividend Payout Ratio (D/P ratio), 5)
Dividend Yield Ratio.

Coverage Ratio: 1) Interest Coverage Ratio, 2) Dividend Coverage Ratio