Accounting Ratios

LEARNING OBJECTIVES

After going through this lesson, we are confident that you should be able to:

 Explain the meaning of accounting ratios.

 Understand the objectives and limitations of accounting
ratios.
 Classify the ratios as profitability, activity and solvency.
 Compute various profitability, activity and solvency ratios.
 Express your views about the operational efficiency and
financial soundness of the company.
 Comment upon the performance of the enterprise.
 Recommend financial measures to be adopted to strengthen
financial structure of the company.

Accounting is one of the methods of analyzing financial statements. It has been our
experience that financial statements in their original form are collection of monotonous
figures. The statements are detailed and do not present the required information at a
glance. Accountants have to toil very hard in digging out the required information.
Accounting ratios are therefore, an attempt to present the information of the financial
statements in simplified, systematized and summarized form. Accountants introduced
ratio analysis to meet this end.

Ratio analysis is an important technique of financial analysis. It is the process of

determining and interpreting numerical relationship between figures of the financial
statements. Absolute figures are valuable but they standing alone convey no meaning
unless compared with another. For example, one trader Geetanshu earns Rs. 10,
00,000 and another trader Himanshu Rs. 12, 00,000. Who is more efficient? Generally,
we may be tempted to conclude that Himanshu who earns a higher profit is more
efficient. In realty, to know the right answer to this question , we must ask what their capital
investments are. Suppose, we are told that Geetanshu has employed a capital of Rs. 40, 00,000
and Himanshu has employed Rs. 50, 00.000 in their respective businesses. Using the technique
of ratio analysis we can calculate the percentage of profit earned on capital employed by each of
them:

Profit Earned During the Period

________________________ X 100

Capital Employed

These figures show that for every Rs. 100 of capital employed Geetanshu earns profit Rs. 25 while
Himanshu earns Rs. 24. It is clear from the above example that Geetanshu is making more
efficient use of the capital employed by him.

Thus ratio analysis is very important in revealing the financial position and soundness of
the business. Accounting ratios show inter-relationships which exist among various
accounting data. When relationships among various accounting data supplied by financial
statements are worked out they are known as accounting ratios. An accounting ratio may
be defined as the mathematical expression of the relationship between two accounting
figures. According to R.N. Anthony, "A ratio is simply one number expressed in terms of
another. It is found by dividing one number with the other."

In the words of Kennedy and Mc. Millan “The relationship of one item to another
expressed in simple mathematical form is known as a ratio”.

According to Myers, "Ratio analysis is a study of relationship among the various

financial factors in a business,"

METHODS OF EXPRESSING ACCOUNTING RATIOS / RATIO ANALYSIS

The analysis of the financial statements can be presented by one of the following
methods:
1. Percentage Method: The relationship between two figures is presented in percentage. For
example, if sales is Rs. 1,00,000 and gross profit is Rs. 25,000, the relationship can be
presented as gross profit to be 25% of sales, i.e.,

Gross Profit 25,000

Gross Profit= ______________ X 100 = _________ X 100 = 25%

 Net Sales 1, 00,000

In this way, it is common practice to present gross profit, operating profit, net profit,
expenses and operating ratio by percentage method.

2. Rate or ‘So Many Times’ Method: According to this method, one figure is expressed
in terms of another relative figure. In the previous example, where sale is Rs. 1, 00,000
and gross profit is Rs. 25, 000 the relationship between the two can be said as gross profit
to be 0.25 times or 1/4th of sales i.e., 25,000/1,00,000 or sales to be 4 times of gross
profit. It is customary to calculate inventory turnover, current and liquid ratios according to
rate method.

3. Pure Ratio Method: The relationship between two figures is presented in pure ratio or
simple ratio, such as in the above example, the ratio of gross profit to sales can be said to
be 25, 000: 1, 00,000 or 1: 4. In other words, the ratio between sales and gross profit may
also be known as 1, 00,000: 25,000 or 4: 1.

These are three different methods of ratio analysis of financial statements but they lead to
same conclusion. Any of the three methods can be followed in solving questions.

Ratio analysis is therefore a tool to present the figures of financial statement in

simple, concise and intelligible form. Ratio analysis, in this way is the process of
establishing meaningful relationship between two figures or set of figures of
financial statement.

OBJECTIVES OF ACCOUNTING RATIOS

The ratio analysis is the most important tool of the financial analysis. According to
Helfert.” The ratio analysis provides guide and clues, especially, in spotting trends better or
poor performance, and in finding out significant deviations from any average or relatively
applicable standard.” To judge the financial soundness of an enterprise it is the best means
available so far in the hands of analysts. The following are some of the important
advantages and uses of this important technique of accounting:

1. Measurement of the profitability: We can measure the profitability of the business

by calculating gross profit, net profit, expenses and other ratios. Profitability is the profit
earning capacity of the business so profitability ratios indicate the actual performance of the
business. If these ratios fall, effective corrective measures will be applied to improve the
working of the business.

2. Judging the operational efficiency of management: The operational efficiency of

the business can be ascertained by calculating operating ratio. As the operating ratio shows
the operational cost of the business so it will be in the interest of business if it is lower. We
use operating net-profit for calculating operating net profit ratio, wherein non-operating
expenses and incomes are not taken into consideration.

3. Assessing the efficiency of the business: We can ascertain whether the firm is
solvent or not by calculating solvency ratios. Solvency ratios show relationship between
liabilities and assets. If total assets are lesser than the outside liabilities it shows unsound
position of the business. In such case the business will try its best to improve its solvency
i.e., ability to repay loans.

4. Measuring short and long term financial position of the company: We can know the
short term and long term financial position of the business by calculating various ratios.
Current and liquid ratios indicate short term financial position, whereas debt equity ratios, fixed
assets ratios and proprietary ratios show long term financial position. In case of unhealthy
short term or long term financial position, efforts are made to improve them.

5. Facilitating comparative analysis of the performance: Even promising company has

to compare its present performance with the previous performance and discover the plus and
minus points. These points can be located by the calculation of different ratios. Causes
responsible for poor performance have to be removed. Comparison with the performance of
other competitive firms can also be made. Comparison tells where the firm stands and what its
prospects are. It enables both intra-firm and inter-firm comparison.

6. Indicator of true efficiency: Financial statements i.e., Trading, P/L Account and
Balance Sheet may indicate the amount of profit or the balances of different accounts but the
profitability can be known by analysis of financial statements i.e., calculation of accounting
ratios. Calculation of gross profit, net profit, operating and earnings ratios shows the profit
earning capacity of business.

7. Helpful in budgeting and forecasting. Accounting ratios provide a reliable data, which
can be compared, studied and analyzed. These ratios provide sound footing for future
forecasting. They indicate the future prospects. The ratios can also serve as a basis for
preparing budgets and also determining future line of action.

8. Helpful in simplifying accounting figures. Accounting ratios make the figures simple
and intelligible. They simplify, summarize and systematize the long monotonous figures. The ratios
can be easily understood by those who do not know accounting. The importance of the ratios lies in
the fact that they provide relationship between different figures.

9. Utility to Shareholders. The ratio analysis is also useful to shareholders who know the
profitability of the company, to creditors, who know solvency of the business, to potential investors in
assessing earning potential, to workers for computation of the bonus and even to the Government
in judging the progress of industry as a whole.

10. For setting standards. On the basis of various financial ratios of the concern certain standards
may be established for various economic activities. For example, its current ratio (/. e current assets /
current liabilities) must be 2 or more, or average credit collection period must not exceed 60 days. It
is also tried to maintain the standards and have a proper coordination between various activities.

11. For effective control. Ratio analysis is used to have a proper control over performance and
costs. They are of great assistance to locate the weak spots in the business so that management
can pay attention to those spots well in time and take remedial measures. For examples, the causes
are found to know why net profit ratio is declining while the gross profit ratio is increasing.

In the words of Briamn and Derbin, "Financial ratios are useful because they summarize briefly
the results of detailed and complicated calculations." They simplify, summarize and systematize a
long array of accounting figures to make them easy to understand and simple to use. Many parties like

bankers, customers, labor, government, creditors etc. find ratio analysis extremely useful to form an
opinion about the financial soundness of an enterprise. "If a ratio is to be important, it must not
only represent a true relationship but must also aid the analyst in making his immediate decision," said
Kron & Boyd.

Precautions While Using Ratio

(i) The user must understand the numbers: He must be capable to understand the numbers.
(ii) To submit to the persons concerned after calculation: After calculating ratio it should be
immediately handed over to the persons concerned so results may be taken out.

(iii) Method of presentation: A special care should be taken while selecting ratios and they should be
presented before the concerned persons e.g., the ratio of productivity be presented before the
production manager etc. A proper selection of ratios and placing them in proper perspective is the
main problem of ratio analysis.

(iv)Determination of ideal ratio: After calculating the ideal ratio, the real ratio should be
compared with the ideal ratio.

(v) Element, of truth: There should be some elements of truth in the ratios which is present in
these numbers on the basis of which these ratios are being calculated.

(vi) Ratios are means and not an end: It should be kept in mind that ratios are only means
and not an end. Therefore, all those facts should be properly considered which can throw light on
the solution of the problem.

(vii) Not to compare the unrelated ratios: The ratios of such two institutions should never be
compared which have no relation.

(viii) To keep in mind the change in price level. When there is a change in the price level then
the ratios of previous years should not be compared with those of current year.

LIMITATIONS OF ACCOUNTING RATIOS/RATIO ANALYSIS

Accounting ratios are insignificant alone. These ratios become meaningful when they are compared
with the previous performance of the firm or with the performance of other firms. The ratios though
indicate profitability, efficiency and financial soundness, but they are not the solution of all
problems.

“No one ratio will give the entire picture, but they do tend to give indications, which cumulatively
assist considerably in appraisal of the financial position and operations of the organization."
Bieriman

"A single ratio in itself is meaningless - it does not furnish a complete picture." -Kennedy &
Mac Millan
 Ratio analysis is very fashionable these days and is useful but one should be aware of its limitations
also. It is not a substitute for sound judgment rather; it is helpful tool to aid in applying judgment to
otherwise complex situations. In other words, ratios are only a first step in the analysis and
interpretation of financial statement and must be supplemented by thorough investigation before
conclusions can be drawn from them.

"A single ratio used without reference to other ratios may produce misleading conclusions.” It
must not only represent a true relationship but must also aid the analyst in making his immediate
decision. An analyst must be aware of the following limitations of financial ratios before using them for a
certain purpose.

1. False results: Ratios are based upon the financial statements. In case, financial statements
are incorrect or the data upon which ratios are based is incorrect, ratios calculated will also be
false and defective. The accounting system itself suffers from many inherent weaknesses, so the
ratios based upon it cannot be said to be always reliable.

2. Limited comparability: The ratio of the one firm cannot always be compared with the
performance of other firm, if uniform accounting policies are not adopted by them. The difference in
the methods of calculation of stock or the methods used to record the depreciation on assets will not
provide identical data, so they cannot be compared.

3. Absence of standard universally accepted terminology: Different meanings are given to

particular term, such as some firms take profit before interest and after tax, others may take profit
before interest and tax. Bank overdraft is taken as current liability but some firms may take it as non-
current. The ratios can be comparable only when uniform terminology is adopted by both the firms.

4. Price level changes affect ratios: The comparability of ratios suffers, if the price of the
commodities in two different years is not the same. Change in price affects the cost of production,
sales and also the value of assets. It means that the ratio will be meaningful for comparison, if the
prices do not change.

5. Ignoring qualitative factors: Ratio analysis is the quantitative measurement of the

performance of the business. It ignores the qualitative aspect of the firm, howsoever important it may
be. It shows that ratio is only one-sided approach to measure the efficiency of the business.
 6. No single standard ratio: There is not a single standard ratio which can indicate the true
performance of the business at all time and in all circumstances. Every firm has to work in different
situations and circumstances, so a particular ratio cannot be supposed to be standard for everyone.
Strikes, lock-outs, floods, wars, etc. materially affect the performance, so it cannot be matched with
the circumstances in normal days.

7. Misleading results in the absence of absolute data: In the absence of actual data, the size of
the

business cannot be known. If gross profit ratio of two firms is 25%. It may be just possible that the
gross profit of one is 2,500 and sales Rs. 10,000, whereas the gross profit and sales of the other
firm is Rs. 5, 00,000 and sales 20, 00,000. Profitability of the two firms is the same but the
magnitude of their business is quite different.

8. Window dressing: Many companies, in order to depict rosy picture of their business indulge
in manipulation. They conceal the material facts and exhibit false position. It makes the financial
statements and the ratio analysis based upon these statements defective. The process of
manipulation includes understatement of current liability, overstatement of current assets, recording
the transaction in the next

financial year, showing the purchases of raw material as purchases of assets etc. Window dressing
restricts the utility of ratio analysis.

9. Impressed by personal bias and ability of the analyst: Accounting as we know is not an
exact science. There is no complete universally accepted terminology. There are many interpretations
to particular accounting information. This is why; accounting results are affected by the ability of the
analyst. If the analyst is biased, he will prove his point of view by manipulation and ratio analysis will
be defective.

10. Ratios only a first step: Ratios are only first step for analysis and interpretation of
financial statements and must be supplemented by through investigations before conclusions
can be drawn from them.

CLASSIFICATION OF ACCOUNTING RATIOS

(i) On the basis of data contained in financial statement, ratios may be classified as under:
 1. Income or profit and loss statement ratios: These ratios are calculated on the basis of
information available from income statement i.e., Trading and P/L Account. These ratios are
gross profit, net profit, expenses, operating expenses and stock turnover ratios.

2. Balance sheet or position statement ratios: These ratios are calculated on the basis of
information available from balance sheet, such as current ratio, liquid ratio, proprietary ratio,
solvency ratio and capital gearing ratios etc.

3. Inter-statement or Hybrid ratios: In these ratios, both the income and position
statement are involved. These ratios may be working capital turnover ratio, debtors and
creditors turnover ratio, total capital turnover ratio, fixed assets turnover ratio, return on
investment and earnings per share ratio.

(ii) On the basis of purpose, ratios may be classified as under:

Classification of ratios depends upon the objectives for which they are calculated. It may also
depend upon the availability of data. Analysis of financial statement is made with a view to ascertain
the efficiency and financial soundness of the company; as such ratios can be classified on the
basis of profitability, turnover and financial capability. On the basis of purpose, ratios may be
classified as under;

1. Financial ratios

(a) Liquidity Ratios or Short Term Financial Ratios :

(i) Current Ratio
(ii) Liquidity Ratio
(iii) Absolute Liquidity Ratio .
(b) Solvency Ratios or Long Term financial Ratios:
(i) Debt - Equity Ratio
(ii) Total Assets to Debt Ratio . .
(iii) Proprietary Ratio

(iv) Capital Gearing (Leverage) Ratio

(v) Interest Coverage ratio

(vi) Long Term Debts to Total Funds Ratio

 (vii) Debt Service Coverage Ratio

2. Activity or Performance or Turnover ratios:

(i) Stock or Inventory Turnover Ratio

(ii) Debtors(Receivables) Turnover Ratio

(iii) Creditors (Payables) Turnover Ratio

(iv) Working Capital Turnover Ratio

(v) Fixed Assets Turnover Ratio

(vi) Current Assets Turnover Ratio

(vii) Capital Employed Turnover Ratio

3. Profitability ratios:

(i) Gross Profit Ratio

(ii) Operating Ratio

(iii) Expenses Ratio

(iv) Operating Profit Ratio

(v) Net Profit Ratio

(vi) Return on Total Assets Ratio

(vii) Return on Investment

(viii) Return on Equity Ratio

(ix) Return on Shareholders’ Funds

(x) Earning Per Share

(xi) Dividend Per Share
(xii) Profit Earning Ratio

(xiii) Price Earning Ratio

(xiv) Book Value

 (xv) Market Price to Book Value Ratio

1. (a) LIQUIDITY RATIOS

The term liquidity means the conversion of the assets into cash without much loss. The liquidity
ratios are used to determine the short- term solvency position of a business enterprise. The liquidity
ratios, therefore, are also called ‘Short-Term Solvency Ratios’. The objective is to find out the ability of
the business enterprise to meet short-term liabilities.
In the words of Soloman J. Flink, “Liquidity is the ability of the firm to meet its current obligations as they
fall due.”
In the words of Herbert B. Mayo,” Liquidity is the ease with which assets may be converted into cash
without loss.”
Short-term creditors of the firm are primarily interested in the liquidity ratios of the firm as they want to
know how promptly or readily the firm can meet its current liabilities. If a firm wants to take a short –
term loan from the bank, bankers also study the liquidity ratios of the firm in order to assess the margin
between current assets and current liabilities. The following ratios throw light on the liquidity or short-
term financial position:

(i) CURRENT RATIO or WORKING CAPITAL RATIO

This ratio explains the relationship between current assets and current liabilities. It is also known as
working capital or banker’s ratio. The excess of current assets over current liabilities of an enterprise is
referred to as working capital. This ratio is calculated by dividing total current assets by total current
liabilities as shown below:

Total Current Assets

Current Ratio = ------------------------------------
Total Current Liabilities
‘Current Assets’ include those assets which can be converted into cash within a year’s time and “current
Liabilities” include those liabilities which are payable in a year’s time.

Current Assets Current Liabilities

1. Cash in hand 1. Bank Overdraft

2. Cash at bank 2. Sundry Creditors
3. Sundry Debtors (After deducting provision) 3. Bills Payable
 4. Bills Receivables (After deducting provision) 4. Outstanding Expenses
5. Closing Stock/ Inventory (Raw Material, 5. Short term Loans or Loan payable within a
Work in Progress and Finished Goods) year
6. Short –term Investments/ Marketable Securities 6. Provision for Taxation
7. Prepaid Expenses 7. Proposed Dividend
8. Accrued Incomes 8. Unclaimed Dividends
9. Tax Deducted at Source

Significance: — This ratio is used to assess the firm's ability to meet its short-term

liabilities on time. According to accounting principles, a current ratio of 2: 1 is supposed to

be an ideal ratio. It means that current assets of a business should, at least, be twice of its

current liabilities. The higher the ratio, the better it is, because the firm will be able to pay its
current liabilities more easily. The reason of assuming 2 : 1 as the ideal ratio is that the

current assets include such assets as stock, debtors etc., from which full amount cannot be

realized in case of need. Hence, even if half the amount is realized from the current asset
on time, the firm can still meet its current liabilities in full.

If the current ratio is less than 2 : 1, it indicates lack of liquidity and shortage of
working capital. But a much higher ratio, even though it is beneficial to the short-term
creditors, is not necessarily good for the company. A much higher ratio than 2 : 1 may
indicate the poor investment policies of the management.

A much higher ratio may be considered to be adverse from the view point of management
on account of the following reasons:—

(I) A much higher ratio indicates that stock might be piling up because of poor sales.

(II) Large amount is locked up in debtors due to inefficient collection policy.

(Ill) The cash or bank balances might be lying idle because of no proper investment

opportunities are available.

The biggest drawback of the current ratio is that it is susceptible to "window-dressing".

This ratio can be improved by an equal decrease in both current assets and current
liabilities. For example, if the current assets of a company are Rs. 4, 50,000 and current
liabilities are Rs. 2, 50.000, its current ratio in this case will be Rs. 4, 50,000 / Rs. 2,
50,000= 1.8:1. If this company pays off its creditors by Rs. 50,000, the current ratio will
be:

4, 00,000 / 2, 00,000 = 2:1

It is, therefore, dangerous to use this ratio alone as an index of measuring the short-term
financial position of a concern.

Following points should be carefully considered while calculating the current ratio:—

(1) Only those assets, which are expected to be realized within a year, should be
included in current assets.
(2) Only those liabilities, which are expected to be paid within a year, should be
included
in current liabilities. Those long-term loans and debentures, which will be due for
payment within one year, are also included in current liabilities.
(3) The term 'investment' is used for fixed assets. But 'Short-term Investments' or
'Trade
Investments should be included in current assets. "Marketable securities' should also
be included in current assets.

(4) Loose Tools, Patents, Goodwill and Trade Marks are not included in current assets.

(5) 'Bank Overdraft' should be included in current liabilities.

(6) 'Loan', 'Loan on Mortgage' and 'Bank Loan' are treated as long-term liabilities,

therefore, these should not be included in current liabilities.

(ii) QUICK RATIO or ACID TEST RATIO or LIQUID RATIO

Quick ratio indicates whether the firm is in a position to pay its current liabilities within a month or
immediately. It is in fact the measure of “Instant” debt paying ability of the business enterprise. The quick
ratio is calculated by dividing total liquid assets (Total Quick Assets) by total current liabilities.

Total Quick Assets

Quick Ratio = ------------------------------------
 Total Current Liabilities
Liquid assets or quick assets mean those assets which will yield cash very shortly. All current assets
except closing stock and prepaid expenses are included in quick assets. Closing stock is excluded from
liquid assets because in most situations, stock cannot be converted into cash. Prepaid expenses are not
convertible into cash; they simply reduce the demand for cash in the current accounting period because
of advance payment made in the earlier period. The provision for bad and doubtful debts must be
deducted from debtors in order to calculate the realizable value of debtors. The same considerations
also apply to bills receivables.

Significance:- An ideal quick ratio is said to be 1:1. If it is more, it is considered to be better. The idea is
that for every rupee of current liability, there should at least be one rupee of liquid assets. This ratio is
better test of short-term financial position of the company than the current ratio, as it considers only those
assets which can be easily and readily convertible into cash. Thus quick ratio is better indicator of short
term debt paying capacity. This ratio is very important for financial institutions and banks.

Difference between Current Ratio and Quick Ratio

Point s of Difference Current Ratio Quick Ratio

1. Concerns It is concerned with current assets It is concerned with quick

and current liabilities. assets and current liabilities.
2. Standard Ratio 2:1 1:1

3. Inventory and Current includes inventory Quick assets excludes inventory

Prepaid Expenses and prepaid expenses and prepaid expenses.

(iii) ABSOLUTE LIQUIDTY RATIO

A more rigorous test of liquidity is assessed by relating super quick assets to quick liabilities. Super quick
assets include cash in hand, cash at bank and marketable securities. Debtors and bills receivable are
excluded because they are less liquid than cash and marketable securities.
Bank overdraft is part of current liabilities but for the purpose of quick liabilities it should not be included in
the list of quick liabilities because in normal circumstances, bank overdraft facility is not withdrawn by the
bank all of sudden. In fact bank overdraft has become a method of financing activities. This is calculated
as:
Super Quick Assets
Absolute Liquidity Ratio= -------------------------------------
 Quick Liabilities

Illustration 1. Following is the Balance Sheet of Gee India Ltd. as on 31 March 2008.
LIABILITIES Rs. ASSETS Rs.
Equity Share Capital 5, 00,000 Land & Building 4, 00,000
12% Preference Share Capital 2, 00,000 Goodwill 70,000
General Reserve 80,000 Loose Tools 50,000
15% Debentures 1, 50,000 Trade Investment 1, 50,000
14% Debentures Debtors 2, 65,000
(Payable on1-10-2009) 25,000
Provision for Tax 50,000 Bills Receivable 70,000
Proposed Dividend 65,000 Prepaid Expenses 60,000
Bills Payable 40,000 Inventory 65,000
Bank Overdraft 50,000 Cash at Bank 70,000
Sundry Creditors 75,000 Cash in Hand 60,000
Outstanding Expenses 10,000
Provision for Debtors 15,000
---------------- ----------------
12, 60,000 12, 60,000
------------------- -----------------
Assess the short-term financial position of the company.

Solution
Short – term financial position can be assessed with the help of (i) current Ratio ,(ii) Quick Ratio and (iii)
Absolute Quick Ratio.
Current Assets
Cash in Hand + Cash at bank + Debtors – Provision + Bills Receivables + Trade Investments +Prepaid
Expenses + Inventory = 60000 +70000 + 265000 – 15000 + 70000 + 150000 + 60000 + 65000 =
725000
Current Liabilities
14% Debentures + Provision for Tax + Proposed Dividend + Bills Payable + Sundry Creditors +
Outstanding Expenses + Bank Overdraft = 25000 + 50000 + 65000 + 40000 + 75000 + 10000 + 50000
= 315000
Quick Assets
Cash in Hand + Cash at bank + Debtors – Provision + Bills Receivables + Trade Investments = 60000
+70000 + 265000 – 15000 + 70000 + 150000 = 600000
Super Quick Assets
Cash in Hand + Cash at bank + Trade Investments = 60000 +70000 + 150000 = 280000
Quick Liabilities
14% Debentures + Provision for Tax + Proposed Dividend + Bills Payable + Sundry Creditors +
Outstanding Expenses = 25000 + 50000 + 65000 + 40000 + 75000 + 10000 = 265000

Current Assets Rs. 725000

Current Ratio = ---------------------------- = -------------------- = 2.30 : 1
Current Liabilities Rs. 315000
 Quick Assets Rs. 600000
Quick Ratio = ---------------------------- = -------------------- = 1.90 : 1
Current Liabilities Rs. 315000

Super Quick Assets Rs. 280000

Absolute Quick Ratio = --------------------------------- = -------------------- = 1.06 : 1
Quick Liabilities Rs. 265000
Illustration 2. Following is the Balance Sheet of G & H Ltd. as on 31 March 2008.

1. (b) SOLVENCY RATIO S / LONG TERM FINANCIAL RATIOS

These ratios are calculated to assess the ability of the firm to meet its long -term liabilities as and when
they become due. These ratios reveal as to how much amount in a business has been invested by
proprietors and how much amount has been raised from outside sources. Solvency ratios disclose the
firm’s ability to meet the interest costs regularly and long-term indebtedness at maturity. Solvency ratios
are also known as Leverage Ratios or Capital Gearing Ratios. These ratios can be studied as follows:

(I) DEBT – EQUITY RATIO

This ratio can be calculated into two different ways:
First Method: According to this method, this ratio expressed the relationship between long – term
debts and shareholders’ funds. It indicates the proportion of funds which are acquired by long-term
borrowings in comparison to shareholder’s funds.
Debt Long Term Loans
Debt Equity Ratio = ----------------- or ------------------------------------
Equity Shareholder’s Funds
Long Term Loans: These refer to long term liabilities which mature after one year. These include
Debentures, Bank Loan, Mortgage Loan, Loan from Financial Institutions, Loan from Subsidiaries and
Public Deposits etc.
Shareholder’s Funds: These include Equity Share Capital, Preference Share Capital, Securities
Premium, General Reserve, Capital Reserve, Debenture Redemption Reserve or Sinking fund, Other
Reserves and Profit & Loss Account (credit) . However, accumulated losses and fictitious assets like
Preliminary Expenses, Underwriting Commission, Share Issue expenses, Discount on Issue of Shares
or Debentures, Loss on Issue of Debentures etc. should be deducted.
Significance: This ratio is calculated to assess the ability of the firm to meet its long-term liabilities.
Generally, debt-equity ratio of 2 : 1 is considered safe. If the debt- equity ratio is more than that, it shows
a rather risky financial position from the long –term point of view, as it indicates that more and more
funds invested in the business are provided by long-term lenders. A high debt-equity ratio is a danger –
signal for long-term lenders.
The lower the ratio, the better it is for long- term lenders because they are more secure in that case.
Lower than 2 : 1 debt equity provides sufficient protection to long-term lenders.
Second Method: According to this method, the ratio is calculated as:
External Equities Total Debt (i.e. Long Term + Short Term)
Debt Equity Ratio = ----------------------------- or ---------------------------------------------------------------------
Internal Equities Shareholder’s Funds

The difference between both the methods is essentially in respect of current liabilities. While the first
method excludes them, the second includes them in debt. The first method appears to be most logical in
this ratio, because, for the purpose of ratio analysis , all items of balance sheet are categorized in four
groups (i) Shareholder’s Funds, (ii) Long Term Debts, (iii) Fixed Assets and (iv) Working Capital.
Illustration:

(II) TOTAL ASSETS TO DEBT RATIO

This ratio represents the relationship between total assets and debt. Total assets include all those assets
which have been purchased from long term resources. These assets do not include Fictitious Assets,
like, Preliminary Expenses, Underwriting Commission, Discount or Loss on Issue of Shares and
Debentures and Profit & Loss Account (Debit), Advertise Suspense Account etc.

Total Assets
Total Assets to Debt Ratio = ----------------------------
Long Term Debts
Significance: The ratio is significant, because it informs the creditors that how far loans advanced by
them are safe. It also provides knowledge regarding the protection provided by the assets of the
company to their debts. This ratio facilitates the lenders and investors to take a decision regarding grant
of loans in future.
The Standard Total Assets to Debt Ratio is 2 : 1.
Illustration : Calculate total Assets to Debt Ratio from the following information:
12% Debentures Rs. 9, 00,000, Short Term Loans Rs. 5, 00,000, Preliminary Expenses Rs. 2, 35,000,
Underwriting Commission Rs. 1, 25,000, Discount on Issue of Debentures Rs. 5, 00,000, Sundry
Assets Rs. 26, 60,000.
Solution:
Total Assets 18, 00,000
Total Assets to Debt Ratio = ---------------------------- = -------------------------- = 2 : 1
Long Term Debts 9, 00,000

Working Note: Total Assets = Sundry Assets – Preliminary Expenses –Underwriting Commission –
Discount on Issue of Debentures
= 26, 60,000 – 2, 35,000 – 1, 25,000 – 5, 00,000 = 18, 00,000
(III) PROPRIETARY RATIO
This ratio indicates the relationship between proprietor’s funds and total assets. The proprietor’s funds
include Equity Share Capital, Preference Share Capital, Capital Reserves, Revenue Reserves,
Securities Premium, Accumulated Profits, Retained Earnings, Profit & Loss Account (Credit) etc. Total
Assets include Fixed Assets, Investments and Current Assets excluding Fictitious Assets. It is calculated
as under:
Equity Shareholder’s Funds
Proprietary Ratio = -------------------- or -----------------------------------------
Total Assets Total Assets

Significance: This ratio is very important for the creditors, because they know the share of proprietor’s
funds in the total assets and satisfy how far their loan is secured. A higher proprietary ratio is generally
treated an indicator of sound financial position from long – term point of view, because it means that a
large proportion of total assets is provided by shareholder’s funds and hence firm is less dependent on
external sources of finance. On the contrary, a low proprietary ratio is a danger signal for long –term
lenders as it indicates a lower margin of safety available to them. This ratio also shows the general
financial position of the company also. 50% is supposed to be the satisfactory proprietary ratio for the
creditors. Less than 50% is the sign of risk for creditors.
Illsustration :

(IV) CAPITAL GEARING ( LEVERAGE) RATIO

The term ‘Capital Gearing’ express the relationship between the equity capital (including all reserves and
accumulated profits) and fixed cost bearing capital. In fixed cost bearing capital we include preference
share capital and fixed interest bearing loans, like debentures, bonds, mortgage loans etc. The business
is said to be highly geared when the capital carrying a fixed rate of interest and dividend is in greater
proportion than capital. But if the equity capital is more than the fixed dividend and interest bearing capital
(e.g. preference share capital, debentures and bonds etc.) the capital structure is said to be low geared.
Gearing is neutral when equity capital and fixed interest and dividend capital is equal resulting in ratio of 1
: 1. It is calculated as under:
 (i) INTEREST COVERAGE RATIO
This ratio is also known as ‘Time – interest – earned ratio’, establishing a relationship between profit
before interest on long term debts and taxes and the interest on long term debts. It is generally
expressed in number of times. It is calculated as under:
Net Profit before Charging Interest and Income Tax
Interest Coverage Ratio = ----------------------------------------------------------------------------------------
Fixed Interest Charged / Interest on Long – Term Loans

Net profit before interest and income tax is to be taken for the calculation of this ratio because this is the
amount of profit out of which interest and income tax is to be paid out. Fixed interest charge includes
interest on long-term loans or debentures.
Significance: This ratio indicates how many times the interest charges are covered by the profits
available to pay interest charges. A long- term lender is interested in finding out whether the business will
earn sufficient profits to pay the interest charges regularly. This ratio measures the margin of safety for
long-term lenders. The higher the ratio, more secure the lender is in respect of payment of interest
regularly. If profit is just equal to interest, it is unsafe positions for the lender as well as for the company
also, as nothing will be left for shareholders.
An interest coverage ratio of 6 to 7 times is considered appropriate.
Illustration:
 (VI) LONG TERM DEBTS to TOTAL FUNDS RATIO

This ratio is an extension of debt-equity ratio and provides similar information as the debt- equity ratio. In
this ratio, the long-term debts are related to capital of the firm and not merely to the shareholders’ funds.
The total capital or capital employed consists of shareholders’ funds and long-term loans. It is calculated
as under:

Long Term Debts

Long term Debt to Total Capital Ratio =-------------------------------------------------------------------------
Shareholders’ funds + Long – Term Debts
Significance: Debts to total funds ratio indicates long term financial soundness of the firm. The firm is
said to be solvent, if its debts to total funds ratio is less than one. In case the ratio is more than one, it
highlights financial weakness and the state the probable insolvency.

(VII) DEBT SERVICE COVERAGE RATIO

The interest coverage ratio indicates the ability of the firm to make payment of interest out of profits
before interest and tax, but it does not indicates the ability of a company to make payment of principal
amount on time. For this purpose debt service coverage ratio is calculated. This ratio is the key indicator
to assess the extent of ability of a borrower to service the loan in regard to timely payment of interest and
repayment of principal amount.

Profit after Tax + Depreciation + Interest on Loan

Debt Service Coverage Ratio = --------------------------------------------------------------------------------
Interest on Loan + Loan Repayment in a Year
Significance: A standard ratio of 2 : 1 is considered satisfactory by the financial institutions. Debt
service coverage ratio enables the lender to take a correct view of the borrower’s repayment capacity. A
high debt service coverage ratio indicates better servicing capacity of the company.

Illustration:
 2. ACTIVITY or PERFORMANCE or TURNOVER RATIO

Turnover means ‘sales’, so turnover ratios are related to sales. It is an accepted

concept that sales have direct relationship with the performance of the business. Higher
sales mean better performance, which really means better efficiency and productivity of
the business. Higher sales also mean more production, which is undoubtedly the result
of the best possible utilization of physical resources i.e. material, machine and
manpower. In this way, words turnover, performance and activity are synonymous.
These three words carry the same meaning. In other words, more sales means the
business is more active and has better performance.

Lesser sale shows inactivity of the business, poor performance and lesser productivity.
All business activities revolve round the sales. It is the sales budget, which is prepared
first of all. Production budget is made to produce the desired quantity of goods, required
for sale. Every company should try to multiply its sales, because it is an indicator of all
round development of the business.

Performance ratios also show, whether the total capital, working capital, fixed assets
and stock of the business are profitably used. The basis for calculation of these ratios is
sales or coast of sales. Some of the important activity ratios are discussed below:

(I) STOCK OR INVENTORY TURNOVER RATIO

The speed with which a business converts inventory into sales is an important indicator
of business activity. The management of any business enterprise must maintain
adequate quantity of stock in hand in order to continue the business as a going concern.
But it must avoid an accumulation of inventory in excess of normal requirements for the
simple reason that the excessive stocks not only tie up the funds and increase storage
or carrying costs but they also may lead to subsequent losses if the goods become
outdated or unsalable. Inventory turnover ratio can be computed either on cost basis or
on sale basis.

1. PROFITABILITY RATIOS

Profitability refers to the ability of the business to earn profit. It shows the efficiency of the
business. These ratios measure the profit earning capacity of the company. Profitability
has direct link with sales and cost of goods sold. This is why; we calculate these ratios
on the basis of sales, cost of goods sold, return on investments and capital employed.
The profitability of the business can be measured with the following ratios.

(i) GROSS PROFIT RATIO

It shows the relationship between the gross profit and sales (or turnover) and is
generally expressed in percentage. This ratio shows the margin of gross profit on
sales. In order to calculate this ratio we require gross profit and net sales. Gross profit,
if not given, can be calculated on the basis of the following formula:

Gross Profit = Net Sales + Closing Stock - (Opening Stock +Net Purchases + Direct
Expenses)

or

Gross Profit = Net Sales - Cost of goods sold.

Cost of goods sold = Opening Stock + Net Purchases + Direct Expenses – Closing
Stock

Net Sales = Cash Sales + Credit Sales – Sales Return

Gross Profit can be ascertained by preparing Trading Account also.

The term net sales means sales less sales return. If sales return is not given sales
will be assumed to be net sales.
In case Net Profit is given. Gross Profit will be calculated by adding selling and
distribution and financial expenses and deducting income. The formula for its calculation
is as under:

Gross Profit

Gross profit ratio = ————— x 100

Net Sales

Illustration1. Calculate gross profit ratio if:

Gross profit = 80,000

Sales = 4, 40,000

Sales return = 40,000

Gross Profit 80,000

Solution: Gross profit ratio = ----------------- x 100 = ------------ X 100 = 20%.

Net Sales 4, 00,000

Note: Net Sales = Sales - Sales Return = 4.40,000 - 40,000 = Rs. 4, 00,000.

Significance and Uses of Gross Profit Ratio

Gross profit ratio reveals profit earning capacity of the business with reference to
its sale. Increase in gross profit ratio will mean reduction in cost of production or direct
expenses and sale at reasonably good price and decrease in the ratio will mean
increased cost of production or sales at lesser price. The true efficiency or profitability
of the business cannot be understood by gross profit because profitability may be
lesser, whereas gross profit is more. For example, if a firm earns a gross profit of Rs.
25,000 during the year when its sales is worth Rs. 1,00,000. In the next year the firm
earned Rs, 40,000 as gross profit when its sales were Rs. 2,00,000. The example
shows that profit in the next year has increased to Rs. 40,000 i.e., an increase of Rs.
15,000 as compared to the previous year, whereas the gross profit ratio shows that the
profitability of the firm during the first year was 25% and in the next year it has come
down to 20%. It shows that we should calculate gross profit ratio in order to have the
correct view of the business.

The gross profit ratio also works as a guide to the management in determining its
selling and distribution expenses. There is no ideal standard measure for gross profit
ratio but the gross profit ratio should be adequate enough not only to cover the
operating expenses but also to provide for depreciation, interest on loans, dividends
and creation of reserves.

The effective stock control system can be adopted on the basis of gross profit
ratio. Higher gross profit ratio is always in the interest of the business.

Causes Responsible for Increase in Gross Profit Ratio

Gross profit ratio may increase due to the following reasons;

1. Increase in the sale proceeds without corresponding increase in the cost of

production or purchase price of goods.
2. Under valuation of opening stock.

3. Over valuation of closing stock

4. Decrease in the cost of production or purchase price without corresponding

decrease in sale price

5. Decrease in direct expenses i.e., expenses on acquiring or manufacturing

goods

6. Omission of the invoices regarding purchases

Causes for Decline in Gross Profit Ratio

Decline in the gross profit ratio clearly indicates the fall in the profitability or profit
earning capacity of the business. This fall may be due to the following reasons.
 1. Purchasing of goods at reasonably higher price. If the goods are purchased
at comparatively higher price the cost of goods will increase and reduce the margin of
profit.

2. Shortage of goods. Loss of goods due to theft, pilferage and spoilage will reduce
the quantity of goods to be sold and the sales will decrease. As the firm had paid for
these goods but is not able to sell, the gross profit will fall.

3. Increase in the manufacturing expenses. An increase in the manufacturing

expenses such as carriage, freight, wages and power will increase the cost of
production and reduce margin of profit.

4. Sales at comparatively lower rates. Sales at lower rates will reduce margin of
profit. Efforts should be made to sell goods at competitive price.

The decline in the gross profit ratio must receive due attention of the management.
Possible reasons for its decline should be identified, thoroughly investigated and the
remedial measures applied.

Illustration2.

Calculate Gross Profit Ratio form the following data:

Rs. Rs.

Opening Stock 1, 00,000 Sales 5, 50,000

Purchases 3, 00,000 Sales Return 50,000

Purchase Return 40,000 Closing Stock 80,000

Carriage and Octroi 20,000

Solution:

Gross Profit 2, 00,000

Gross Profit Ratio = -------------------- X 100 = ----------------- X 100 = 40%

Net Sales 5, 00,000

Net Sales = Sales – sales Return = 5, 50,000 – 50,000 = 5, 00,000

Gross Profit = Net Sales – Cost of Goods Sold

= 5, 00,000 – (1, 00,000+3, 00,000 – 40,000 + 20,000 – 80,000) = 2, 00,000

Illustration3.

You are being given data of two companies G Ltd. and H Ltd., belonging to Sheet Metal
industry. Calculate the Gross Profit Ratio of the two companies. Which is doing better?

G Ltd. H Ltd.

Rs. Rs.

Net Profit after interest 1, 50,000 2, 20,000

Indirect Expenses 20,000 30,000

Interest paid on Debentures 30,000 50,000

Sales 6, 60,000 7, 60,000

Sales Return 20,000 40,000

Solution:

Gross Profit

Gross Profit Ratio = -------------------- X 100

Net Sales

Gross Profit = Net Profit after Interest + Indirect Expenses+ Interest on Debentures

Gross Profit of G Ltd. = 1, 50,000 + 20,000 + 30,000 = Rs. 2, 00,000

Gross Profit of H Ltd. = 2, 20,000 + 30,000 + 50,000 = Rs. 3, 00,000

Net Sales = Sales – Sales Return

Net Sales of G Ltd. = 6, 60,000 – 20,000 = 6, 40,000

Net Sales of H Ltd. = 7, 60,000 – 40,000 = 7, 20,000

2, 00,000

Gross Profit Ratio of G Ltd. = ---------------- X 100 = 31.25%

6, 40,000

3, 00,000

Gross Profit Ratio of H Ltd. = -------------- X 100 = 41.67%

7, 20,000

As ratio indicates, H Ltd is operating better in comparison to G Ltd.

Illustration4.

Calculate the Gross Profit Ratio from the following information:

Rs.

Credit Sales 3, 00,000

Cash Sales (Being 25% of Total Sales)

Purchases 3, 20,000

Excess of closing Stock over Opening Stock 40,000

Solutions:

If total Sales = 100

-- Cash Sales = 25

--------

Credit Sales = 75

--------

Hence, If Credit sales is Rs. 75 than total sales will be = Rs. 100
 100

If Credit sales is Re. 1 than total sales will be = --------

75

100

If Credit sales is Rs. 3, 00,000 than total sales will be = -------- X 3, 00,000 = Rs. 4,
00,000

75

Cost of Goods Sold = Purchases – Excess of Closing Stock over Opening Stock

= Rs.3, 20,000 – Rs. 40,000 = Rs. 2, 80,000

Gross Profit = Total Sales – cost of Goods Sold

= Rs. 4, 00,000 – Rs. 2, 80,000 = Rs. 1, 20,000

Gross Profit Rs.1, 20,000

Gross Profit Ratio = -------------------- X 100 = -------------------- X 100 = 30%

Net Sales Rs. 4, 00,000

Illustration5.

Calculate Gross Profit Ratio from the following information:

Cash Sale was 1/3 rd of Total Sales, Cash Sale was Rs. 1, 40,000.

Cash Purchases was 25% of Credit Purchase. Cash Purchase was Rs. 50,000

Opening Stock Rs. 30,000; Closing Stock was Rs. 10,000 more than the opening Stock,
Carriage Rs. 12,000.

Solutions:

If cash sale is Re. 1 than Total Sale will be Rs. 3

If cash sale is Rs. 1,40,000 than Total Sale will be Rs. 1,40,000 X 3 = Rs.
4,20,000
If cash Purchase is Rs. 25 than Credit Purchases will be Rs. 100 and hence Total
Purchase will be Rs. 125

If Cash Purchase is Rs. 25 than Total Purchase will be Rs. 125

125

If Cash Purchase is Rs. 50,000 than Total Purchase will be = -------- X 50,000 = Rs. 2,
50,000

25

Cost of Goods Sold = Opening Stock + Purchases + carriage – Closing Stock

= 30,000 + 2, 50,000 + 12,000 – 40,000 = Rs. 2, 52,000

Gross Profit = Total Sales – Cost of Goods Sold

= Rs. 4, 20,000 – Rs. 2, 52,000 = Rs. 1, 68,000

Gross Profit Rs.1, 68,000

Gross Profit Ratio = -------------------- X 100 = -------------------- X 100 = 40%

Net Sales Rs. 4, 20,000

Illustration6.

A company earns a gross profit of 20% on cost. Its credit sales are twice its cash
sales. If credit sales are Rs. 4, 00,000, calculate the gross profit ratio of the company.

Solutions:

Credit Sales = Rs. 4,00,000

Cash Sales = Rs. 2,00,000

Hence, Total Sales = 6, 00,000

20

Gross Profit being 20% on Cost i.e. ------ On Sales.

120
 20

Hence Gross Profit is ------ X Rs. 6, 00,000 = Rs. 1, 00,000

120

Gross Profit Rs.1, 00,000

Gross Profit Ratio = -------------------- X 100 = -------------------- X 100 = 16.67%

Net Sales Rs. 6, 00,000

(ii) OPERATING RATIO / OPERATING COST RATIO

Operating ratio indicates the ratio of operational cost to the sales.

Operating cost consists of cost of goods sold and other operating
expenses. Operational efficiency of the business will be more in case of
lesser operating ratio and vice versa. The ratio can be calculated on the
basis of the following formula:

Operating Cost

Operating Ratio = —————— x 100

Net Sales

Operating Cost = Cost of goods sold + Operating expenses

Operating Expenses: Those expenses which are concerned with the day-
to-day affairs of the business are called operating expenses. It includes
administrative expenses like salaries, rent, printing and stationary,
depreciation, director’s salary, electricity, insurance etc., and selling and
distribution expenses like advertising, cash discount allowed, bad debts,
commission and travelling expenses of salesman etc., interest expenses of
general nature like interest on short term loans and interest on bills
payable. We exclude the financial expenses like interest on debentures,
bonds or on long term debts, charities and donations, provision for doubtful
debts, provision for taxation, loss on sale of investment or fixed assets,
loss by fire or accidents and other unusual and non recurring expenses like
preliminary expenses, inauguration expenses, publicity on issue of shares
and debentures etc.

Similarly, non operating like profit on sale of investment or fixed assets,

rent received, dividend received, interest received are also not included.

Operating ratio is also related to net profit ratio. As such it can also
be calculated by the following formula:

Operating ratio = 100% - Net profit

ratio.
In other words: Operating Ratio + Operating profit ratio =
100%

Significance and Uses of Gross Profit Ratio

Operating ratio is a measurement of the efficiency and

profitability of the business enterprise. The ratio indicates the extents of
sales that are absorbed by the cost of goods sold and operating expenses.
Lower the operating ratio; the better it is, because it will leave higher
margins of profit on sales. After examining the ratio, the analyst devotes
his utmost attention to those expenses that can be reduced. Lower the
operating ratio, the greater is the operating profit to pay more dividends
and create reserves.

Illustration7.

Calculate the operating ratio from the following:

Rs.
Sales
Sales Return
Purchases
Opening Stock
Closing Stock
Carriage
Wages
Manufacturing Expenses
Office Expenses
Selling Expenses
Discount
Bad Debts
Interest on Short Term Loans
Interest on Long Term Loans
Loss by Fire
Goodwill Written off