Page 1
Ratio
Ratio is an arithmetical expression of relationship between two related or interdependent items.
Accounting Ratio
The ratios calculated on the basis of accounting information are termed as Accounting Ratios. So, Accounting ratios are
those which are based on financial statements and express an arithmetical relation between various accounting variables.
OBJECTIVES OF RATIO ANALYSIS
1. To locate the areas of the business which need more attention.
2. To determine the potential areas which can be improved with the effort in the desired direction.
3. To provide a deeper analysis of profitability, liquidity, solvency and efficiency levels in the business.
4. To provide information for making cross-sectional analysis, i.e. to compare the performance with the best industry
standards.
5. To provide information useful for making estimates and preparing the plans for the future.
Advantages of Accounting Rations
1. Helpful in Analysis of Financial Statements
2. Simplification of Accounting Data
3. Helpful in Comparative Study
4. Helpful in Locating the Weak Spots of the Business
5. Helpful in Forecasting
6. Estimate about the Trend of the Business
Limitations of Accounting Ratios
1. False Accounting Data Gives False Ratios
2. Comparison not Possible if Different Firms Adopt Different Accounting Policies
3. Ratio Analysis Becomes Less Effective Due to Price Level Changes
4. Ratios may be Misleading in the Absence of Absolute date
5. Limited Use of a Single Ratio
6. Window-dressing
CLASSIFICATION OF RATIOS
Liquidity Ratios Solvency Ratios Activity Ratios Profitability Ratios
— Current Ratio — Debt to Equity Ratio — Inventory Turnover Ratio — Gross Profit Ratio
— Quick Ratio — Total Assets to Debt — Trade Receivables Turnover Ratio — Operating Ratio
— Proprietary Ratio — Trade Payables Turnover Ratio — Operating Profit Ratio
— Interest Coverage Ratio — Working Capital Turnover Ratio
— Net Profit Ratio
— Return on Investment
LIQUIDITY RATIO
? The ability of the business to pay the amount due to stakeholders as and when it is due is known as liquidity and
the ratios calculated to measure it are termed as Liquidity Ratios.
? They assess the short-term solvency of the business, i.e. ability of the firm to meet its short-term obligations.
Liquidity Ratios include two main ratios:
(i) Current Ratio (ii) Quick Ratio
1. Current Ratio / working capital ratio = Current Assets
Current Liabilities
? Current Assets= T trade receivables (debtors + b/r) less provisions
I inventory (raw materials+ work in progress+ finished goods) excluding stores, spare parts and loose
tools.
S short term loans and advances
C current investments/ short term investments/ marketable securities (always ignore trade
investments)
C cash and cash equivalents (cash+ cash at bank+ cheques in hand)
Page 2
Ratio
Ratio is an arithmetical expression of relationship between two related or interdependent items.
Accounting Ratio
The ratios calculated on the basis of accounting information are termed as Accounting Ratios. So, Accounting ratios are
those which are based on financial statements and express an arithmetical relation between various accounting variables.
OBJECTIVES OF RATIO ANALYSIS
1. To locate the areas of the business which need more attention.
2. To determine the potential areas which can be improved with the effort in the desired direction.
3. To provide a deeper analysis of profitability, liquidity, solvency and efficiency levels in the business.
4. To provide information for making cross-sectional analysis, i.e. to compare the performance with the best industry
standards.
5. To provide information useful for making estimates and preparing the plans for the future.
Advantages of Accounting Rations
1. Helpful in Analysis of Financial Statements
2. Simplification of Accounting Data
3. Helpful in Comparative Study
4. Helpful in Locating the Weak Spots of the Business
5. Helpful in Forecasting
6. Estimate about the Trend of the Business
Limitations of Accounting Ratios
1. False Accounting Data Gives False Ratios
2. Comparison not Possible if Different Firms Adopt Different Accounting Policies
3. Ratio Analysis Becomes Less Effective Due to Price Level Changes
4. Ratios may be Misleading in the Absence of Absolute date
5. Limited Use of a Single Ratio
6. Window-dressing
CLASSIFICATION OF RATIOS
Liquidity Ratios Solvency Ratios Activity Ratios Profitability Ratios
— Current Ratio — Debt to Equity Ratio — Inventory Turnover Ratio — Gross Profit Ratio
— Quick Ratio — Total Assets to Debt — Trade Receivables Turnover Ratio — Operating Ratio
— Proprietary Ratio — Trade Payables Turnover Ratio — Operating Profit Ratio
— Interest Coverage Ratio — Working Capital Turnover Ratio
— Net Profit Ratio
— Return on Investment
LIQUIDITY RATIO
? The ability of the business to pay the amount due to stakeholders as and when it is due is known as liquidity and
the ratios calculated to measure it are termed as Liquidity Ratios.
? They assess the short-term solvency of the business, i.e. ability of the firm to meet its short-term obligations.
Liquidity Ratios include two main ratios:
(i) Current Ratio (ii) Quick Ratio
1. Current Ratio / working capital ratio = Current Assets
Current Liabilities
? Current Assets= T trade receivables (debtors + b/r) less provisions
I inventory (raw materials+ work in progress+ finished goods) excluding stores, spare parts and loose
tools.
S short term loans and advances
C current investments/ short term investments/ marketable securities (always ignore trade
investments)
C cash and cash equivalents (cash+ cash at bank+ cheques in hand)
O other current assets (prepaid expenses/unexpired amounts+ payment in advance + accrued
incomes)
? Current Liabilities= STB (short term borrowings- bank overdraft+ matured debentures/loan)
STP (short term provisions – provision for taxation [C.Y.]+ proposed dividends)
TP (trade payables= creditors + b/p)
OCL (other current liabilities= outstanding expenses+ unearned incomes+ unclaimed dividend+
unpaid dividends+ calls in advance)
? Ideal ratio is 2:1.
? Both 'Very High' and 'Very Low' Current Ratio are not good for a firm.
? 'Very High' Current Ratio may lead to Low Profitability: A very high current ratio may be due to excessive investment
in the current assets, which may result in idle funds. It leads to lower profitability as idle funds do not earn anything.
? Very Low' Current Ratio may cause Risk to Solvency: A very low current ratio may be due to inadequate investment
in the current assets, which may result in low liquidity. It may threaten the solvency of the enterprise.
2. Quick ratio/ acid test ratio/ liquid ratio= Quick Assets/liquid assets
Current Liabilities
? Quick Assets= T trade receivables (debtors + b/r) less provisions
S short term loans and advances
C current investments/ short term investments/ marketable securities (always ignore trade
investments)
C cash and cash equivalents (cash+ cash at bank+ cheques in hand)
? Current Liabilities= STB (short term borrowings- bank overdraft+ matured debentures/loan)
STP (short term provisions – provision for taxation [C.Y.]+ proposed dividends)
TP (trade payables= creditors + b/p)
OCL (other current liabilities= outstanding expenses+ unearned incomes+ unclaimed dividend+
unpaid dividends+ calls in advance)
? Ideal ratio is 1:1.
An unnecessarily low ratio will be very risky and a high ratio suggests unnecessarily deployment of resources in
otherwise less profitable short-term investments.
? Quick Assets = Current Assets – inventory(closing)- prepaid expenses/+ payment in advance
? Working capital = Current Assets – Current Liabilities
Distinction between Current Ratio and Quick Ratio
Basis Current Ratio Quick Ratio
1. Meaning It establishes the relationship between It establishes the relationship
between
current assets and current liabilities. liquid assets and current liabilities.
2. Objective It aims to asses ability of the firm to meet It aims to asses the ability of the firm
to
its current liabilities within 12 months
from
meet its current liabilities
immediately.
the date of Balance Sheet or within the
period of operating cycle.
3. Ideal Ratio 2:1 is considered as an ideal ratio. 1:1 is considered as an ideal ratio.
4. Formula Current Assets = Current Ratio / Current
Liabilities =
Quick Ratio = Quick Assets / Current
Liabilities
SUMMARY OF ACCOUNTING RATIOS
LIQUIDITY RATIOS
Name of the Ratio Formula Significance
1. Current Ratio Ideal
Ratio = 2:1
Current Assets / Current Liabilities = …. : …. This ratio indicates the firm's ability to meet its
short – term liabilities on time. It helps in assessing
short – term solvency of the enterprise. It shows
the number of times current assets are in excess of
the current liabilities.
Page 3
Ratio
Ratio is an arithmetical expression of relationship between two related or interdependent items.
Accounting Ratio
The ratios calculated on the basis of accounting information are termed as Accounting Ratios. So, Accounting ratios are
those which are based on financial statements and express an arithmetical relation between various accounting variables.
OBJECTIVES OF RATIO ANALYSIS
1. To locate the areas of the business which need more attention.
2. To determine the potential areas which can be improved with the effort in the desired direction.
3. To provide a deeper analysis of profitability, liquidity, solvency and efficiency levels in the business.
4. To provide information for making cross-sectional analysis, i.e. to compare the performance with the best industry
standards.
5. To provide information useful for making estimates and preparing the plans for the future.
Advantages of Accounting Rations
1. Helpful in Analysis of Financial Statements
2. Simplification of Accounting Data
3. Helpful in Comparative Study
4. Helpful in Locating the Weak Spots of the Business
5. Helpful in Forecasting
6. Estimate about the Trend of the Business
Limitations of Accounting Ratios
1. False Accounting Data Gives False Ratios
2. Comparison not Possible if Different Firms Adopt Different Accounting Policies
3. Ratio Analysis Becomes Less Effective Due to Price Level Changes
4. Ratios may be Misleading in the Absence of Absolute date
5. Limited Use of a Single Ratio
6. Window-dressing
CLASSIFICATION OF RATIOS
Liquidity Ratios Solvency Ratios Activity Ratios Profitability Ratios
— Current Ratio — Debt to Equity Ratio — Inventory Turnover Ratio — Gross Profit Ratio
— Quick Ratio — Total Assets to Debt — Trade Receivables Turnover Ratio — Operating Ratio
— Proprietary Ratio — Trade Payables Turnover Ratio — Operating Profit Ratio
— Interest Coverage Ratio — Working Capital Turnover Ratio
— Net Profit Ratio
— Return on Investment
LIQUIDITY RATIO
? The ability of the business to pay the amount due to stakeholders as and when it is due is known as liquidity and
the ratios calculated to measure it are termed as Liquidity Ratios.
? They assess the short-term solvency of the business, i.e. ability of the firm to meet its short-term obligations.
Liquidity Ratios include two main ratios:
(i) Current Ratio (ii) Quick Ratio
1. Current Ratio / working capital ratio = Current Assets
Current Liabilities
? Current Assets= T trade receivables (debtors + b/r) less provisions
I inventory (raw materials+ work in progress+ finished goods) excluding stores, spare parts and loose
tools.
S short term loans and advances
C current investments/ short term investments/ marketable securities (always ignore trade
investments)
C cash and cash equivalents (cash+ cash at bank+ cheques in hand)
O other current assets (prepaid expenses/unexpired amounts+ payment in advance + accrued
incomes)
? Current Liabilities= STB (short term borrowings- bank overdraft+ matured debentures/loan)
STP (short term provisions – provision for taxation [C.Y.]+ proposed dividends)
TP (trade payables= creditors + b/p)
OCL (other current liabilities= outstanding expenses+ unearned incomes+ unclaimed dividend+
unpaid dividends+ calls in advance)
? Ideal ratio is 2:1.
? Both 'Very High' and 'Very Low' Current Ratio are not good for a firm.
? 'Very High' Current Ratio may lead to Low Profitability: A very high current ratio may be due to excessive investment
in the current assets, which may result in idle funds. It leads to lower profitability as idle funds do not earn anything.
? Very Low' Current Ratio may cause Risk to Solvency: A very low current ratio may be due to inadequate investment
in the current assets, which may result in low liquidity. It may threaten the solvency of the enterprise.
2. Quick ratio/ acid test ratio/ liquid ratio= Quick Assets/liquid assets
Current Liabilities
? Quick Assets= T trade receivables (debtors + b/r) less provisions
S short term loans and advances
C current investments/ short term investments/ marketable securities (always ignore trade
investments)
C cash and cash equivalents (cash+ cash at bank+ cheques in hand)
? Current Liabilities= STB (short term borrowings- bank overdraft+ matured debentures/loan)
STP (short term provisions – provision for taxation [C.Y.]+ proposed dividends)
TP (trade payables= creditors + b/p)
OCL (other current liabilities= outstanding expenses+ unearned incomes+ unclaimed dividend+
unpaid dividends+ calls in advance)
? Ideal ratio is 1:1.
An unnecessarily low ratio will be very risky and a high ratio suggests unnecessarily deployment of resources in
otherwise less profitable short-term investments.
? Quick Assets = Current Assets – inventory(closing)- prepaid expenses/+ payment in advance
? Working capital = Current Assets – Current Liabilities
Distinction between Current Ratio and Quick Ratio
Basis Current Ratio Quick Ratio
1. Meaning It establishes the relationship between It establishes the relationship
between
current assets and current liabilities. liquid assets and current liabilities.
2. Objective It aims to asses ability of the firm to meet It aims to asses the ability of the firm
to
its current liabilities within 12 months
from
meet its current liabilities
immediately.
the date of Balance Sheet or within the
period of operating cycle.
3. Ideal Ratio 2:1 is considered as an ideal ratio. 1:1 is considered as an ideal ratio.
4. Formula Current Assets = Current Ratio / Current
Liabilities =
Quick Ratio = Quick Assets / Current
Liabilities
SUMMARY OF ACCOUNTING RATIOS
LIQUIDITY RATIOS
Name of the Ratio Formula Significance
1. Current Ratio Ideal
Ratio = 2:1
Current Assets / Current Liabilities = …. : …. This ratio indicates the firm's ability to meet its
short – term liabilities on time. It helps in assessing
short – term solvency of the enterprise. It shows
the number of times current assets are in excess of
the current liabilities.
2. Quick Ratio or
Liquid Ratio or
Acid – Test Ratio
Ideal Ratio =1:1
Liquid or Quick Assets / Current Liabilities
= ….. : ……
This ratio determine ability of the firm to meet its
current liabilities immediately. It is a better
measure of liquidity as it considers only those
assets which can be easily and readily converted
into cash.
Important Points
1. Current Assets=Current Investments + Inventories (except Loose Tools, Stores and Spares)+Trade Receivables (Sundry
Debtors and Bills Receivable less Provision for Doubtful Debts) + Cash and Cash Equivalents (Cash in hand, Cash at bank,
Cheques/Drafts in hand, etc.) + Short – term loans and advances + Other current assets (Prepaid Expenses + Accrued
Incomes + Advance Tax)
2. Current Liabilities = Short – term Borrowings + Trade Payables (Sundry Creditors and Bills Payable) + Other Current
Liabilities (Current maturities of Long – term debts, interest accrued but not due, interest accrued and due, outstanding
expenses, unclaimed dividend, calls – in – advance, etc.) + Short – term Provisions (Provision for Tax, Proposed Dividend,
Provision for Employee Benefits)
3. Quick Assets = Current Assets – Inventories – Prepaid Expenses – Advance Tax
4. Working Capital = Current Assets – Current Liabilities
SOLVENCY RATIO
1. Debt equity ratio = debt / borrowed funds/ Non-current liabilities
Equity / owner funds / shareholders fund
? Debt /non-current liabilities= long term borrowings (loans+ debentures+ public deposits)
Long term provisions (all employees and workers related provisions like provident
fund, Gratuity )
? Equity / shareholders fund = share capital (equity+ preference)
Reserves and surplus (sssccpo- S security premium)
S sinking fund/D.R.R.
S Surplus in the statement of p&l a/c
C capital Reserve
C capital redemption reserve
P P&L a/c or P&L appropriation a/c {if its Dr. balance its minus and cr. Balance
its plus}
O other reserves (general reserves)
? Ideal ratio is 2:1.
? A high ratio means that the enterprise is depending more on external debts as compared to shareholders' funds. It
indicates that external equities are at higher risks.
? On the other hand, a low Debt to Equity Ratio means that the enterprise is depending more on shareholders' funds
than external debts. It indicates that external equities are at a lower risk and have higher safety.
2. Total assets to debt ratio = Total assets
Debt
? Total assets = Non-current assets + current assets
? A high ratio means higher safety margin for lenders, whereas, low ratio indicates lower safety margin for the
lenders.
3. Proprietary ratio = equity
Total Assets
? A higher ratio is generally taken as an indicator of sound financial position from long – term point of view, because
it means that a large proportion of total assets has been financed by the equity and firm is less dependent on
external sources of finance.
4. Interest coverage Ratio = net profit before interest and tax
Fixed interest charges
? net profit before interest and tax = net profit after interest and tax X 100 + fixed interest charges
(100 – tax rate )
? fixed interest charges = coupon rate or the interest rate on debt
? like 10 % debentures = 2,00,000 then interest will be Rs.20,000
? A high ratio is considered better for the lenders as it means higher safety margin.
Page 4
Ratio
Ratio is an arithmetical expression of relationship between two related or interdependent items.
Accounting Ratio
The ratios calculated on the basis of accounting information are termed as Accounting Ratios. So, Accounting ratios are
those which are based on financial statements and express an arithmetical relation between various accounting variables.
OBJECTIVES OF RATIO ANALYSIS
1. To locate the areas of the business which need more attention.
2. To determine the potential areas which can be improved with the effort in the desired direction.
3. To provide a deeper analysis of profitability, liquidity, solvency and efficiency levels in the business.
4. To provide information for making cross-sectional analysis, i.e. to compare the performance with the best industry
standards.
5. To provide information useful for making estimates and preparing the plans for the future.
Advantages of Accounting Rations
1. Helpful in Analysis of Financial Statements
2. Simplification of Accounting Data
3. Helpful in Comparative Study
4. Helpful in Locating the Weak Spots of the Business
5. Helpful in Forecasting
6. Estimate about the Trend of the Business
Limitations of Accounting Ratios
1. False Accounting Data Gives False Ratios
2. Comparison not Possible if Different Firms Adopt Different Accounting Policies
3. Ratio Analysis Becomes Less Effective Due to Price Level Changes
4. Ratios may be Misleading in the Absence of Absolute date
5. Limited Use of a Single Ratio
6. Window-dressing
CLASSIFICATION OF RATIOS
Liquidity Ratios Solvency Ratios Activity Ratios Profitability Ratios
— Current Ratio — Debt to Equity Ratio — Inventory Turnover Ratio — Gross Profit Ratio
— Quick Ratio — Total Assets to Debt — Trade Receivables Turnover Ratio — Operating Ratio
— Proprietary Ratio — Trade Payables Turnover Ratio — Operating Profit Ratio
— Interest Coverage Ratio — Working Capital Turnover Ratio
— Net Profit Ratio
— Return on Investment
LIQUIDITY RATIO
? The ability of the business to pay the amount due to stakeholders as and when it is due is known as liquidity and
the ratios calculated to measure it are termed as Liquidity Ratios.
? They assess the short-term solvency of the business, i.e. ability of the firm to meet its short-term obligations.
Liquidity Ratios include two main ratios:
(i) Current Ratio (ii) Quick Ratio
1. Current Ratio / working capital ratio = Current Assets
Current Liabilities
? Current Assets= T trade receivables (debtors + b/r) less provisions
I inventory (raw materials+ work in progress+ finished goods) excluding stores, spare parts and loose
tools.
S short term loans and advances
C current investments/ short term investments/ marketable securities (always ignore trade
investments)
C cash and cash equivalents (cash+ cash at bank+ cheques in hand)
O other current assets (prepaid expenses/unexpired amounts+ payment in advance + accrued
incomes)
? Current Liabilities= STB (short term borrowings- bank overdraft+ matured debentures/loan)
STP (short term provisions – provision for taxation [C.Y.]+ proposed dividends)
TP (trade payables= creditors + b/p)
OCL (other current liabilities= outstanding expenses+ unearned incomes+ unclaimed dividend+
unpaid dividends+ calls in advance)
? Ideal ratio is 2:1.
? Both 'Very High' and 'Very Low' Current Ratio are not good for a firm.
? 'Very High' Current Ratio may lead to Low Profitability: A very high current ratio may be due to excessive investment
in the current assets, which may result in idle funds. It leads to lower profitability as idle funds do not earn anything.
? Very Low' Current Ratio may cause Risk to Solvency: A very low current ratio may be due to inadequate investment
in the current assets, which may result in low liquidity. It may threaten the solvency of the enterprise.
2. Quick ratio/ acid test ratio/ liquid ratio= Quick Assets/liquid assets
Current Liabilities
? Quick Assets= T trade receivables (debtors + b/r) less provisions
S short term loans and advances
C current investments/ short term investments/ marketable securities (always ignore trade
investments)
C cash and cash equivalents (cash+ cash at bank+ cheques in hand)
? Current Liabilities= STB (short term borrowings- bank overdraft+ matured debentures/loan)
STP (short term provisions – provision for taxation [C.Y.]+ proposed dividends)
TP (trade payables= creditors + b/p)
OCL (other current liabilities= outstanding expenses+ unearned incomes+ unclaimed dividend+
unpaid dividends+ calls in advance)
? Ideal ratio is 1:1.
An unnecessarily low ratio will be very risky and a high ratio suggests unnecessarily deployment of resources in
otherwise less profitable short-term investments.
? Quick Assets = Current Assets – inventory(closing)- prepaid expenses/+ payment in advance
? Working capital = Current Assets – Current Liabilities
Distinction between Current Ratio and Quick Ratio
Basis Current Ratio Quick Ratio
1. Meaning It establishes the relationship between It establishes the relationship
between
current assets and current liabilities. liquid assets and current liabilities.
2. Objective It aims to asses ability of the firm to meet It aims to asses the ability of the firm
to
its current liabilities within 12 months
from
meet its current liabilities
immediately.
the date of Balance Sheet or within the
period of operating cycle.
3. Ideal Ratio 2:1 is considered as an ideal ratio. 1:1 is considered as an ideal ratio.
4. Formula Current Assets = Current Ratio / Current
Liabilities =
Quick Ratio = Quick Assets / Current
Liabilities
SUMMARY OF ACCOUNTING RATIOS
LIQUIDITY RATIOS
Name of the Ratio Formula Significance
1. Current Ratio Ideal
Ratio = 2:1
Current Assets / Current Liabilities = …. : …. This ratio indicates the firm's ability to meet its
short – term liabilities on time. It helps in assessing
short – term solvency of the enterprise. It shows
the number of times current assets are in excess of
the current liabilities.
2. Quick Ratio or
Liquid Ratio or
Acid – Test Ratio
Ideal Ratio =1:1
Liquid or Quick Assets / Current Liabilities
= ….. : ……
This ratio determine ability of the firm to meet its
current liabilities immediately. It is a better
measure of liquidity as it considers only those
assets which can be easily and readily converted
into cash.
Important Points
1. Current Assets=Current Investments + Inventories (except Loose Tools, Stores and Spares)+Trade Receivables (Sundry
Debtors and Bills Receivable less Provision for Doubtful Debts) + Cash and Cash Equivalents (Cash in hand, Cash at bank,
Cheques/Drafts in hand, etc.) + Short – term loans and advances + Other current assets (Prepaid Expenses + Accrued
Incomes + Advance Tax)
2. Current Liabilities = Short – term Borrowings + Trade Payables (Sundry Creditors and Bills Payable) + Other Current
Liabilities (Current maturities of Long – term debts, interest accrued but not due, interest accrued and due, outstanding
expenses, unclaimed dividend, calls – in – advance, etc.) + Short – term Provisions (Provision for Tax, Proposed Dividend,
Provision for Employee Benefits)
3. Quick Assets = Current Assets – Inventories – Prepaid Expenses – Advance Tax
4. Working Capital = Current Assets – Current Liabilities
SOLVENCY RATIO
1. Debt equity ratio = debt / borrowed funds/ Non-current liabilities
Equity / owner funds / shareholders fund
? Debt /non-current liabilities= long term borrowings (loans+ debentures+ public deposits)
Long term provisions (all employees and workers related provisions like provident
fund, Gratuity )
? Equity / shareholders fund = share capital (equity+ preference)
Reserves and surplus (sssccpo- S security premium)
S sinking fund/D.R.R.
S Surplus in the statement of p&l a/c
C capital Reserve
C capital redemption reserve
P P&L a/c or P&L appropriation a/c {if its Dr. balance its minus and cr. Balance
its plus}
O other reserves (general reserves)
? Ideal ratio is 2:1.
? A high ratio means that the enterprise is depending more on external debts as compared to shareholders' funds. It
indicates that external equities are at higher risks.
? On the other hand, a low Debt to Equity Ratio means that the enterprise is depending more on shareholders' funds
than external debts. It indicates that external equities are at a lower risk and have higher safety.
2. Total assets to debt ratio = Total assets
Debt
? Total assets = Non-current assets + current assets
? A high ratio means higher safety margin for lenders, whereas, low ratio indicates lower safety margin for the
lenders.
3. Proprietary ratio = equity
Total Assets
? A higher ratio is generally taken as an indicator of sound financial position from long – term point of view, because
it means that a large proportion of total assets has been financed by the equity and firm is less dependent on
external sources of finance.
4. Interest coverage Ratio = net profit before interest and tax
Fixed interest charges
? net profit before interest and tax = net profit after interest and tax X 100 + fixed interest charges
(100 – tax rate )
? fixed interest charges = coupon rate or the interest rate on debt
? like 10 % debentures = 2,00,000 then interest will be Rs.20,000
? A high ratio is considered better for the lenders as it means higher safety margin.
Notes:
1. Debt = Long-term Borrowings + Long-term Provisions
2. Equity = Equity Share Capital + Preference Share Capital + Reserves & Surplus.
3. Equity = Non-Current Assets + Working Capital - Non-Current Liabilities
4. Equity = Share Capital + Reserves & Surplus.
5. Equity = Shareholders' Funds + Preference Share Capital
6. Equity = Capital Employed - Debt
7. Equity = Non-Current Assets + Current Assets - Current Liabilities - Non-Current Liabilities
8. Equity = Total Assets - Total Debt
9. Total assets = total liabilities
10. Total assets / total liabilities= shareholders fund+ non c.l. + c.l.
11. Total debt = long term debt + current debt
12. Total liabilities = long term liabilities + current liabilities
SOLVENCY RATIOS
Name of Ratio Formula Significance
1. Debt to Equity
Ratio
Ideal Ratio = 2:1
Debt / Equity = .......
This ratio is calculated to assess the long – term financial
soundness of the enterprise. It indicates the extent to which
the enterprise depends on external funds for its business.
2. Total Assets to
Debt Ratio
Total Assets / Debt = ........
This ratio measures the extent to which debt is covered by the
assets, i.e. it measures the safety margin available to the
lenders of long – term debts. A high ratio means higher safety
margin for lenders, whereas, low ratio indicates lower safety
margin.
3. Proprietary
Ratio
Proprietors' Funds (Equity) / Total
Assets = ......
This ratio aims to measure the proportion of total assets, which
have been funded by the owners or shareholders. A high ratio
is generally taken as an indicator of sound financial position as
it means that a large proportion of total assets has been
financed by equity.
4. Interest
Coverage Ratio
Profit before interest and Tax /
Interest on Long – term Debt =
...Times
This ratio indicates how many times the interest charges are
covered by the profits out of which interest will be paid. This
ratio measures the margin of safety for long – term lenders. A
high ratio is considered better for the lenders as it means
higher safety margin.
Important Points
1. Debt = Long – term Borrowings (Debentures, Mortgage Loan, Term Loans from Banks and other financial institutions,
Public Deposits, etc.) + Long – term Provisions (Provision for Employee Benefits, Provision for Provident fund, Provision
for Warranty Claims, etc.)
2. Equity = Share Capital (Equity Share Capital, Preference Share Capital) + Reserves and Surplus (Capital Reserve,
Securities Premium Reserve, General Reserve, etc.)
3. Total Assets = Non – Current Assets (Fixed Assets (Tangible and Intangible Assets), Non – Current Investments, Long
– term Loans and Advances) + Current Assets (Inventories (including Loose Tools, Stores and Spares), Trade Receivables
(Sundry Debtors and Bills Receivable less Provision for Doubtful Debts), Cash and Cash Equivalents, Short – term loans
and advances, Other current assets (Prepaid expenses + Accrued Incomes + Advance tax)}
4. Profit before Interest and Tax = Profit after Interest and after Tax + Tax + Interest on Long – term Debt*.
5. *Interest on Long – term Debt: It includes interest on long – term debt such as interest on Debentures, Mortgage
Loan, Term Loans, Public Deposits, etc.
ACTIVITY OR TURNOVER RATIO
1. Inventory turnover ratio= Cost of revenue from operations
Average inventory
? Cost of revenue from operations = Revenue from operations – gross profit
Or
Cost of revenue from operations = op inventory – cl. Inventory + purchases – purchase return + direct
expenses
op inventory – cl. Inventory= change in stock
purchases – purchase return = net purchases
direct expenses = all expenses of trading a/c dr. side like wages , carriage , freight, octroi etc
Page 5
Ratio
Ratio is an arithmetical expression of relationship between two related or interdependent items.
Accounting Ratio
The ratios calculated on the basis of accounting information are termed as Accounting Ratios. So, Accounting ratios are
those which are based on financial statements and express an arithmetical relation between various accounting variables.
OBJECTIVES OF RATIO ANALYSIS
1. To locate the areas of the business which need more attention.
2. To determine the potential areas which can be improved with the effort in the desired direction.
3. To provide a deeper analysis of profitability, liquidity, solvency and efficiency levels in the business.
4. To provide information for making cross-sectional analysis, i.e. to compare the performance with the best industry
standards.
5. To provide information useful for making estimates and preparing the plans for the future.
Advantages of Accounting Rations
1. Helpful in Analysis of Financial Statements
2. Simplification of Accounting Data
3. Helpful in Comparative Study
4. Helpful in Locating the Weak Spots of the Business
5. Helpful in Forecasting
6. Estimate about the Trend of the Business
Limitations of Accounting Ratios
1. False Accounting Data Gives False Ratios
2. Comparison not Possible if Different Firms Adopt Different Accounting Policies
3. Ratio Analysis Becomes Less Effective Due to Price Level Changes
4. Ratios may be Misleading in the Absence of Absolute date
5. Limited Use of a Single Ratio
6. Window-dressing
CLASSIFICATION OF RATIOS
Liquidity Ratios Solvency Ratios Activity Ratios Profitability Ratios
— Current Ratio — Debt to Equity Ratio — Inventory Turnover Ratio — Gross Profit Ratio
— Quick Ratio — Total Assets to Debt — Trade Receivables Turnover Ratio — Operating Ratio
— Proprietary Ratio — Trade Payables Turnover Ratio — Operating Profit Ratio
— Interest Coverage Ratio — Working Capital Turnover Ratio
— Net Profit Ratio
— Return on Investment
LIQUIDITY RATIO
? The ability of the business to pay the amount due to stakeholders as and when it is due is known as liquidity and
the ratios calculated to measure it are termed as Liquidity Ratios.
? They assess the short-term solvency of the business, i.e. ability of the firm to meet its short-term obligations.
Liquidity Ratios include two main ratios:
(i) Current Ratio (ii) Quick Ratio
1. Current Ratio / working capital ratio = Current Assets
Current Liabilities
? Current Assets= T trade receivables (debtors + b/r) less provisions
I inventory (raw materials+ work in progress+ finished goods) excluding stores, spare parts and loose
tools.
S short term loans and advances
C current investments/ short term investments/ marketable securities (always ignore trade
investments)
C cash and cash equivalents (cash+ cash at bank+ cheques in hand)
O other current assets (prepaid expenses/unexpired amounts+ payment in advance + accrued
incomes)
? Current Liabilities= STB (short term borrowings- bank overdraft+ matured debentures/loan)
STP (short term provisions – provision for taxation [C.Y.]+ proposed dividends)
TP (trade payables= creditors + b/p)
OCL (other current liabilities= outstanding expenses+ unearned incomes+ unclaimed dividend+
unpaid dividends+ calls in advance)
? Ideal ratio is 2:1.
? Both 'Very High' and 'Very Low' Current Ratio are not good for a firm.
? 'Very High' Current Ratio may lead to Low Profitability: A very high current ratio may be due to excessive investment
in the current assets, which may result in idle funds. It leads to lower profitability as idle funds do not earn anything.
? Very Low' Current Ratio may cause Risk to Solvency: A very low current ratio may be due to inadequate investment
in the current assets, which may result in low liquidity. It may threaten the solvency of the enterprise.
2. Quick ratio/ acid test ratio/ liquid ratio= Quick Assets/liquid assets
Current Liabilities
? Quick Assets= T trade receivables (debtors + b/r) less provisions
S short term loans and advances
C current investments/ short term investments/ marketable securities (always ignore trade
investments)
C cash and cash equivalents (cash+ cash at bank+ cheques in hand)
? Current Liabilities= STB (short term borrowings- bank overdraft+ matured debentures/loan)
STP (short term provisions – provision for taxation [C.Y.]+ proposed dividends)
TP (trade payables= creditors + b/p)
OCL (other current liabilities= outstanding expenses+ unearned incomes+ unclaimed dividend+
unpaid dividends+ calls in advance)
? Ideal ratio is 1:1.
An unnecessarily low ratio will be very risky and a high ratio suggests unnecessarily deployment of resources in
otherwise less profitable short-term investments.
? Quick Assets = Current Assets – inventory(closing)- prepaid expenses/+ payment in advance
? Working capital = Current Assets – Current Liabilities
Distinction between Current Ratio and Quick Ratio
Basis Current Ratio Quick Ratio
1. Meaning It establishes the relationship between It establishes the relationship
between
current assets and current liabilities. liquid assets and current liabilities.
2. Objective It aims to asses ability of the firm to meet It aims to asses the ability of the firm
to
its current liabilities within 12 months
from
meet its current liabilities
immediately.
the date of Balance Sheet or within the
period of operating cycle.
3. Ideal Ratio 2:1 is considered as an ideal ratio. 1:1 is considered as an ideal ratio.
4. Formula Current Assets = Current Ratio / Current
Liabilities =
Quick Ratio = Quick Assets / Current
Liabilities
SUMMARY OF ACCOUNTING RATIOS
LIQUIDITY RATIOS
Name of the Ratio Formula Significance
1. Current Ratio Ideal
Ratio = 2:1
Current Assets / Current Liabilities = …. : …. This ratio indicates the firm's ability to meet its
short – term liabilities on time. It helps in assessing
short – term solvency of the enterprise. It shows
the number of times current assets are in excess of
the current liabilities.
2. Quick Ratio or
Liquid Ratio or
Acid – Test Ratio
Ideal Ratio =1:1
Liquid or Quick Assets / Current Liabilities
= ….. : ……
This ratio determine ability of the firm to meet its
current liabilities immediately. It is a better
measure of liquidity as it considers only those
assets which can be easily and readily converted
into cash.
Important Points
1. Current Assets=Current Investments + Inventories (except Loose Tools, Stores and Spares)+Trade Receivables (Sundry
Debtors and Bills Receivable less Provision for Doubtful Debts) + Cash and Cash Equivalents (Cash in hand, Cash at bank,
Cheques/Drafts in hand, etc.) + Short – term loans and advances + Other current assets (Prepaid Expenses + Accrued
Incomes + Advance Tax)
2. Current Liabilities = Short – term Borrowings + Trade Payables (Sundry Creditors and Bills Payable) + Other Current
Liabilities (Current maturities of Long – term debts, interest accrued but not due, interest accrued and due, outstanding
expenses, unclaimed dividend, calls – in – advance, etc.) + Short – term Provisions (Provision for Tax, Proposed Dividend,
Provision for Employee Benefits)
3. Quick Assets = Current Assets – Inventories – Prepaid Expenses – Advance Tax
4. Working Capital = Current Assets – Current Liabilities
SOLVENCY RATIO
1. Debt equity ratio = debt / borrowed funds/ Non-current liabilities
Equity / owner funds / shareholders fund
? Debt /non-current liabilities= long term borrowings (loans+ debentures+ public deposits)
Long term provisions (all employees and workers related provisions like provident
fund, Gratuity )
? Equity / shareholders fund = share capital (equity+ preference)
Reserves and surplus (sssccpo- S security premium)
S sinking fund/D.R.R.
S Surplus in the statement of p&l a/c
C capital Reserve
C capital redemption reserve
P P&L a/c or P&L appropriation a/c {if its Dr. balance its minus and cr. Balance
its plus}
O other reserves (general reserves)
? Ideal ratio is 2:1.
? A high ratio means that the enterprise is depending more on external debts as compared to shareholders' funds. It
indicates that external equities are at higher risks.
? On the other hand, a low Debt to Equity Ratio means that the enterprise is depending more on shareholders' funds
than external debts. It indicates that external equities are at a lower risk and have higher safety.
2. Total assets to debt ratio = Total assets
Debt
? Total assets = Non-current assets + current assets
? A high ratio means higher safety margin for lenders, whereas, low ratio indicates lower safety margin for the
lenders.
3. Proprietary ratio = equity
Total Assets
? A higher ratio is generally taken as an indicator of sound financial position from long – term point of view, because
it means that a large proportion of total assets has been financed by the equity and firm is less dependent on
external sources of finance.
4. Interest coverage Ratio = net profit before interest and tax
Fixed interest charges
? net profit before interest and tax = net profit after interest and tax X 100 + fixed interest charges
(100 – tax rate )
? fixed interest charges = coupon rate or the interest rate on debt
? like 10 % debentures = 2,00,000 then interest will be Rs.20,000
? A high ratio is considered better for the lenders as it means higher safety margin.
Notes:
1. Debt = Long-term Borrowings + Long-term Provisions
2. Equity = Equity Share Capital + Preference Share Capital + Reserves & Surplus.
3. Equity = Non-Current Assets + Working Capital - Non-Current Liabilities
4. Equity = Share Capital + Reserves & Surplus.
5. Equity = Shareholders' Funds + Preference Share Capital
6. Equity = Capital Employed - Debt
7. Equity = Non-Current Assets + Current Assets - Current Liabilities - Non-Current Liabilities
8. Equity = Total Assets - Total Debt
9. Total assets = total liabilities
10. Total assets / total liabilities= shareholders fund+ non c.l. + c.l.
11. Total debt = long term debt + current debt
12. Total liabilities = long term liabilities + current liabilities
SOLVENCY RATIOS
Name of Ratio Formula Significance
1. Debt to Equity
Ratio
Ideal Ratio = 2:1
Debt / Equity = .......
This ratio is calculated to assess the long – term financial
soundness of the enterprise. It indicates the extent to which
the enterprise depends on external funds for its business.
2. Total Assets to
Debt Ratio
Total Assets / Debt = ........
This ratio measures the extent to which debt is covered by the
assets, i.e. it measures the safety margin available to the
lenders of long – term debts. A high ratio means higher safety
margin for lenders, whereas, low ratio indicates lower safety
margin.
3. Proprietary
Ratio
Proprietors' Funds (Equity) / Total
Assets = ......
This ratio aims to measure the proportion of total assets, which
have been funded by the owners or shareholders. A high ratio
is generally taken as an indicator of sound financial position as
it means that a large proportion of total assets has been
financed by equity.
4. Interest
Coverage Ratio
Profit before interest and Tax /
Interest on Long – term Debt =
...Times
This ratio indicates how many times the interest charges are
covered by the profits out of which interest will be paid. This
ratio measures the margin of safety for long – term lenders. A
high ratio is considered better for the lenders as it means
higher safety margin.
Important Points
1. Debt = Long – term Borrowings (Debentures, Mortgage Loan, Term Loans from Banks and other financial institutions,
Public Deposits, etc.) + Long – term Provisions (Provision for Employee Benefits, Provision for Provident fund, Provision
for Warranty Claims, etc.)
2. Equity = Share Capital (Equity Share Capital, Preference Share Capital) + Reserves and Surplus (Capital Reserve,
Securities Premium Reserve, General Reserve, etc.)
3. Total Assets = Non – Current Assets (Fixed Assets (Tangible and Intangible Assets), Non – Current Investments, Long
– term Loans and Advances) + Current Assets (Inventories (including Loose Tools, Stores and Spares), Trade Receivables
(Sundry Debtors and Bills Receivable less Provision for Doubtful Debts), Cash and Cash Equivalents, Short – term loans
and advances, Other current assets (Prepaid expenses + Accrued Incomes + Advance tax)}
4. Profit before Interest and Tax = Profit after Interest and after Tax + Tax + Interest on Long – term Debt*.
5. *Interest on Long – term Debt: It includes interest on long – term debt such as interest on Debentures, Mortgage
Loan, Term Loans, Public Deposits, etc.
ACTIVITY OR TURNOVER RATIO
1. Inventory turnover ratio= Cost of revenue from operations
Average inventory
? Cost of revenue from operations = Revenue from operations – gross profit
Or
Cost of revenue from operations = op inventory – cl. Inventory + purchases – purchase return + direct
expenses
op inventory – cl. Inventory= change in stock
purchases – purchase return = net purchases
direct expenses = all expenses of trading a/c dr. side like wages , carriage , freight, octroi etc
? Average inventory = op inventory + cl. Inventory
2
? A very high ratio is not desirable because it indicates that the inventory level is very low and it may lead to shortage
of working capital.
? On the other hand, a low ratio indicates that inventory does not sell quickly and there is over – investment in stock
and inefficient use of funds.
2. Average age of inventory (stock velocity) = 12/365/52
inventory turnover ratio
? If not mentioned it is to be calculated in days (to be round off if necessary )
3. Trade receivables turnover ratio = Net credit revenue from operations
Average Trade receivables
? Net credit revenue from operations = total revenue from operations – cash revenue from operations
? Revenue from operations less returns from revenue from operations should be recorded
? Average Trade receivables = op. Trade receivables + cl. Trade receivables
2
Or
? Average Trade receivables = average debtors + average B/R
4. Average collection period (debtors velocity) = 12/365/52
Trade receivables turnover ratio
• A high ratio indicates the shorter collection period, i.e. debts are collected promptly.
• On the other hand, a low ratio indicates a longer collection period, i.e. delayed payments by Trade Receivables.
5. Trade payables turnover ratio = Net credit purchases
Average Trade payables
? Net credit purchases = total purchases – cash purchases
? Purchases should be less returns
? Average Trade payables = op. Trade payables + cl. Trade payables
2
Or
? Average Trade payables = average creditors + average B/p
6. Average Payment period (creditors velocity) = 12/365/52
Trade payables turnover ratio
• A high ratio indicates the shorter payment period, i.e. either availability of less credit or earlier payments.
• A low ratio indicates a larger payment period, i.e. either availability of more credit or delayed payments.
7. Working capital turnover ratio = revenue from operations
Working capital
? Working capital = Current Assets – Current Liabilities
? Both 'Very High' and 'Very Low' Working Capital Turnover Ratios are not good for a firm
? • 'Very High' Ratio indicates shortage of Working Capital: A very high ratio indicates overtrading, i.e. doing business
with very less working capital. It shows shortage of working capital and may put the concern in financial difficulties.
? • 'Very Low' Ratio indicates Excess Working Capital: A very low ratio indicates under – trading, i.e. doing business
with working capital in excess of the requirements.
ACTIVITY OR TURNOVER RATIO
ACTIVITY RATIOS
OR TURNOVER
RATIOS
Name of Ratio Formula Significance
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