Accounting Ratios: Meaning and Classification (With Formulas) - Commerce PDF Download

Meaning of Accounting Ratio:

According to J. Batty “the term accounting ratio is used to describe significant relationships between figures shown on a Balance Sheet, in a Profit and Loss Account, in a Budgetary Control System or in any part of the accounting organisation.” In simple words, it is an assessment of significance of any figure in relation to another.

The accounting ratios indicate a quantitative relationship which is used for analysis and decision-making. It provides basis for inter-firm as well as intra-firm comparisons. Besides, in order to make the ratios effective, they are compared with ratios of base period or with standards or with the industry average ratios.

Classification of Accounting Ratios:

Accounting ratios may be classified in a number of ways to suit any particular purpose.

Different kinds of ratios are selected for different types of situations:

The most widely used classification are:

(a) Classification According to Sources:

Accounting ratios can be further classified into following three groups:

1. Balance Sheet Ratios:

These ratios are also known as financial ratios. These ratios deal with relationship between two items or group of items which are both available in Balance sheet.

Examples of these ratios are:

Current ratio, Liquid ratio, Debt-Equity ratio, Capital bearing ratio, Proprietary ratio, etc.

2. Profit and Loss Account Ratios:

These ratios deal with the relationship between two items or group of items which are usually taken out from the profit and loss account.

Examples of these ratios are:

Gross profit ratio, Net profit ratio, Operating ratio, Operating profit ratio, Interest coverage ratio etc.

3. Inter-statement Ratios or Combined Ratios:

These ratios deal with the relationship between items, one of which is drawn from profit and loss account and other is from balance sheet.

Examples of these ratios are:

Stock turnover ratio, Debtors turnover ratio, Creditors turnover ratio, Assets turnover ratio. Return on capital employed, etc.

(b) Classification According to Nature:

Under this classification, ratios are grouped as:

1. Liquidity Ratios:

The terms liquidity and short-term solvency are synonymously used. The liquidity ratios indicate the liquidity position of the enterprise. These ratios analyse the ability of the firm to meet its current liabilities out of current assets. Liquid ratios are of help in ascertaining the effectiveness of the working capital management.

Examples of these ratios are:

Current ratio, Quick ratio, Inventory turnover ratio, Debtors turnover ratio, Creditors turnover ratio etc.

2. Leverage Ratios:

It refers to those financial ratios which measure the long-term solvency and capital structure of the firm. They show the mix of funds provided by the owners and lenders and also the risk involved in debt financing.

Examples of these ratios are:

Debt-Equity ratio, Capital gearing ratio, Fixed assets to Net worth ratio, Interest coverage ratio etc.

3. Turnover or Activity Ratios:

These ratios measure the efficiency with which the funds have been employed in the business. They indicate frequency of sales with respect to its assets. These are computed with reference to sales or cost of goods sold and expressed in terms of times or rates.

Examples of these ratios are:

Stock Turnover ratio, Debtors Turnover ratio, Creditors Turnover ratio, Fixed Assets Turnover ratio, etc.

4. Profitability Ratios:

Profitability is an indication of the efficiency with which the operations of the business are carried on. Profitability ratios show the effect of business transactions on the profits. A lower profitability ratio may arise due to lack of control over business expenses.

Examples of these ratios are:

Gross profit ratio, Net profit ratio, Operating ratio, Operating profit ratio, Return in capital employed, etc.

A. Analysis of Liquidity or Liquid Ratios:

These ratios play a vital role in the analysis of short-term financial position of a business. Banks and other short-term loan creditors are generally interested in such an analysis. Shareholders, debenture holders and other long term creditors can use these ratios to assess the ability of the firm to pay dividend and interest charges.

In short, these ratios indicate the capacity or ability of the firm to meet the maturing or current liabilities, the efficiency of the management in utilizing the working capital and the progress attained in current financial position.

Some of these ratios are:

1. Current Ratio or Working Capital Ratio:

Current ratio may be defined as the ratio of current assets and current liabilities and is obtained by dividing current assets by current liabilities. It is also known as working capital ratio. Working capital is defined as excess of current assets over current liabilities. This ratio is the indicator of short-term liquidity position of a firm. The term liquidity means the ability of the firm to meet its short-term maturing obligations.

Thus, if current assets amount to Rs. 2,00,000 and current liabilities Rs. 1,00,000, then,

Current assets mean cash or those assets convertible or expected to be converted into cash within a year. It includes: Cash in hand and at bank, Marketable securities or readily realisable investments, Bills receivables, Book debts (excluding bad debts and provision), Inventories and Pre-paid expenses. Current liabilities mean those liabilities which are to be paid within a year.

It includes:

Sundry creditors, Bills payable, Short-term loans, Bank-overdraft, Cash credit, Outstanding expenses, Provision for taxation, Proposed dividend, Unclaimed dividend, etc.

Significance and Interpretation:

Current ratio measures short-term solvency or liquidity position of the firm. It indicates the availability of current assets to meet its current liabilities. A relatively high current ratio is considered as an indication that the company is in a position to pay its current liabilities out of current assets and its liquidity position is good.

But, at the same time, a higher current ratio would mean that the company may have an excessive investment in current assets that does not produce a significant return.

If the balance sheet is window-dressed i.e., current assets are made to appear stronger than what really is, then this ratio will not be an ideal indicator of liquidity. On the other hand, a low current ratio is considered as an indication of difficult liquid position.

It indicates that the company will face difficulty in meeting its maturing liabilities. An increase in the proportion of inventory and a decrease in the proportion of cash in the current assets makes the position less liquid. This ratio has a particular significance to short-term creditors. Higher the ratio, greater is the margin of safety to creditors.

As a convention, current ratio 2 : 1 is taken as standard which means that for every Re. 1 of current liabilities, current as9ets of the value of Rs. 2 are available for payment. The logic is that if the current assets are reduced to half i.e., Re. 1 instead of Rs. 2, then also the creditors will be able to get their payments in full.

But such a generalisation is not always true. The standard ratio will vary from industry to industry and season to season.

However, this ratio fails to indicate the liquidity of individual components of current assets. For example, if current assets of a firm include huge amount of old and doubtful debts and obsolete inventory, its debt paying capacity is deteriorated.

Hence, current ratio should not always be used as the sole index of short-term solvency. The size and nature of business and quality of current assets are also material consideration in determining liquidity. Therefore, current ratio should be considered in conjunction with liquid ratio to ascertain the true liquidity position of the business.

2. Liquid Ratio or Add-test Ratio or Quick Ratio:

Current ratio is a crude test of liquidity. For better analysis of liquidity the current ratio is modified. The modified version is called ‘Liquid ratio’ or ‘Quick ratio’. Thus current ratio is a liberal test of liquidity while quick ratio is a conservative test of liquidity.

Quick ratio or liquid ratio is the ratio between quick or liquid assets and quick or liquid liabilities. It shows the availability of funds for meeting the immediate liabilities. This ratio is obtained by dividing liquid assets by liquid liabilities. If the liquid assets amount to Rs. 1,00,000 and liquid liabilities Rs. 1,00,000, then— ,

Liquid assets mean those assets which are immediately convertible into cash without much loss. It includes cash, debtors-less bad debts, short-term bills receivable and temporary investments held in lieu of cash. Inventories and pre-paid expenses are excluded from liquid assets. Inventories are not included in quick assets as it takes long time for its conversion into cash.

Similarly, pre-paid expenses are excluded from quick assets since no cash will be realised from it. Liquid liabilities mean those liabilities which are payable within a short period of time. Normally, bank overdraft and cash credit facility are excluded from quick liabilities as they are used as permanent mode of financing by the firm. If bank overdraft is payable on demand, it is to be included in quick liabilities.

Significance and Interpretation:

This ratio is an important indicator of financial health of a firm. As per convention, normal quick ratio should be 1: 1. It implies that every rupee of quick liabilities should be backed by quick assets of equal value. If the ratio is less than this, it means that arrangement from outside sources of funds will have to be made for meeting some portion of the immediately maturing liabilities.

This is not a desirable situation and it should be avoided.

However, liquidity position of an organisation is largely effected by the composition of debtors figure. If huge amount of old and doubtful debts are included in the figure of debtors, then, obviously, the conclusions from the ratio will be invalid. The ratio used in combination with current ratio can be a very good test of liquidity.

If the current ratio is 2:1 and quick ratio is nearly 1:1, the liquidity position may be considered to be satisfactory. If the current ratio is higher than 2: 1 but quick ratio is less than 1: 1, it indicates excessive inventory. Like current ratio, quick ratio also should not be followed blindly. Its interpretation will depend upon size, nature of business and velocity of the turnover of stock etc.

3. Absolute Liquidity Ratio:

Absolute liquidity is represented by cash and near cash items. Hence, in computation of this ratio, only absolute liquid assets are compared with liquid liabilities. The absolute liquid assets are cash in hand, cash at Bank and marketable securities.

It is calculated as follows:

Significance and Interpretation:

This ratio measures the instant capacity of the firm to meet its quick liabilities. Debtors are excluded from the list of liquid assets in order to obtain absolute liquid assets since there are some doubts relating to their liquidity. However this ratio is not widely used in practice.

4. Working Capital Turnover Ratio:

This ratio indicates that whether or not working capital (i.e., excess of current assets over current liabilities) has been effectively used in making sales.

It is calculated as:

Significance and Interpretation:

This ratio makes it clear whether the business is being carried on with small or large amount of working capital in relation to sales. A low working capital turnover ratio may reflect an inadequacy of net working capital as a result of low turnovers of inventory or receivables. On the other hand, a high turnover ratio may be due to high turnover of inventory or receivables. This ratio takes a number of forms in the analysis.

Some of them are discussed below:

(a) Inventory Turnover Ratio:

It is also known as Stock Turnover Ratio. Normally, it establishes a relationship between cost of goods sold during a period and average inventory held in that period. This ratio indicates whether investment in inventory is within proper limit or not.

It is an index of liquidity of a firm showing the rate at which inventories are converted into sales and then into cash. This ratio helps the financial manager to evaluate the inventory policy. This ratio is obtained by dividing cost of goods sold by average inventory or by dividing net sales by average inventory.

Thus:

Inventory Turnover Ratio = Cost of goods sold / Average inventory

Cost of goods sold = Opening stock + Purchases – Closing stock

or Cost of goods sold = Sales – Gross profit.

Average Inventory = 1/2(Opening stock + Closing stock)

When number of days in a year (i.e., 365 days) are divided by the inventory turnover ratio, we get the average inventory holding period:

If the average inventory holding period is expressed in month, 365 days will be replaced by 12 months in the numerator. Sometime inventory turnover ratio is computed with reference to sales instead of cost of goods sold. However, the use of the first formula is more logical as, in that case, both the numerator and denominator are expressed at cost.

Significance and Interpretation:

Inventory turnover ratio indicates the efficiency of inventory management. It shows how fast inventory is used/sold. It is an effective tool to measure the liquidity of inventory and thereby to avoid any danger of over-stocking.

A high inventory turnover ratio indicates brisk sales which is good from liquidity point of view. A low ratio indicates that inventories are not used/sold and lying in the warehouse for a long time. It may reflect dull business, over-investment in inventory, accumulation of huge amount of slow-moving and obsolete stock, etc.

A high level of obsolete stock means blockage of capital. This will cause high interest and other inventory carrying cost. The ultimate impact is impairment of profitability.

It is also warned that a high inventory turnover ratio should also be carefully analysed. A high turnover ratio might be achieved by slashing the selling price which reduces profit. A too high inventory turnover may also be a result of low inventory level. There may be many out-of-stock situations. Thus high turnover ratio should also be investigated further.

So inventory turnover ratio should not be too high or too low. It should be kept in mind that stock turnover ratio is greatly influenced by nature of business. For example, stock turnover ratio in food and vegetables will be much higher than the engineering industry.

(b) Debtors Turnover Ratio:

When a firm sells goods on credit and the realisation of credit sales is delayed, the receivable or book debt is created. Cash is received from these receivables or debtors afterwards. The speed or velocity at which these receivables are being converted into cash affects the liquidity of the firm. This ratio indicates the efficiency of the credit and collection policies of the firm.

It is computed as:

When the number of days in a year (i.e., 365 days) are divided by the debtors turnover ratio we get the average collection period i.e., the period during which fund remains blocked in the hands of customer.

If the average collection period is to be expressed in month, 365 days will be replaced by 12 months in the numerator. Receivables consist of sundry debtors and bills receivable. Average receivable may be the average of opening receivables and closing receivables.

Significance and Interpretation:

The velocity or turnover of debtors gives an indication of the efficiency with which the debtors or receivables are being managed. The higher the ratio or, in other words, shorter the average collection period, better will be quality of debtors. It implies prompt payment by debtors.

Average collection period is the determinant of the age of the debtors. It depends upon credit policy and collection policy and sales volume. This ratio offers an indication of the degree to which the credit policy of the firm is being in-forced. A shorter average collection period indicates better liquidity position as the firm which realizes debts in time will be able to make prompt payment to suppliers, employees etc.

On the other hand, if the debtors turnover ratio is low, it will mean longer average collection period. Longer collection period implies a too liberal and inefficient credit collection performance. Apart from weakening the liquidity of the firm, if may result in bad debt—which will erode the profitability.

But a low collection period or a high debtors turnover ratio may not necessarily be favourable. It may be the result of a very conservative credit policy of the firm.

Conservative credit policy ensures good quality of debtors but it may affect sales volume and profit adversely In order to judge the efficiency of credit policy of the firm, debtors turnover ratio or average collection period should be compared with industry average.

(c) Creditors Turnover Ratio:

This ratio also measures the liquidity of the firm. It indicates whether the firm is making payment to the trade creditors in time or not. In other words, this ratio shows what period will be required to pay the suppliers in respect of credit purchases. This ratio is calculated by dividing the credit purchase with the figure of average accounts payable. Accounts payable include both sundry creditors and bills payable.

It is calculated as:

Average payment period is obtained by dividing the number of days in a year (365 days) by the creditors turnover ratio:

If the average payment period is expressed in month, 365 days will be replaced by 12 months in the numerator.

Significance and Interpretation:

The ratio indicates the number of days the firm usually takes on an average to pay its creditors. A higher creditors turnover ratio or lower creditors payment period signifies that the creditors are being paid promptly, thus enhancing the credit-worthiness of the firm. But the firm has to invest more in working capital.

A low creditors turnover ratio is apparently favourable as, in that case the firm enjoys a lengthy credit period. Therefore, the firm has to invest less in working capital. But it will diminish the credit-worthiness of the firm. So the creditors turnover ratio should be neither too high nor too low.

B. Solvency or Long-term Financial Position Ratios:

Solvency generally refers to the capacity or ability of the firm to meet its short-term and long-term obligations. The capacity to pay-off the current debts of a firm is represented by the liquidity ratios. Liquidity ratios—which indicate the short-term financial position of the firm— have been already explained. Now, under this heading, only the long-term solvency ratios are dealt with.

Generally, shareholders, debenture holders and other long-term creditors like banks, financial institutions etc. are interested in these ratios. These ratios are also used to analyse the capital structure i.e., the mix of funds provided by owners and outsiders.

Some selected ratios are discussed:

1. Debt-Equity Ratio:

This ratio shows the relationship between debt capital and equity or shareholders fund in the capital structure of the firm. It is determined to measure the firm’s obligations to creditors in relation to funds invested by the owners.

Generally it is calculated as:

There are some controversy whether current liabilities should be included in debt or not. Argument forwarded for inclusion of current liabilities is that they are part of a company’s total obligation and, like other sources of funds such as equity, long-term debts they are also not cost-free. Similarly, the modern approach is to include Redeemable Preference Shares in debt and Irredeemable Preference Shares in equity.

Significance and interpretation:

Debt-Equity ratio indicates the respective claim of creditors and owners in the assets of the firm. It shows the extent to which debt financing has been used in the business. A higher debt-equity ratio indicates higher proportion of debt content in the capital structure of the firm.

There is possibility of increasing the rate of return or EPS to equity shareholders so long as the cost of debt is lower than the rate of return on investment. But financing from debt increases the financial risk of shareholders.

Normally, cost of debt capital is much cheaper than the cost of equity since the interest on debt is tax-deductible. For this reason, under favourable conditions (i.e., when sales are rising), a high debt-equity ratio may be adopted to take advantage of cheaper debt capital. On the other hand, a low debt-equity ratio indicates lesser claims of creditors or outside suppliers of capital and a higher margin of safety for them.

Under unfavorable conditions (i.e., when sales are falling), it is desirable to use a low debt-equity ratio. A debt-equity ratio of 2:1 is the norm accepted by financial institutions for financing firms in the private sector, whereas, for public sector enterprises, a 1: 1 ratio is expected to be maintained.

2. Capital Gearing Ratio:

The capital gearing ratio is used to analyse the capital structure of a firm. The term capital gearing refers to the proportion between the fixed interest or dividend bearing funds and non- fixed interest or dividend bearing funds. The fixed interest bearing funds are raised through debentures and long-term loans.

Fixed dividend bearing funds are raised through issue of preference shares. The non-fixed interest or dividend bearing funds are provided by equity shareholders whose interest is represented by equity share capital and reserve and surplus. Thus, the proportion of debentures and preference share capital to net-worth or equity shareholders fund is referred to as gearing ratio.

It is calculated as:

Equity Shareholders Fund = Equity Share Capital + Reserve & Surplus – Fictitious Assets.

Significance and Interpretation:

If the fixed interest or dividend bearing funds are more than equity shareholders fund or net worth, the capital structure is said to be highly geared. In other words, the gearing is in inverse ratio to the equity capital i.e., low equity based firms are highly geared, high equity based firms are low geared.

The study of this ratio indicates whether the firm is trading on equity or not. If the firm is trading on equity or is a highly geared firm, the return in equity shareholders will be high. But the firm has a high degree of financial risk. It has to redeem the debt capital as per stipulated schedule.

It has to pay interest on debt at fixed rate even if there is no profit, and pay fixed rate of dividend on preference share capital only in the year in which the company earns profit. So, a too high gearing ratio is not preferable from the solvency point of view.

However, in favourable conditions (when sales are rising) when the rate of return on investment is higher than rate of interest on debt or rate of dividend on preference shares, a high gearing ratio will enhance the return to equity shareholders.

Again, in unfavorable conditions (i.e., when sales are falling) if rate of return on investment is very low, a high gearing ratio becomes disastrous to equity shareholders. So gearing ratio should be carefully planned so that equity shareholders’ interest is not impaired.

3. Proprietary Ratio:

This ratio establishes the relationship between total assets and shareholders’ fund. The purpose of the ratio is to indicate the percentage of owner’s fund invested in fixed assets.

It is calculated by dividing proprietary fund by total assets:

Proprietary Fund = Equity Share Capital + Pref. Share Capital + Reserve & Surplus – Fictitious Assets

Total assets do not include fictitious assets.

Significance and Interpretation:

This ratio is a test of long-term financial position of the firm. It indicates how much of the total assets have been procured with shareholders fund. Higher the ratio, lower is the dependence on external fund and hence, greater is the solvency of the firm.

4. Fixed Assets to Proprietors’ Fund:

This ratio establishes the relationship between fixed assets and shareholders fund.

It is calculated as:

Significance and Interpretation:

The ratio indicates the extent of proprietors fund invested in acquisition of fixed assets. If it is less than 1, it will mean that a part of proprietor’s fund is investment in financing working capital of the firm. For example, if the ratio is 0.75:1, it will mean that 75% of the proprietor’s fund is investment in fixed assets and 25% is invested in working capital.

If the ratio is more than 1, it will mean that creditors have been used to acquire a part of fixed assets. If short-term funds are used in the purchase of fixed assets, it will adversely affect the liquidity position, as it will not be possible to liquidate fixed assets for paying short- term liabilities.

Thus, a fundamental principle of sound financing policy is that all fixed assets should be financed out of long-term funds. Short-term funds should be utilised only for working capital requirement of the firm.

5. Interest Coverage Ratio:

This ratio relates to the fixed interest charges to the income earned by the company. It is an important test of solvency for the company. All long-term creditors are interested to know the company’s ability to meet its current interest charges. The ratio between fixed interest charges and earnings before interest and taxes (EBIT) is a rough indication of the company’s ability to pay fixed interest charges out of profit.

Thus:

Significance and Interpretation:

This ratio gives an idea of the number of times that fixed interest charges are covered by earnings. It is an index of the financial strength of an enterprise and indicates the margin of safety of the long-term creditors. If the ratio is 5 times, it will mean that the company is able to pay interest five times out of its earning. A high ratio assures the lender regular and periodical interest income.

However, a too high interest coverage ratio may be the result of using a very small amount of debt in the capital structure. In this case, the firm cannot avail the full benefit of trading on equity. Again, a too low interest coverage ratio may be the result of using excessive amount of debt capital than warranted by the profitability of the firm.

So, an immediate action may be taken to redeem a portion of debt to improve profitability.

C. Analysis of Profitability:

Profitability indicates the efficiency or effectiveness with which the operations of the business is carried on. Poor operational performance may result in poor sales and, therefore, low profit. Low profitability may be due to lack of control over expenses. Profitability is the main base for liquidity as well as solvency.

Creditors, banks and financial institutions are interested in profitability ratios as they indicate liquidity or the capacity of the business to meet interest obligations. A company with sufficient profits will enhance the long-term solvency position of the business. Equity shareholders are interested in profitability ratios since they indicate the growth as well as rate of return on their investment.

The major types of profitability ratios are:

1. Gross Profit Ratio:

This is the ratio of gross profit to net sales and is expressed in percentage.

Thus:

Significance and Interpretation:

The ratio throws light on the degree of managerial efficiency in production and sales. It indicates the ability of the firm to widen the gap between sales and cost of sales. This ratio may be high due to higher selling prices in relation to costs or lower costs in relation to selling price or increased sales volume of the higher profit margin items. A low gross profit ratio should be carefully investigated.

The gross profit ratio may be low due to:

(i) Failure to control cost and to take the benefits of large scale economies,

(ii) Excessive investment in plant and machinery, and

(iii) Cut-throat competition.

2. Net Profit Ratio:

This is the ratio of net profit after taxes to net sales. Net profit, as used here, is the balance of profit and loss account which is arrived at after considering all non-operating incomes such as interest on investment, dividend received etc. and operating expenses such as office and administrative expenses, selling and distribution expenses and non-operating expenses like loss on sale of fixed assets, provision for contingent liability, etc.

Thus:

Significance and Interpretation:

This ratio is used to measure the overall profitability and is useful to owners. This ratio indicates how much of sales is left after meeting all expense. For examples, if the ratio is 10%, it will mean that 10 paise per rupee of sale belongs to the owners as their reward for taking risk in investment. So, higher this ratio, more is the return to shareholders.

3. Operating Ratio:

This is the ratio of cost of goods sold plus operating expenses to net sales of the firm.

This is closely related to the ratio of operating profit to net sales:

Operating cost consists of cost of goods sold, office and administrative expenses and selling and distribution expenses. Financial charges such as interest, provision for taxation and loss on sale of investments etc. are excluded from operating expenses.

Significance and Interpretation:

This ratio indicates the operational efficiency with which the business is being carried on. It reveals the percentage of net sales that is absorbed by cost of goods sold and operating expenses. Hence, the lower the operating cost, the higher will be operating profit. On the other hand, a higher operating ratio leaves a lesser margin for meeting non-operating expenses, creation of reserves and payment of interest and dividend.

4. Operating Profit Ratio:

This is the ratio of operating profit and net sales and is expressed in percentage.

Operating Profit = Net Profit + Non-operating Expenses – Non-operating Income = Sales – (Cost of goods sold t Office & Adm. Expenses + Selling & Dist. Expenses)

Significance and Interpretation:

This ratio can also be computed by subtracting the operating ratio from 100. For example, if the operating ratio is 85% then the operating profit ratio would be 15% (i.e., 100 – 85). The implication of operating ratio and operating profit ratio is the same. This ratio indicates the extent of sales revenue available for interest, tax and dividend payments etc.

5. Return on Capital Employed (ROCE):

The main objective of making investment in any business is to earn adequate return on capital invested. Hence, the return on capital employed is used as a measure of success of a business in achieving this objective. Otherwise known as return on investment, this is the barrometer of overall performance of the firm.

It is calculated as:

Capital employed may be either gross capital employed or net capital employed:

Gross Capital Employed = Total Assets – Fictitious Assets

= Fixed Assets + Current Assets

Net Capital Employed = Total Assets – Current Liabilities

= Fixed Assets + Current Assets – Current Liabilities

Alternatively, = Fixed Assets + Working Capital

Net Capital Employed = Share Capital + Reserve & Surplus – Fictitious Assets

+ Long-term Loans + Short-term Loans

Significance and Interpretation:

Return on capital employed is considered to be the best measure of profitability in order to assess the overall performance of the business. A comparison of the ratio with similar firms, with the industry average and over time would provide sufficient insight into how efficiently the long-term funds of owners and creditors are being used. The higher the ratio, the more efficient use of the capital employed.

So, determining a minimum rate of return on investment is very essential part of management planning and control. The investments which generate rates lower than the minimum rate of return are rejected.

However, it is very difficult to set a standard rate of return on capital employed as number of factors such as nature of business, risk involved, inflation, changes in economic conditions etc. may influence such a rate.

6. Return on Equity Capital:

This ratio relates to the net profits finally available to equity shareholders to the amount of capital invested by them. It is obtained by dividing the profits available to equity shareholders by the equity shareholders fund.

Significance and Interpretation:

The ratio indicates how efficiently the equity shareholders fund is being managed in the firm. Return on equity share capital or EPS helps to determine the market price of equity of the company. Therefore, this ratio is of special interest to the existing as well as prospective equity shareholders.

D. Activity Ratios or Turnover Ratios:

These ratios are used to evaluate the efficiency with which the firm uses its assets. They indicate the frequency of sales with respect to its assets. These are computed with reference to sales or cost of goods sold and expressed in terms of times or rates.

Some activity ratios are:

1. Capital Turnover Ratio:

It is the ratio of sales to capital employed. Thus, Capital Turnover Ratio = 

Significance and Interpretation:

It indicates the firm’s ability to generate sales per rupee of long-term investment. The greater the ratio, the more efficient is the utilisation of long-term creditors and owners fund.

2. Fixed Assets Turnover Ratio:

This is the ratio of net sales to net fixed assets. Thus,

Significance and Interpretation:

It is a measure of efficiency of utilisation of fixed assets. The ratio is calculated in determining to what extent the investment in fixed assets has been achieving its objective of generating sales. The higher the ratio, the more efficient is the utilisation of fixed assets in generating sales.