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1.

INTRODUCTION
A ratio shows the relationship between two numbers. Accounting
ratio shows the relationship between two accounting figures. Ratio analysis is the
process of computing and presenting the relationship between the items in the
financial analysis, because it helps to study the financial performance and position
of a concern.
As aratio are simple to calculate and easy to understand there is a tendency
to employ them profusely. While such statistical calculationstimulate be thinking
and develop understanding there is a danger of accumulation of a mass of data
that obscures rather than clarifies to steer a careful course. His experience and
objectives of analysis help him in determine which of the ratios are more
meaningful in a given situation.

The Parties Interested:- the person interested in the analysis of financial can be
grouped under three heads.
Owners Or Investor
Creditors And
Financial Executives.
Although all these three groups are interested in the financial conditions and
operating results of an enterprises the primary information that each seeks to
obtain forms these statement is to serve. Investors desire a primary basis for
estimating earning capacity. Creditors (trade and financial) are concerned
primarily with liquidity and ability to pay interest and redeem loan within a
specific period. Management is interested in evolving analysis tools that will
measure costs,efficiency, liquidity and profitability with a view to making
intelligent decisions.

2. FORMS
There are three different forms in which an accounting ratio can be expressed.
1) Pure Ratio 2) Percentage and 3) Rate

1) PURE RATIO:-A pureratio a simple division of one number by another.


The relationship between current assets & current liabilities is expressed
in this way. If the current assets are Rs.2,00,000 and current liabilities
Rs.1,00,000, the ratio is divided by dividing Rs.2,00,000 by Rs.1,00,000. It
will be expressed as 2:1.

2) PERCENTAGE:-certain accounting ratios become more meaningful if


expressed as a percentage. The relationship between profits and sales is
expressed in this way. For example, if sales are Rs.4,00,000 and gross
profits is 50% of sales.

3) RATE:- sometimes ratios are expressed as rates i.e. number of times


over a certain period. Relationship between stock and sales is expressed
in this way. If stock turnover rate is said to be 8 times in a year. It
means that the stock is converted into sales 8 times in 12 months.

3. CLASSIFICATION
3.1. BASED ON FINANCIAL STATEMENT
Accounting ratios express the relationship figures taken from financial
statements. Figures may be taken from Balance sheet, Profit & Loss Account or
both. One way of classification of ratios is based upon the source from which
figures are taken. This is known as the conventional classification.
1) BALANCE SHEET RATIOS: -If ratios are based on figures of Balance sheet,
they are called Balance sheet ratio e.g. ratio of current assets to current
liabilities or ratio of Debt to Equity. While calculating these ratios, there is
no need to refer to the Revenue statement. These ratios judge the liquidity.
Solvency and capital structure of the concern. We are going to study the
following six balance sheet ratios in this chapter. Ratio, capital Gearing
Ratio, Debt-Equity Ratio and stock working Capital Ratio.
2) REVENUE STATEMENT RATIOS:- Ratios based on the figures from the
Revenue statement are called revenue statement ratios. These ratios study
the relationship between the profitability and the sales of the concern. We
are going to Gross Profit Ratio and Net Operating Profit Ratio and stock
Turnover Ratio.
3) COMPOSITE RATIOS:- These ratios indicate the relationship between two
items, of which one is found in the balance sheet and the other in the
revenue statement. There are two types of composite ratios.
a) Same composite ratios study the relationship between the profits and
the investments of the concern. E.g. Return On Capital Employed on
Proprietors Funds, Return of Equity Capital etc.
b) other composite ratios that we going to study are debtors Turnover,
Creditors Turnover, Dividend payout and debt service.

3.2. BASED ON FUNCTION

Accounting ratio can also be classified according to their functions (i.e. their
purpose) into Liquidity ratios, Leverage ratios, Activity ratios, Profitability ratios
and Coverage ratios.
1. Liquidity ratios show the relationship between the current assets and
current liabilities of the concern.
Examples are Liquidity ratio and current ratio.
2. Leverage ratios show the relationship between proprietors funds and
debts used in financing the assets of the concern. Examples are capital
Gearing ratio, Debt-Equity ratio and Proprietor ratios. These are also known
as Capital structure ratios or Solvency ratios.
3. Activity ratios (also known as turnover ratios or productivity ratios) show
the relationship between the sales and the assets. Examples are stock
turnover ratio; Debtors turnover ratio etc.
4. Profitability ratios show the relationship between.
a) Profits and sales; for example, Operating ratio, Gross profit ratio,
Operating net profit ratio, Expenses ratio etc. OR
b) profits and investors; for example, Return on Investments Return on
equity Capital etc.
5. Coverage ratios show the relationship between the profits on one hand the
claims of outsiders (divided, interest etc.) to be paid out of such profits.
Examples are Dividend payout ratio, Debt service and Debt service
coverage ratio.

3.3. BASED ON USER


1. Ratios for Short Term Creditors: - Current Ratio, Liquidity Ratio and Stock
Working Capital.
2. Ratios for Share Holder: - Return on Proprietors Funds, Return on Equity
Capital.
3. Ratios for Management: - Return on capital Employed, Turnover Ratio,
Operating Ratio, Expense Ratios.
4. Ratios for Long Term Creditors: - debt Equity Ratio, Return on Capital
Employed, Proprietor Ratio.

4. BALANCE SHEET RATIOS


COMPUTATION OF BALANCE SHEET RATIOS AT A GLANCE BALANCE SHEET

I
1
2
3
4
5
6
7

II
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16

ITEM
SOURCE OF FUND
Equity Share Capital
Reserve & Surplus
Equity Shareholder Funds (1+2)
Preference Share Capital
Proprietors Funds (3+4)
Borrowed Funds
Capital Employed
(5+6)

ITEM
USE OF FUND
Fixed Assets
Debtors
Bills Receivable
Other Quick Assets
Total Quick Assets
(2+3+4)
Closing Stock
Pre-payments
Current Assets
(5+6+7)
Creditors
Bills Payable
Other Quick Liabilities
Total Quick Liabilities
(9+10+11)
Bank Overdraft
Current Liabilities (12+13)
Working Capital
(8-14)
Capital Employed
(1+15)

AMOUNT
FC
RS
EF
PC
PE
BF
CE

AMOUNT
FA
DR
BR
OQA
QA
CST
PP
CA
CD
BP
OQL
QL
OD
CL
WC
CE

Balance Sheet Ratio

Equity/ Formula

Para
4.1

Current Ratio

CR=CA/CL

4.2
2

Quick/ Liquid Ratio

Stock Working Capital

Proprietors Ratio

QR=QA/QL

SWC=
PR=PF/TA*100
[ TA= Total Assets=FA+CA=CE+CL
=Total of Horizontal B/s-factious
Assets]

4.3

4.4

4.5
5

Debt-Equity Ratio

DER=BF/PF

4.6
6

Capital Gearing Ratio

CGR=PC+BF/EF

4.1. CURRENT RATIO


4.1.1. Meaning: - This ratio compares the current assets with current Liabilities. It
is expressed in the form of a pure Ratio e.g. 2:1.
4.1.2. Formula
Current Ratio= Current Assets =CA/CL
4.1.3. Components
Current Assets [CA] will include:
1) Sundry Debtors (Less Provision]
2) Loose Tools
3) Income Accrued/ due
4) Bills Receivable
5) Cash and Bank Balances
6) Marketable Investors
7) Closing Stock of Raw Material, WIP, FGs, Stores and spares.
8) Pre-Payments (i.e. Pre-paid Expenses and Advance Tax)
9) Short Term Loans and Advances given current Liabilities [CL] will include
a) sundry Creditors
b) Bills Payable
c) Outstanding Expense
d) Unclaimed Dividends and Prosed Dividend
e) Income Received in Advance
f) Bank Overdraft
g) Short Terms Loans

4.2. QUICK / LIQUID RATIO


4.2.1. Meaning: - Liquid ratio compares quick assets with the quick Liabilities. It is
expressed in the form of a pure ratio. It is also known as Quick ratio or Acid test
ratio.
4.2.2. FORMULA
Liquid Ratio = Quick Assets/Quick Liabilities = QA/QL
4.2.3. Components
Quick Assets [QA] = current Assets Less Closing Stock Less Pre-payments i.e.
1. Debtors
2. Loose Tools
3. Income accrued/ due
4. Bills Receivable
5. Cash & Bank Balances
6. Marketable Investments
Quick Liabilities [QL] = Current Liabilities Less Bank Overdraft/ Cash Credit
i.e.
1) Sundry Creditors
2) Bills Payable
3) Outstanding expenses
4) Unclaimed dividend & proposed dividend
5) Provision for Taxation

4.3. STOCK TO WORKING CAPITAL RATIO


4.3.1. Meaning: - This ratio shows the relationship between the Closing Stock and
the working capital. It helps to judge the quantum of inventories in relation to the
working capital of the business. It is expressed as a percentage. It is also known as
Inventory Working Capital Ratio.
4.3.2. FORMULA
Stock to Working Capital Ratio= stock/ working capital*100= CST/WC*100
4.3.3. Components
Stock [CST] would mean closing stock.
Working Capital [WC] = Current Assets Less = Current Liabilities (as in Para
4.1.3)

4.4. PROPRIETORY RATIO


4.4.1. Meaning: - Proprietary ratio compares proprietors funds with total
liabilities (or total assets) it is usually expressed in the form of percentage. It is
also known as Net Worth to Total Assets Ratio. Equity Ratio, Net Worth Ratio or
Assets Backing Ratio.
4.4.2. FORMULA
Proprietary Ratio = Proprietors Funds OR Shareholder Equity/ Total Asset
OR Total Liabilities
=PF/TA or TL*100

4.4.3. Components
Proprietors Funds [PF] will include
1. Paid up Equity Capital (EC)
2. Reserve & Surplus (R&S) including, Capital Reserves, P&L A/c cr.
Less:- Accumulated Losses (i.e. P&L A/c Dr. balance)
Less: - fictitious Assets Like Miscellaneous Expenditure not Written Off.
3. Paid Up Preference Capital (PC)
Thus, PF=EC +RS+PC or EF+PC
Total Assets [TA] (Fixed Assets +Investments + current Assets)
= Total Liabilities [TL] (Own Funds + Loans+ Current Liabilities)
= Total of the (Horizontal) Balance Sheet excluding Fictitious Assets &
Accumulated Losses (if any = Capital Employed +current Liabilities)

4.5. DEBT EQUITY RATIO


Meaning: - this ratio compares the long - term debt with shareholders funds. It is
usually expressed as a pure ratio.
FORMULA
This ratio is calculated in two ways
1. Debt/Equity= Borrowed Funds/Proprietors funds =BF/PF OR
BF/BE+PF
Both ways are acceptable.

COMPONENTS
Borrowed Funds [BF] includes
1. Debenture, Loan, etc.
2. Interest accrued and due on such BF

Proprietors Funds [PF] includes


1. Equity Shares Capital (EC)
2. Reserve & Surplus (RS)
Less: - a) Profit & Loss A/c Dr. balance (Loss)
b) Miscellaneous Expenditure Not written of if any.
3. Preference Share Capital

4.6. CAPITAL GEARING RATIO


Meaning: - Gearing means the process of increasing the equity shareholders
return through the use of debt. Equity shareholders earn more when the rate of
return on total capital is more than the rate of interest on debt. This is also known
as Leverage or trading an equity. The capital Gearing Ratio shows the
relationship between two types of capital viz. i. Equity Capital including reserve
and ii. Preference Capital and Long term borrowings. It is usually expressed as a
pure ratio. This is also known as Capital Structure Ratio.

FORMULA
Capital Gearing Ratio =
1. = Capital Entitled to Fixed Rate of Interest OR Dividend/
Capital not So Entitled to Fixed Rate of Interest OR Dividend
2. Preference Capital + Debentures/Equity Capital + Share Premium A/c+ CR
Components
Capital entitled to fixed interest or dividend
1. Preference Capital (PC)
2. Debenture, Long term Loans, i.e. Borrowed funds (BF)
Capital not entitled to fixed interest or dividend (= Equity Funds)
1. Equity Capital (EC)
2. Reserve & Surplus (RS)
Less: - Profit & Loss A/c Dr. balance.
Less: - Fictitious Assets
thus, CGR= PC+BF/EF

5.REVENUE STATEMENT RATIOs


COMPUTATION OF PROFIT & LOSS RATIOs AT A GLANCE
INCOME STATEMENT
ITEM
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
21.
22.
23.
24.
25.
26.

Credit Sales
cash Sales
Total Sales (1+2)
Opening Stock
Credit Purchase
Cash Purchase
Total Purchase (5+6)
Direct Expenses
Less:- Closing Stock
Cost of Goods Sold
(4+7+8-9)
Gross Profit
(3-10)
Administration Expenses
Selling expenses
Finance Expenses (Excl. Interest)
Operating Expenses
(12+13+14)
Operating Profit(11-15)
Net Non- Operating Income/ Expenses
Profit before Interest & Tax (16+17)
Interest On Loans
Net Profit Before Tax(18-19)
Income Tax
Net Profit After Tax (20-21)
Preference Dividend
Profit Available for Equity Shareholders(22-23)
Equity Dividends
Retained Earning(24-25)

AMOUNT
CRS
CAS
S
OST
CRP
CAP
P
DE
(CST)
COGS
GP
AE
SE
FE
OE
OP
NO
PBIT
INT
NPAT
IT
NPAT
PD
PAES
ED
RET

Profit & Loss Ratio

Equation / Formula

Para

1.

Gross Profit Ratio

GPR=GP/S*100

5.1

2.

Opening Ratio

OR=COGS+DE/S*100

5.2

3.

Expenses Ratio

ER=AE or SE or FE/S*100

5.3

4.

Operating Profit Ratio

OPR=OP/S*100

5.4

5.

Net Profit Ratio

NPR= NPBT/S*100

5.5

Stock Turnover ratio

STR = COGS/OST + CST/2


OR
COGS/ Avg. Stock

5.6

Average Stock

AS = Opening Stock + Closing Stock/2

6.

5.1 GROSS PROFIT RATIO


5.1.1. Meaning: - this ratio compares gross profit with net sales. It is usually
expressed in the form of percentage.
5.1.2. Formula
Gross profit = Gross Profit/Net Sales * 100 = GP/S * 100
5.1.3. Components
Gross profit [GP] = Sales Less Cost of goods Sold
Cost of goods sold [COGS] [In case of a Trading Concern]
1.
2.
3.
4.

Opening stock
Add: - Purchase
Add: - Direct Expenses
Less; - Closing Stock
= COGS

[In case of a Manufacturing Concern]


1. Opening stock of finished goods
2. Add: - Cost of goods produced
[Direct/ Price Cost (Materials + Labor + Expenses)]
3. Less: - Closing stock of finished goods
=COGS
Net Sales [S]
= Sales Less return Less Allowances.

5.2 OPERATING RATIO


5.2.1 Meaning: -Operating ratio expenses the relationship between total
operating costs and net sales. It is expensed by way of a percentage.

5.2.2 Formula
Operating Ratio: - Cost of Goods Sold + Operating Expenses/Net Sales*100
= COGS + OE/S * 100
5.2.3 Components: - Cost of Goods Sold [COGS] [as per Para 5.1.3]
operating Expenses [OE] =
1. Office and Administration Expenses
2. Selling and Distribution Expenses
3. Finance Expenses Excluding Interest on Loans and Debenture Net Sales
[S] [as per Para 5.1.3]

5.3 EXPENSES RATIO


5.3.1 Meaning: - this ratio expenses the relationship between each item of
expenditure and net sales. It is expressed as a percentage. Total of all
Expenses ratios will be each in Operating Ratio.
5.3.2 FORMULA
Any Expenses Ratio = Expenditure/Net Sales*100
e.g. Administrative Expenses Ratio= Administration Expenses/Net sales*100
Selling Expenses Ratio = Selling Expenses/Net Sales * 100
Finance Expenses Ratio = Finance Expenses/Net Sales*100
(Excluding Interest on Loans & Debentures)

5.4 OPERATING PROFIT RATIO


5.4.1 Meaning: - Operating profit ratio indicates the relationship between
operating profit and the sales. It is usually expressed in the form of a
percentage. It is also known as Net Operating Profit Ratio.
5.4.2 FORMULA
Operating Profit = Operating Profit/Net Sales * 100 = OP/S * 100

5.4.3 Components
Operating profit [OP]
1. Gross Profit
2. Less: - Operating expenses [OE] (as per Para 5.2.3)
(Net per Para 5.2.3)
Net Sales [S] =
Sales Less Returns Less Allowances.

5.5 NET PROFIT RATIO


5.5.1 Meaning: - Net ratio indicates the relationship between net profit and the
sales. It is usually expensed in the form of a percentage.
5.5.2 FORMULA
Net Profit = Net Profit ( before Tax)/Net Sales * 100 = NEPBT/S * 100
5.5.3 Components: Net Profit before tax [NPBT] =
1. Operating net profit [as per Para 5.4.3]
2. Add: - Non Operating income
3. Less: - Non Operating Expenses = NPBT
Net Sales [S] = Sales Less Returns Less Allowances.

5.6 STOCK TURNOVER RATIO


5.6.1 Meaning: - Stock turnover ratio shows the relationship between the cost of
Goods Sold and the average stock. This ratio is normally expressed as a
rate.
5.6.2 FORMULA
A. Stock turnover Ratio = Cost of Goods Sold/Average Stock = COGS/AS =
COGS/ OST + CST/2

If Stock is valued at sales price, formula will be


= Net Sales/Average Stock (at Selling Price)/2
Note: -In the absence of information, Closing Stock can be used instead of
average stock in the above formula.
B. Stock Velocity Stock [Stock Holding Period]
Stock velocity means the period (months or days) taken for converting
average stock into sales. It shows the Stock Holding Period.
12/Stock Turnover Ratio = Number Of months production on band or
Number of months it takes for converting stock into sales
365/Stock Turnover Ratio = Number of days production on band or
Number of days it takes for converting stock into sales
5.6.3 Components
Cost of Goods Sold [ COGS] = Sales Tess Gross Profit
Average Stock [AS] = Opening Stock + Closing Stock/2

6. COMPOSITE RATIO
COMOSEITE RATIOS AT A GLANCE
Composite Ratios

Formula / equation

Para

1.

Return on Investment/ Capital


Employed

ROI = PBIT/CE * 100

6.1

2.

Return on proprietors Fund

RPF = NPAI / PF * 100

6.2

3.

Return on Equity Capital

ROE = PAES / EF * 100

6.3

4.

Dividend Payout

DP = ED / PAES * 100

6.4

5.

Debt Service Ratio

DSR = PBIT/INT

6.5

6.

Debt Service Coverage Ratio

DSCR = Cash Profit/ Interest +


Investments

6.6

7.

Debtors Turnover Ratio

DTR = CRS / DR + BR

6.7

8.

Credit Turnover Ratio

CTR = CRP/ CD + BP

6.8

6.1 RETURN ON CAPITAL EMPLOYED


6.1.1 Meaning: - This ratio measures the Relationship Between net profit (before
interest and tax) and the capital employed to earn it. It is expressed as a
percentage. This ratio is also known as Return on Investment [ROI].
6.1.2. FORMULA
Return on Capital Employed: - Profit (before Interest & Tax * 100 / CE
6.1.3. Components
Profit (before Interest, Tax [PBIT =
1. Profit before interest on long term borrowing, tax & dividends.
2. Less abnormal, non recurring items

1.
2.
3.
4.
5.

1.
2.
3.
4.

Capital Employed [CE]


Equity Capital
Add: - Preference Capital + Reserve & Surplus
Add: - Long term Borrowings ( Terms Loans + Debentures)
Less: - fictitious assets like Miscellaneous Expenses not written Off
Less: -Profit & Loss A/c Dr. Balance (Loss)
note: -Capital employed may be taken to mean Assets Employed, in which
case.
Capital Employed [CE] can also be computed as
Fixed Assets (Less depreciation) (including investments)
Add: -Current Assets
Less: - Current Liabilities
Exclude Fictitious Assets.

6.2 RETURN ON PROPRITORS FUNDS


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

6.2.2. FORMULA
Return Proprietors Funds: -Net Profit (after Tax)/ Proprietors Funds *100
NPAT/PF * 100
6.23. Components
Net Profit [NPAT] = Profit after interest and tax proprietors funds [PF] =
1. Equity Capital [EC]
2. Add: - Reserve & Surplus [RS]
Less: - Fictitious Assets like Miscellaneous Expenses not written off
Less: - Profit & Loss A/c Dr. Balance (loss)
3. Add: -Preference Capital [PC]