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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

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.

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.

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.

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.

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.

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

Equity/ Formula

Para

4.1

Current Ratio

CR=CA/CL

4.2

2

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

CGR=PC+BF/EF

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

4.2.1. 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

4.3.1. 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)

4.4.1. 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)

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

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

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

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

Equation / Formula

Para

1.

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.

OPR=OP/S*100

5.4

5.

NPR= NPBT/S*100

5.5

OR

COGS/ Avg. Stock

5.6

Average Stock

6.

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

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.

5.2.1 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]

5.3.1 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)

5.4.1 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.

5.5.1 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.

5.6.1 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

= 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.

Employed

6.1

2.

6.2

3.

6.3

4.

Dividend Payout

DP = ED / PAES * 100

6.4

5.

DSR = PBIT/INT

6.5

6.

Investments

6.6

7.

DTR = CRS / DR + BR

6.7

8.

CTR = CRP/ CD + BP

6.8

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.

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.

6.2.1 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]

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