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RATIO: ratio is a simple mathematic expression of relationship between two or related items in quantitative form. It may be a number expressed in a term of another number. The relationship between two or more figures may be expressed as: (a) Quotient (b) rate (c) a percentage i.e. say 2:1, 2 times, 75%
Importance of profitability ratio
For the accountant and business manager, profit is synonymous with owner’s earnings and is found by subtracting costs, including interest charges from the total revenue accruing to a firm during a particular period of its operations. Profit is any volume and profitability is a ratio. Being a ratio, profitability is a meaningful measure and can be used as an effective standard of performance regardless of a firm’s size. Profitability ratios are followings: Gross profit ratio: this ratio tells the management what sales can generate earnings before any costs of business (except cost of goods) are met. (1) It shows the percentage by which the selling price can fall and the percentage by which the cost of goods sold can increase before gross profit can be nullified. (2) A low gross profit may reflect unfavorable purchasing and mark-up policies. (3) A low gross profit may indicate the inability of the management to develop ratio.
Gross profit ratio = gross profit Net sales * 100
Net profit ratio: this ratio establishes relationship between the net profit and sales and is generally expressed as a percentage. Net profit ratio = net profit Net sales * 100
Importance (1)It indicates operational efficiency and inefficiency of an enterprise. (2)High net profit ratio tells us index of better operational efficiency. Net operating profit ratio: This ratio establishes relationship between operating profit and sales. It is expressed as; Net operating profit = operating profit Net sales *100
Importance (1) It measures operational efficiency of a business enterprise. Expenses ratio: these ratio are calculated to establish relationship between the various expenses incurred by a business enterprise and its sales. These ratios supplement the information provided by operating ratio. Expenses ratio = expenses ratio Net sales * 100
Importance (1) Theses ratio indicates the economy and efficiency with which the various expenses are incurred to attain the goal of maximizing profit and minimizing profit and minimizing cost.
Return on investment: This ratio is also known as net worth ratio or return on total assets. ROI establishes relationship between NET PROFIT (after tax and shareholders funds). It is expressed as Return on investment or ROI = net profit Total assets * 100
Importance (1) It helps to measure the profit which a firm earns on in vesting a unit of capital. (2) The ROI when calculated in this manner would also slow whether the company’s borrowings policy was wise economically and whether. RETURN ON EQUITY SHARE HOLDERS FUND: equity shareholders are real owners of a company. They bear more risk. They are entitled to get their share of dividend only after the payment of fixed dividend to the preference shareholders. Return on share holder fund/net worth/proprietors fund = net profit Shareholder fund * 100 Importance: (1) It helps in measuring over all profitability or operational efficiency of a company. (2) It enables the management to know whether the basic objective of the business – maximization of profit is achieved or not and the shareholder to decide whether their investment is safe and remunerative or otherwise. (3) The growth or otherwise of a company can also be measured by means of a trend ratios calculated for several number of years. RETURN ON CAPITAL EMPLOYED: The return on capital employed ratio is
the ratio calculated to establish relationship between profits actual earned and the capital actually employed in the business. Return on capital employed = net profit Cap. Employed * 100 [Net profit after tax before interest] [Capital employed =total assets] Importance (1)It is the only measure which indicates the overall profitability and efficiency of the business concern. (2)It facilitates inter-firm and intra-firm comparison. (3)It enables the management to know whether the investment made is utilized productively or not. (4)It enables the management to take sound financial decisions. (5)It is an integral part of budgeting and budgetary control system. (6)It helps to the management to formulate policies. EARNING PER SHARE: It tells about the earnings of per share. Means how much we are getting of the per shares performance. EPS = retained earning No. of equity shares Importance: (1) It helps in determining the market price of the equity shares of the company. (2) A comparison of earning per share of the company with another will also help in the deciding whether the equity share capital in being effectively used or not.
Dividend pay out ratio: it is calculated to determine the relationship between dividend per equity share and earning per share. In other words, it is calculated to know the amount earnings retained in the business which reduces the cost of capital and increases the rate of dividend payable to equity shareholders.
Dividend pay out ratio= dividend per equity share EPS
Importance: (1)The pay-out ratio and the retained earnings ratio are indicators of the amount of earnings that have been ploughed back in the business. (2)The lower the pay-out ratio, the higher will be the amount of earnings ploughed back in the business and vice-versa. DIVIDEND YIELD RATIO: it is calculated to compare dividend per share and its effect on market value per share. It is expressed asDividend yield ratio = dividend per equity share EPS * 100
PRICE EARNING RATIO: this ratio is very helpful to the investing public to decide whether to make or not to make an investment in the shares of a company. It is calculated to establish relationship between market price per share and earnings per share. It is expressed as(13) Price earning ratio = market price per equity share EPS * 100 Importance: (1) It helps to know high P E R appreciation in the value of share.
Importance of solvency ratio Those ratios which are calculated to determine the firms ability to meet its long
term obligations. The long term obligation includes the claims of debentures holders and other financial institutions which have offered long term loans to the fir. Followings are the solvency ratios: Debt equity ratio: it is calculated to know the extent of outside funds and shareholders funds used in acquiring the assets for a firm. In other words it is calculated to measure the relative claims of outsiders and share holders against the assets of a firm. Debt equity ratio = long term debt Shareholder fund * 100 Importance (1)The ratio indicates the proportion of owner’s stake in the business. Excessive liabilities tend to cause insolvency. (2)The ratio indicates the extent to which the firm depends upon outsiders for its existence. (3)The ratio provides a margin of safety to the creditors. Proprietary ratio: it is the ratio of shareholders funds to total assets. It is also called as net worth to total assets ratio or equity ratio. It serves as a measure of long term solvency of long term solvency. it is expressed as: Proprietary ratio = share holder fund Total ASSETS Importance: (1)This ratio focuses the attention on the general financial strength of the business enterprise. (2)The ratio is of particular importance to the creditors who can find out the proportion of shareholders fund in the total assets employed in the business. (3)A high proprietary ratio will indicate a relatively little danger to the creditors, etc, in the event of forced reorganization or winding up of the company.
Fixed assets ratio: this ratio establishes relationship between fixed assets and proprietors fund. This ratio indicates the extent to which the fixed assets are financed by owners’ funds. It is expressed: Fixed assets ratio = fixed assets Long term fund * 100 [LTF=shareholder fund, LT debt]
Current assets ratio: it is calculated to know the relationship between the current assets and current liability. It is expressed as: Current ratio = current assets Current liability * 100 Importance: (1)The current ratio is an index of the concerns financial stability since it shows the extent of the working capital which is the amount by which the current assets exceed the current liabilities.
Liquid ratio: it is calculated to know the relationship between the liquid assets and the current liabilities or quick liability. Liquid, quick, acid ratio = liquid assets Liquid liability * 100 [CA exclude stock and pre.exp.] [CL exclude bank o/d]
Importance: (1) It helps to know adequate working capital to run its day to day operations.
CAPITAL GEARING RATIO: this ratio indicates the relationship between equity shareholders funds and fixed interest bearing debentures/loans and
preference share capital. If the fixed interest bearing debenture and preference share capital exceeds equity shareholders funds, it is called highly geared capital and if equity shareholders funds exceed the interest bearing debentures and preference share capital, it is called low geared capital. And if both are equal it will be called evenly geared capital. It is expressed as: Capital gearing ratio = fixed interest bearing securities Equity share capital * 100 [FIBS=debenture, loans, preference share capital Importance: (1) It is useful in indicating the extra residual benefits accruing to the equity shareholders. (2) Such a benefit accrues to the equity shareholders because the company earns a certain rate of return on total capital.
INTEREST COVERAGE RATIO: this ratio indicates whether the earning of a firm is sufficient to pay interest charges periodically or not. In other words, it is calculated to know whether the creditors are secured or unsecured in respect of their periodical interest income. It is also known as debt service ratio or fixed charge cover. It is expressed as: Interest coverage/fixed charges cover ratio= net profit Interest payable [Net profit= after tax before interest]
Importance of turnover ratio The efficiency or activity ratios are those ratios calculated to know or measure the operational efficiency of a business concern. The operational efficiency a
firm is judged based on its profit earning capacity and the optimum utilization of its available resources in accordance with financial policies relating to its operation. These are also known as turn over ratios.
Stock turnover ratio: This ratio indicates the velocity of the movement of goods during the year. Movement or otherwise of good decides the success or failure of a business concern because it has direct influences on profits of business. Every business should maintain enough stock to cope up with sales. It is expressed as Stock turn over = COGS Avg. stock
Importance: It helps to remove unnecessarily block of the capital. It helps to reduce Chances of becoming stock obsolete Without this Cost of capital will be more Chances of deterioration in quality of goods. DEBTORS TURNOVER RATIO: a firm can sell their product on cash or on credit. When the goods are sold on credit, the parties to whom the goods have been sold, are called as debtor or book debts in accounting terminology. There must be proper collection policy to ensure proper collection of debts without which there is every possibility of out standing debts becoming bad. This ratio indicates the speed with which the debtors are turnover during a year. It is expressed in number of times the debtors are turned over. It is expressed as: Debtor turn over = Importance: net credit sales Avg. accounts receivable
(1) (1) Accounts receivable turnover ratio or debtor’s turnover ratio
indicates the number of times the debtors are turned over a year. (2) The higher the value of debtor’s turnover the more efficient is the management of debtors or more liquid the debtors are. (3) Low debtors turnover ratio implies inefficient management of debtors or less liquid debtors. It is the reliable measure of the time of cash flow from credit sales. AVERAGE COOLECTION PERIODS: the quality of debtors can be evaluated by ascertaining average collection period also. This is calculated to know how many days credit is outstanding of debts. It is expressed as: Debtors collection period = avg. accounts receivable Net credit sales * no. of days/months
Creditors’ turnover ratio: when the goods or services are purchased on credit, the parties from whom such purchases have been made are called as trade creditors in accounting terminology. They are also known as payables. This ratio indicates the velocity with which the creditors are turn over in relation to credit purchases during a year lower the ratio, greater is the credit period enjoyed by the firm to repay creditors and vice versa. Creditors turn over = net credit purchase Avg. accounts payable
Importance: (1) The average payment period ratio represents the number of days by the firm to pay its creditors. (2) A high creditor’s turnover ratio or a lower credit period ratio signifies that the (3) Creditors are being paid promptly. (4)This situation enhances the credit worthiness of the company.
(5) However a very favorable ratio to this effect also shows that the business is not taking the full advantage of credit facilities allowed by the creditors. AVGRAGE PAYMENT PERIOD: The quality of creditors can be evaluated by ascertaining average collection period also. This is calculated to know how many days credit will be given by the suppliers. It is expressed as: Creditors payment period = avg. accounts payable Net credit sales * no. of days/month
WORKING CAPITAL TURNOVER RATIO: working capital is the excess of the current liabilities. This is calculated to study the efficiency with which the working capital is utilized in the business. This ratio is also called as “Net current turn over”. It is expressed as: Working capital turnover = cost of sales Working capital FIXED ASSETS TURNOVER RATIO: this ratio is calculated to measure the adequacy or otherwise of investment in the fixed assets. This ratio in expressed as: Fixed assets turnover = net sales Fixed assets or cost of sales fixed assets