Notes:ratio analysis

CHAPTER-5
ACCOUNTING RATIO
ACCOUNTTING RATIO – By R.N Anthony “A Ratio is simply one number expressed in terms of
another. It is found by dividing one number onto other.” In accounting ratio two or more than two
monetory term are compare to each other.

TYPES OF ACCOUNTING RATIO

1. LIQUIDITY RATIO- “Liquidity” refers to the ability of the firm to meet its current liabilities. The
liquidity ratio, therefore, are also called “Short term Solvency ratio.” These ratio are used to asses
the short term financial position of concern.
In the words of J. Flink, “Liquidity is the ability of the firm to meet its current obligation as they fall
due.”
Liquidity ratio includes two ratios:-
I. Current Ratio or Working Capital Ratio- This ratio explains the relationship between
current assets and current liabilities of a business. The formula for calculating the ratio is :-

Current ratio = Current Assets Ideal Ratio = 2:1

Current Liabilities

Current Assets: Cash in hand + Cash at bank + B/R + Short-term investment + Debtors + Stock +
Prepaid expenses.
Current liabilities: Bank overdraft+ B/P + Provision for taxation + Proposed dividend +
Outstanding Expenses + Loans payable within one year.
II. Quick Ratio or Acid test Ratio: Quick Ratio indicates weather the firm is in a position to pay the
current liabilities within a month or immediately. The formula is:-

Quick Ratio = Liquid Assets Ideal ratio = 1:1

Current liabilities
Liquid Assets: Current Assets- Stock- Prepaid expenses.
2. SOLVENCY RATIO – these ratios are calculated to assess the ability of firm to meet its Long-term
Liabilities as and they become due.
It includes three ratios:-
I. Debt Equity Ratio: This ratio expresses the relationship between long term
debts & share holder funds. It indicates the proportion funds which are acquired by long term
borrowings in comparison shareholder fund to shareholders funds.

Debt Equity Ratio = Long term loans

Shareholder funds

Shareholders’ funds: Equity Share capital + Preference Share capital + Securities premium +
General Reserve + Capital Reserve + Other Reserve + Cr. Balance of P & L Account – Fictitious
assets.
Long-term loan: Debenture + Bank Loan + Mortgage Loan + Loan from financial institution +
Public Deposit.
II. Total Assets ratio: This ratio is the variation of the debt-equity ratio& gives the same indication
as the debt-equity ratio.
Total Assets ratio: Total Assets
Debts
Total Assets: All fixed assets & current assets. But fictitious assets are deducted.
Long-term loan: Debenture + Bank Loan + Mortgage Loan + Loan from financial institutions +
Public Deposit.
III. Proprietary Ratio: this ratio indicates the proportion of total assets funded by owners or
shareholders.

Proprietary Ratio = Shareholder funds

Total assets
Total Assets: All fixed assets & current assets. But fictitious assets are deducted.
Shareholders’ funds: Equity Share capital + Preference Share capital + Securities premium +
General Reserve + Capital Reserve + Other Reserve + Cr. Balance of P & L Account – Fictitious
assets.
IV Interest Coverage Ratio: It is a ratio which deals with the servicing of interest on loan.

Interest Coverage Ratio = Net Profit before

Interest and Tax
Interest on long term debt

3. ACTIVITY RATIO: These ratios are calculated on the basis of “cost of sales” therefore, these
ratios are called as “Turn over Ratio”. Turnover indicates these speed or no. of times the capital
employed has been rotated in the process of doing business.
It includes five ratios:-
I. Inventory Turnover Ratio: This ratio indicates the relationship between the costs of
goods sold the year and average stock kept during the
year.
Cost of goods sold: Opening stock + Purchases + Carriage + Wages + other direct charges-
closing stock. Or
Net Sales- Gross Profit.
Average stock = Opening Stock + Closing Stock
2
II. Debtor Turnover Ratio: This ratio indicates the relationship between credit sale and average
debtor during the year.
Debtor Turn Over Ratio = Net Credit Sales
Average Debtor + Average B/R
III. Creditor Turnover Ratio: This ratio indicates the relationship between credit purchase and
creditors during the year.
Creditor Turnover Ratio: Net Credit Purchases
Average Creditor + Average B/P
IV. Working Capital Turnover Ratio: This ratio indicates the relationship between Net Sales and
Working Capital during the year.
Working Capital Turnover Ratio: Net Credit Sales
Working Capital
Working Capital: Current Assets – Current Liabilities.
V. Fixed Assets Turn Over Ratio: The formula is used for calculating this ratio as follows:-
Fixed Assets Turn Over Ratio = Net Sales
Net Fixed Assets
Net Fixed Assets: Fixed Assets – Depreciation.

4. PROFITABILITY RATIO: The main object of all business concern to earn profit. Profit is the
measurement of the efficiency of the business. Profitability ratio measures the various aspects of
the profitability of the company, such as, what is the rate of profit on sales? , Whether the profits
are increasing or decreasing, and there causes.
It includes seven Ratios:
I. Gross Profit Ratio: This ratio shows the relationship between the gross profit and sales.
Gross Profit Ratio = Gross Profit * 100
Net Sales
II. Operating Ratio: This ratio measures the proportion of an enterprise’s cost of sales and
operating expenses comparison to its sales.
 Operating Ratio = Cost of Sales + Operating expenses *
100
Net Sales
III.Net Profit Ratio: This ratio shows the relationship between the net profit and sales.
Net Profit Ratio= Net Profit * 100
Net Sales
Operating Profit Ratio = Operating Profit * 100
Net Sales
IV. Return on Investment (R.O.I): This ratio reflects the overall profitability of the business. It is
calculated by comparing the profit earned and capital employed to earn it. This ratio is usually in
percentage and also known as ‘Rate of Return’.

R.O.I = Profit before interest, tax &

dividend * 100
Capital Employed
Capital Employed = Equity Share Capital + Preference Share Capital + Reserve & Surplus + Cr.
Balance of P & L + Long term Loans – Fictitious assets – Non-operating assets
Or
Fixed Assets + Current Assets.
V. Earning per Share (E.P.S): Overall profitability of a company can also be judged by calculating
‘earning per share’. In this context, earning refers to profit available for equity shareholder.
E.P.S = Net Profit (after interest & tax)
Number of equity share
VI. Price-Earning (P.E.) Ratio: It is computed by dividing the market price of a share by E.P.S. That
is:-
E.P.S = Market Price of share
E.P.S
VII. Dividend per Share: Profit remaining after payment of tax, preference dividend is available to
equity shareholder. Out of these apart retained in the business and the remaining is distributed
among equity shareholders and as dividend.
D.P.S = Dividend paid to equity
shareholder
Number of equity share