Accounting ratios

Ratio
Relationship between two figures, expressed in arithmetical
terms are called a ‘ratio’.
Ratio may be expressed in the following four ways:
1. Simple ratio: it is expressed by the simple division of one
number by another. For example, if the current assets
of a business are Rs. 2,00,000 and its current liabilities
are Rs. 1,00,000, the ratio of ‘current assets to current
liabilities’ will be 2:1.
2. Rate: In this type, it is calculated how many times a
figure is, in comparison to another figure. For example, if
a firm’s credit sales during the year are Rs. 2,00,000 and
its trade receivables at the end of the year are Rs.
40,000, then it shows that the credit sales are 5 times in
comparison to trade receivable.
3. Percentage: In this type, the relation between two
figures is expressed hundredth.
4. Fraction: say, net profit is one-fifth of capital. While
calculating a ratio, it should be understood that it is
desirable to divide the “more favourable figure” by the
“less favourable figure”.

Objectives of ratio analysis

  To locate the weak spots of business which need
more attention.
 To provide deeper analysis of the liquidity,
solvency, activity and profitability of the business.
 To provide information for making cross-sectional
analysis, i.e., for making comparison with that of
some selected firms in the same industry.
 To provide information for making time-series
analysis.
 To provide information useful for making
estimates and preparing the plans for the future.

Advantages of accounting ratios

1. Helpful in analysis of financial statements: ratio analysis
is an extremely useful device for analysing the financial
statements. It helps the bankers, trade payables,
investors, shareholders etc. in acquiring enough
knowledge about the profitability and financial health of
the business. In the light of the knowledge so acquired
by them, they can take necessary decisions about their
relationship with the concern.
2. Simplification of accounting data: Accounting ratio
simplifies and summarises a long array of accounting
data and makes them understandable. It discloses the
relationship between two such figures which have a
cause and effect relationship with each other.
 3. Helpful in comparative study: With the help of ratio
analysis comparison of profitability and financial
soundness can be made between one firm and another
in the same industry. Similarly, comparison of current
year figures can also be made with those of previous
years with the help of ratio analysis.

Limitation of accounting ratios

1. Limited use of a single ratio: The analyst should not
merely rely on a single ratio. He should study several
connected ratios before reaching a conclusion.
2. Ignores qualitative factors: ratio analysis is a quantitative
measurement of the performance of the business. It
ignores qualitative factors which are also essential for
interpretation.
3. Ratio analysis becomes less effective due to price level
changes: Price level over the years goes on changing ,
therefore, the ratios of various years cannot change.

Classification of ratios
Ratio may be classified into the four categories as follows:
Liquidity ratios
Solvency ratios
Turnover ratios
Profitability ratios
A. LIQUIDITY RATIOS: “liquidity” refers to the ability of the
firm to meet its current liabilities. The liquidity ratios,
therefore, are called ‘short-term solvency ratios’.
Liquidity ratios include two ratios:
(i) Current ratio or working capital ratio
(ii) Quick ratio or acid test ratio or liquid ratio
B. SOLVENCY RATIO: These ratios are calculated to assess
the ability of the firm to meet its long-term liabilities
and when they become due.
Some important solvency ratio are:
(i) Debt-equity ratio
(ii) Total assets to debt ratio
(iii) Proprietary ratio
(iv) Interest coverage ratio
C. ACTIVITY RATIO: these ratios are calculated on the basis
of ‘cost of revenue from operations’ or ‘revenue from
operations’, therefore, these ratios are also called as
‘turnover ratios’.
Some important turnover ratios are:
(i) Inventory turnover ratio
(ii) Trade receivable turnover ratio
(iii) Trade payables turnover ratio
(iv) Working capital turnover ratio
D. PROFITABILITY RATIO: The main object of all the
business concerns is to earn profit. Profit is the
 measurement of the efficiency of the business.
Profitability ratios measure the various aspects of the
profitability of a company.
Some important profitability ratios are:
(i) Gross profit ratio
(ii) Operating ratio
(iii) Operating profit ratio
(iv) Net profit ratio
(v) Return on investment