Professional Documents
Culture Documents
Introduction:
Ratios are presentation technique, which helps the reader to get idea about the performances &
Position of a firm with least efforts. He can get overall view of the firm from the ratios presented to
him. He can compare such ratios with the ratios of the past & also with ratios other firm in
industry. For getting insight we must know how such ratios are calculated.
Types of Ratios
Liquidity Ratios: Short term solvency ratios. (Pure Ratio shown in 1 : 1 form)
Current Ratio
Liquid Ratio
Quick Ratio
Current Assets
1. Current Ratio
Current Liabilities
Objective:
The objective is to measure the ability of the firm to meet its short – term obligations and to reflect the
short – term financial strength/ solvency of a firm. It suggests whether firm can meet its short term
obligation from short – term Assets.
Components:
Current Assets refer to those assets which are held for their conversion into cash normally within a
year and include the following:
Interpretation:
It indicates rupees of current assets available for each rupee of current liability. Higher the ratio,
greater is the margin of safety for short–term creditors and vice versa. However, too high/too low ratio
calls for further investigation since the too high ratio may indicate the presence of idle funds with the
firm or the absence of investment opportunities with the firm and too low ratio may indicate problem
of short-term insolvency. Traditionally, a current ratio of 2:1 is considered to be a satisfactory ratio.
Liquid Assets
2. Liquid Ratio or Acid Test Ratio=
Liquid Liabilities
Objective:
The objective is to measure the ability of the firm to meet its short – term obligations as and when due
without relying upon the realization of stock.
Interpretation :
It indicates rupees of quick assets available for each rupee of liability due on short term notice.
Traditionally, a quick ratio of 1:1 is considered to be a satisfactory ratio. However, this traditional rule
should not be used blindly since a firm having a quick ratio of more than 1, may not be meeting its
short–term obligations in time if its current assets consist of doubtful and slow paying debtors while a
firm having a quick ratio of less than 1, may be meeting its short–term obligations in time because of
its very efficient debtors management.
Quick Assets
3. Quick Ratio
Liquid Liabilities
Quick Assets = Current ratio less stock and debtor. This ratio suggests whether available cash &
cash equivalent (which can quickly convertible in cash) are sufficient to meet its short term
liabilities.
Profitability Ratios (Always is percentage except EPS)
Gross Profit
1. Gross Profit Ratio 100
Net Sales
Objective :
The objective is to determine the efficiency with which production and/or purchase operations are
carried on.
Interpretation:
This ratio indicates (a) an average gross margin earned on a sale of Rs. 100, (b) the limit beyond which
the fall in sales prices will definitely result in losses. And (c) what portion of sales is left to cover
operating expenses and non – operating expenses like to pay dividend and to create reserves. Higher
the ratio, the more efficient the production and /or purchase management. This ratio may increase due
to one of the following factors:
Objective:-
The objective is to determine the overall profitability due to various factors such as operational
efficiency.
Interpretation:
This ratio indicates (a) an average net margin earned on a sale of Rs. 100 (b) what portion of sales is
left to pay dividend and to create reserves, and (c) firm’s capacity to withstand adverse economic
conditions when selling price is declining.
3. Operating Ratio =
Objective:
The objective is to determine the operational efficiency with which production and /or purchases and
selling operations are carried on.
Interpretation:-
This ratio indicates an average operating cost incurred on sales of goods worth Rs. 100. Lower the
ratio, greater is the operating profit to cover the non – operating expenses, to pay dividend and to
create reserves and vice–versa.
In relation to Investment
Profit before Int & tax [profit available to equity shareholder,
Pref. shareholder, debenture holder
Less: Interest
Profit before tax
Less: Tax
Profit after tax [Profit available to equity shareholder
& Pref. shareholder]
Less: Pref. Dividend
= Equity Profit [Profit available to equity share holder]
Format of Capital Employed:
P.B.I.T
1. Return on Capital Employed= 100
Capital Employed
Interpretation:-
Higher the ratio, the more is the efficient the management and utilization of Capital Employed.
P. A. T
2. Return on Equity = Equity 100
Objective:-
The objective is to find out how efficiently the funds belonging to the shareholders (equity and
preference) have been used.
Interpretation:
This ratio indicates the firm’s ability of generating profit per 100 rupees of shareholders’ funds. Higher
the ratio, the more efficient the management and utilization of shareholders’ funds is.
Equity Profit
100
3. Return on Equity shareholder fund = Equity shareholder fund
Objective:
The objective is to find out how efficiently the funds supplied by the equity shareholders have been
used.
Interpretation:
This ratio indicates the firm’s ability of generating profit per 100 rupees of equity
shareholders’ funds. Higher the ratio, the more efficient the management and more is the
utilisation of equity shareholders’ funds.
Equity Profit
4. Return on equity share capital = Equity Share Capital 100
Objective:
The objective is to find out how efficiently the funds supplied by the equity shareholders have been
used.
Interpretation:
This ratio indicates the firm’s ability of generating profit per 100 rupees of equity share capital. Higher
the ratio, the more efficient the management and utilization of equity shareholders’ Capital is.
Equity Profit
5. Earning Per Share = No. of Equity Shares
Objective:-
The objective is to measure the profitability of the firm on per equity share basis.
Interpretation:
In, general, higher the EPS, better it is and vice versa. EPS helps in determining the market price of
the equity shares of the company. It also helps in estimating the company’s capacity to pay dividend.
Debt
1. Debt – Equity Ratio (Leverage Ratio) = Equity 100
Objective :-
The objective is to measure the relative proportion of debt and equity in financing the assets of a firm.
Interpretation:-
It indicates the margin of safety to long – term Debt. A low debt equity ratio implies the use of more
equity than debt which means a larger safety margin for Debt providers since owner’s equity is treated
as a margin of safety by debenture holder and vice versa. The implications from the point of view of
long term providers of loan and the firm may be seen as under.
Debt Pref. Shares
2. Capital Gearing Ratio = Equity Share Capital 100
Objective:-
The objective is to find proportion of fix return bearing security to not fix return bearing securities in
total capital of firm.
Interpretation:-
It indicate that for every 100 Rs. of equity capital what proportion of fix return bearing capital existing.
More this ratio higher is the risk of fix commitment & more burden for generating equity profit.
However it may result in to benefit by effect on trading on equity.
Objective:-
The objective is to find out how much the proprietors have financed for the purchases of assets.
Interpretation:-
This ratio indicates the extent to which the assets of the firm have been financed out by proprietors’
fund.
Total Assets = All Assets (Excluding Fictitious Assets like preliminary exp. underwriting exp,
debenture discount.)
P. B. I. T
4. Interest Coverage Ratio =
Interest On Loan
Objective:-
The objective is to measure the debt servicing capacity of a firm so far fixed interest on long – term
debt and debenture is concerned.
Interpretation:
Interest coverage ratio shows the number of times the amount of interest on long – term debt is covered
by the profits out of which that will be paid. It indicates the limit beyond which the ability of the firm
to service its debt would be adversely affected. Higher the ratio, greater the firm’s ability to pay
interest but very high ratio may imply lesser use of debt and very efficient operations.
Cash available for debt payment means P.A.T. +Depreciation & other non cash expenditure dr. to P
& L account + Interest on debt
Activity Ratios:-
Capital Turnover Ratio Debtors Turnover Ratio (Debtors Ratio)
Fixed Assets Turnover Ratio Creditors Turnover Ratio (Creditors Ratio)
Stock Turnover Ratio
Net Sales
1. Capital Turnover Ratio (In times) = (Avg.) Capital Employed [Debt Equity]
Objective:
The objective is to determine the efficiency with which the capital employed is utilized.
Interpretation:
It indicates the firm’s ability to generate sales per rupee of capital employed. In general, higher the
ratio, the more efficient the management and utilization of capital employed is.
Net Sales
2. Fixed Assets Turnover Ratio (in times) = (Avg.)Fixed Assets
Objective:
The objective is to determine the efficiency with which the fixed assets are utilized.
Interpretation:
It indicates the firm’s ability to generate sales per rupee of investment in fixed assets. In general,
higher the ratio, the more efficient the management and utilization of fixed assets is and vice versa.
Objective:-
The objective is to determine the efficiency with which the inventory is utilised.
Interpretation:-
It indicates the speed with which the inventory is converted into sales. In general, a high ratio indicates
efficient performance. However, too high ratio and too low ratio should be called for further
investigation. A too high ratio may be the result of a very low inventory levels which may result in
frequent stock – outs and thus the firm may incur high stock – out costs. On the other hand, a too low
ratio may be the result of excessive inventory levels, slow moving or obsolete inventory and thus, the
firm may incur high carrying costs. Thus, a firm should have neither very high ratio nor low ratio.
(Stock out means customer going out of shop due to unavailability of stock.)
Cr. Sales
4. Debtors Turnover Ratio (in times) = (Avg.) Debtors B/R
Debtors Ratio OR
(Avg) Debtors B/R
Debt Velocity Ratio (in days) = 365/360/12/52(week )
Credit Sales
Objective:-
The objective is to determine the efficiency with which the trade debtors are managed.
Interpretations:
High Debtors T/O ratio =shorter debtors ratio = quick recovery of money.
Low debtors T/O ratio = higher debtor ratio = delay in recovery of money.
It shows the efficiency of collection policy of the firm. It is always a goods idea to collect quickly,
money from debtors as uncertainty of collection increases with credit policy being liberal. However a
firm should under take cost benefit study of liberal credit policy, if benefit is more than cost than it
should increase credit period.
Benefit Cost
In profit due to In sales In bad – debt
In collection expenses
In Interest cost on money blocked with debtor
Tutorial Notes:
(i) The ‘Provision for doubtful debts’ is not deducted from the total amount of trade debtors
since here, the purpose is to calculate the number of days for which sales are tied up in
debtors and not to ascertain the realizable value of debtors.
(ii) If the figure of Average Debtors cannot be ascertained due to the absence of the figure of
opening Debtors, the figure of closing Debtors may be applied by giving a suitable note to
that effect.
(iii) If the figure of Net Credit Sales is not ascertainable, the figure of total sales given may be
used assuming that all sales are credit sales.
Interpretation:
High creditor T/O ratio = low creditor ratio = quick payment to creditor
Low creditor T/O ratio = high creditor ratio = delayed payment to creditor
It shows the market standing of the firm. A new firm may have less creditor’s ratio, as their market
standing will be less. An established firm will have greater market standing hence it is in position to
pay their creditor later. However a firm should study advantage of paying early and availing of cash
discount.
Net Sales
6. Total Assets Turnover Ratio (in times) =
Total Assets
Objective:
How efficiently assets are employed in business.
Interpretation:
This ratio suggests how a rupee of asset contributes to earn sales more the ratio more efficiently assets
are used in gainful operation.