Unit – ii

 Introduction - Significance - Limitations

 Classification According to Statement:
1. Short-Term Solvency
 Current Ratio
 Liquidity Ratio
 Classification According to Function:
1. Long-Term Solvency 2. Profitability Ratio
 Debt-Equity Ratio  Gross-Profit Ratio
 Proprietary Ratio  Net-Profit Ratio
 Operating Ratio
 Ratios are simply a means of highlighting in arithmetical
terms the relationship between figures drawn from financial
statements.
 A Ratio is a mathematical expression of relationship between
two interconnected figures.
 Ratio analysis is a tool of financial statement analysis,
in the hands of management in which, inferences are
drawn based on the computation and analysis of
different ratios.
 A tool used by individuals to conduct a quantitative analysis
of information in a company's financial statements
 Proportion
 Percentage
 Quotient
 Rate
 Fraction
 Example
Relating the numbers 3000 and 1000

 Proportion/Quotient  Rate
§ 3:1 § 3 times
 Percentage  Fraction
3000 3000 3
§ ∗ 100 = 300% § =
1000 1000 1
 Collection of necessary data
 Computation of ratios
 Comparison of ratios
 Analysis and interpretation of ratios
 Helpful in Simplifying Financial data.
 Helpful in Determining Trends.
 Helpful in Controlling.
 Benefits to Other Parties Interested in the Business.
 Helpful in locating Weak Spots.
 Helpful in Comparative Study.
 Helpful in Measuring Operating efficiency.
 Overall Profitability
 Limited use of Single Ratio.
 Wrong Ratios Based on Wrong Data.
 Incorrect Comparison.
 Different Meaning.
 Difficulty in Forecasting.
 Lack of Qualitative Analysis.
 Difficulty of Price Level Changes.
 Lack of Proper Standards.
 Classification According to Accounting Statement.
1. Short-term Financial Position
 Classification According to Functions.
1. Long-term Financial Position
2. Profitability
 Classification on the Basis of Importance.
1. Efficiency (or) Activity
Unit - ii
 Current Ratio is the proportion of current assets to current
liabilities.
 Gives the relationship between current assets and liabilities.

Current Assets
Current Ratio =
Current Liabilities
 Current Assets Current Liabilities
Cash in hand Accounts payable
Cash at bank Creditors
Marketable securities Bills payable
Short term investments Income received in advance
Advances recoverable Outstanding expenses
Accounts receivable Bank overdraft
Debtors Cash credits
Bills Receivable Short term loans
Stock of Notes payable
Raw materials Tax payable
Work-in-process Dividend payable
Finished goods Provision for taxation
Spares Proposed dividend
Accrued income
Prepaid expenses
Unit - ii
 Liquid Ratio / Quick Ratio / Acid Test Ratio is the proportion of
liquid assets to liquid liabilities.
 Gives the relationship between
‘Current Assets other than Stock and Prepaid Expenses’
(Quick Assets)
to
‘Current Liabilities other than Bank Overdraft and Cash Credit’.
(Quick Liabilities)
 Liquid Ratio / Quick Assets
Quick Ratio / =
Acid Ratio Quick Liabilities

(or) = Quick Assets / Current Liabilities

[Quick Assets] = [Current Assets] – [Stock and Prepaid Expenses]

[Quick Liabilities]= [Current Liabilities] – [Cash Overdraft and Cash Credit]

Illustration 1: The following is the Balance Sheet of Indira Ltd.,

Liabilities Rs. Assets Rs.

Share Capital 30,000 Fixed assets 16,500
Creditors 8,000 Cash 7,000
Bills payable 2,000 Bills Receivable 2,000
Provisions for tax 3,500 Stock 17,500
Prepaid exp. 500
43,500 43,500
Calculate :
a) Current Ratio b) Liquid Ratio
 Current Assets Liquid Ratio / Quick Assets
Current Ratio = Quick Ratio / =
Current Liabilities Acid Ratio Quick Liabilities

[Quick Assets] = [Current Assets] – [Stock and Prepaid Expenses]

[Quick Liabilities] = [Current Liabilities] – [Cash Overdraft and Cash Credit]

 Current Assets Rs. Current Rs.
Liabilities
Cash 7,000 Creditors 8,000
Bills Receivable 2,000 Bills Payable 2,000
Stock 17,500 Provisions for tax 3, 500
Prepaid exp. 500
Total Current 27,000 Total Current 13,500
Assets Liabilities

a) Current Ratio = Current Assets / Current Liabilities

= 27,000 / 13,500
=2 Current Assets
Current Ratio =
Current Liabilities
 Current Assets Rs. Current Liabilities Rs.
Cash 7,000 Creditors 8,000
Bills Receivable 2,000 Bills Payable 2,000
Stock 17,500 Provisions for tax 3, 500
Prepaid exp. 500
Total Current 27,000 Total Current 13,500
Assets Liabilities

b) Liquid Ratio = Quick Assets / Current Liabilities

Quick Assets = Total current assets – (stock + prepaid expenses)

= 27,000 – (17,500 + 500) = Rs. 9,000

Liquid Ratio = 9,000 / 13,500 = 0.67

 Creditors 2,50,000
 Bills Payable 1,50,000
 Stock 1,00,000
 Debtors 3,00,000
 Prepaid Expenses 20,000
 Cash in Hand 50,000
 Cash at Bank 1,50,000
Unit - ii
 An important measure of long-term solvency
 Proportion of external equities & internal equities
 Gives the relationship between borrowed funds &
owner’s funds.
 External Equities
 Internal Equities
External Equities Internal Equities
 Long-term debts:
Equity share Capital

◦ Debentures
 Preferences share Capital
◦ Bonds
◦ Other long-term borrowings  Reserves & Surplus
 (-) Accumulated Losses
 Current Liabilities:
◦ Creditors  (-) Capitalized Expenditure

◦ Bill Payable
◦ Outstanding expenses
◦ Incomes received in advance
 External Equities
Debt Equity Ratio =
Internal Equities

External Equities = Long-term Debt + Current Liabilities

Internal Equities = Equity Shares Capital + Preferences Shares Capital
+ Reserves & Surplus – Fictitious Assets
 Liabilities Rs. Assets Rs.
5,000 Equity shares of Rs.50
2,50,000 Building 3,00,000
each
1,000 8% Preference shares of
1,00,000 Machinery 2,50,000
Rs.100 each
2,000 9% Debentures of Rs.100
2,00,000 Stock 1,20,000
each
Reserves 1,50,000 Debtors 1,00,000
Creditors 75,000 Cash at Bank 27,500
Prepaid
Bank overdraft 25,000 2,500
Expenses
 External Equities
Debt Equity Ratio =
Internal Equities

 External Equities = Long-term Debt + Current Liabilities

= 2,00,000 + 75,000 + 25,000
= 3,00,000
 Internal Equities = Equity Shares Capital + Preferences Shares
Capital + Reserves & Surplus – Fictitious Assets
= 2,50,000 + 1,00,000 + 1,50,000 – 0
= 5,00,000
 Debt Equity Ratio = 3,00,000 / 5,00,000 = 0.6
Unit - ii
 Proportion of shareholder’s funds to total tangible assets.
 Shows how much of total tangible assets are financed by
shareholder’s funds.
 Shareholder’s Funds
Proprietary Ratio =
Total Tangible Assets

Shareholder’s Funds = Internal Equities

Internal Equities = Equity Shares Capital + Preferences Shares Capital
+ Reserves & Surplus – Fictitious Assets
Total Tangible Assets = Fixed Assets + Current Assets – Intangible Assets
 Liabilites Rs. Assets Rs.
5,000 Equity shares of Rs.50
2,50,000 Building 3,00,000
each
1,000 8% Preference shares
1,00,000 Machinery 2,50,000
of Rs.100 each
2,000 9% Debentures of
2,00,000 Stock 1,20,000
Rs.100 each
Reserves 1,50,000 Debtors 1,00,000
Creditors 75,000 Cash at Bank 27,500
Bank overdraft 25,000 Prepaid Expenses 2,500
8,00,000 8,00,000
 Shareholder’s Funds = Internal Equities
= Equity Shares Capital + Preferences Shares
Capital + Reserves & Surplus – Fictitious Assets
= 2,50,000 + 1,00,000 + 1,50,000 – 0
= 5,00,000
 Total Tangible Assets = Fixed Assets + Current Assets – Intangible Assets
= 5,50,000 + 2,50,000 – 0
= 8,00,000
 Proprietary Ratio = 5,00,000 / 8,00,000 = 0.625
 Liabilites Rs. Assets Rs.
Equity share capital 2,00,000 Building 4,00,000
10% Preference share
1,00,000 Furniture 2,50,000
capital
11% Debentures 3,00,000 Goodwill 80,000
10% Term Loans 1,00,00 Patent Rights 20,000
Reserves & Surplus 50,000 Prepaid Expenses 10,000
Creditors 70,000 Debtors 60,000
Preliminary Expenses to be
Bills Payable 30,000 30,000
written off
Discount on the issues of
Bank overdraft 50,000 20,000
shares
9,00,000 8,00,000
Calculate :
a) Debt Equity Ratio b) Proprietary Ratio
 Gross Profit Ratio
 Net Profit Ratio
 Operating Ratio
 Percentage of gross profit on net sales
 Gives the relationship between gross profit and net sales
 Expressed as Percentage.
 Gross Profit
Gross Profit Ratio = * 100
Net Sales

Gross Profit = Net Sales – Cost of Goods Solds

Net Sales = Sales – Sales Returns
[Cost of Goods Solds] = [Opening stock] + [Purchases and other direct
Expenses] - [Closing Stock]
 Percentage of net profit on net sales
 Gives the relationship between net profit and net sales
 Expressed as Percentage.
 Net Profit After Tax
Net Profit Ratio = * 100
Net Sales

Net Profit After Tax = Gross Profit + Indirect Incomes – Indirect Expenses
Net Sales = Sales – Sales Returns
 Gives the relationship between cost of goods sold and
other operating expenses to net sales.
 Expressed as Percentage.
 Operating Cost
Operating Ratio = * 100
Net Sales

Operating Cost = Cost of Goods Sold + Operating Expenses

Operating Expenses = Administrative Expenses + Selling and Distribution
Expenses
Net Sales = Sales – Sales Returns
Illustration 1: From the following particulars,

Particulars Rs. Particulars Rs.

Sales 1,00,000 Purchases 60,000
Purchases
Sales Returns 10,000 15,000
Returns
Opening Stock 20,000 Closing Stock 5,000
Administrative
10,000 Selling Expenses 1,000
Expenses
Income from
5,000
Investments
Tax rate 40%
Calculate :
a) Gross Profit Ratio b) Net Profit Ratio c) Operating Ratio
 Particulars Rs. Particulars Rs.

Sales 1,00,000 Purchases 60,000

Purchases
Sales Returns 10,000 15,000
Returns

Opening Stock 20,000 Closing Stock 5,000

Administrative
10,000 Selling Expenses 1,000
Expenses

Income from
5,000
Investments

Tax rate 40%

 Trading and Profit & Loss Account
Particulars Rs. Particulars Rs.
Opening Stock 20,000 Sales 1,00,000
Purchases 60,000 (-) Sales Returns 10,000 90,000
(-) Purchases Returns 15,000 45,000 Closing Stock 5,000
Gross Profit c/d 30,000
95,000 95,000
Administrative
10,000 Gross Profit b/d 30,000
Expenses
Income from
Selling Expenses 1,000 5,000
Investments
Net Profit 24,000
35,000 35,000
 Gross Profit
Gross Profit Ratio = * 100
Net Sales

30,000
Gross Profit Ratio = * 100
90,000
= 100 / 3
= 33.33 %
 Net Profit After Tax
Net Profit Ratio = * 100
Net Sales

Tax rate 40%

Net Profit after Tax = Net Profit – Tax Profit 14,400

= 24,000 – (40% of 24,000) Net Profit Ratio = * 100
= 24,000 – (40/100 * 24,000) 90,000
= 24,000 – 9,600 = 0.16 * 100 = 16%
= 14,400
 Operating Cost
Operating Ratio = * 100
Net Sales

Operating Cost = Cost of Goods Sold + Operating Expenses

Cost of Goods Sold = Opening stock +
+ Purchases and other direct Expenses
- Closing Stock
Operating Expenses = Administrative Expenses
+ Selling and Distribution Expenses
 Operating Cost
Operating Ratio = * 100 Cost of Goods Sold = 20,000 + 45,000 – 5,000
Net Sales = 60,000
Operating Expenses = 10,000 + 1,000
Operating Cost = Cost of Goods Sold + Operating Expenses = 11,000
Cost of Goods Sold = Opening stock Operating Cost = 60,000 + 11,000
= 71,000
+ Purchases and other direct Expenses
- Closing Stock Operating Ratio = (71,000 / 90,000 ) * 100
= 78.89 %
Operating Expenses = Administrative Expenses
+ Selling and Distribution Expenses
 Trading and Profit & Loss Account
Particulars Rs. Particulars Rs.
Opening Stock 1,00,000 Sales 5,60,000
Purchases 3,50,000
Wages 9,000 Closing Stock 1,00,000
Gross Profit c/d 2,01,000
6,60,000 6,60,000
Administrative Expenses 40,000 Gross Profit b/d 2,01,000
Selling & Distributive
49,000 Income from Investments 10,000
Expenses
Profit on Sales of
Non Operating Expenses 30,000 8,000
Investments
Net Profit 1,00,000
2,19,000 2,19,000
Calculate :
a) Gross Profit Ratio b) Net Profit Ratio c) Operating Ratio
 Sales 2,20,000  GPR = (GP/NS )*100
 Sales Returns 20,000  GP = NS-CGS
 Opening Stock 30,000  CGS = OS+NP-CS
 Purchases 1,75,000  NP = P-PR
 Pur Returns 15,000  NS = S-SR
 Closing Stock 40,000 NP 1,60,000
NS 2,00,000
CGS 1,50,000
GP 50,000
GP Ratio 25%
Unit - II