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May 19, 2011

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Ratio Analysis

Attribution Non-Commercial (BY-NC)

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Ratio Analysis

Attribution Non-Commercial (BY-NC)

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+ 15/22 IInd Floor Ashok Nagar, New Delhi-110018.

Ph.: 25499279, 55711031(O), 9810378235(M)

[98106-34853]

Class: XII Accountancy Ratio Analysis P.No.:1

1. Gross Profit Ratio. This ratio is calculated as gross profit divided by net sales. Gross Profit is the excess of

sales over cost of goods sold. To find net sales return, sales tax and excise duty should be deducted from sales.

It is calculated as follows:

Gross Profit × 100

Net Sales

Gross profit = Net Sales – Cost of goods sold

Net sales = Gross sales – (sales return + Sales tax + Excise duty)

Significance. This ratio indicates the relationship between gross profit and sales. Higher the ratio, less is the

cost of goods sold. Increase in the gross profit ratio over the period is the indicator of better profitability.

Decrease in the ratio should be properly investigated to find the exact reason. The possible reasons are: increase

in cost of goods sold due to increase in the cost of material, productive wages or manufacturing expenses or due

decrease in the selling price. This ratio can be used in controlling cost of goods sold, fixing the price of the

products and in comparing gross margin over various years. For the purpose of analysis the actual gross profit

ratio should ratio should be compared with either industry average or standard gross profit ratio.

2. Net Profit Ratio. This ratio is calculated as net profit divided by sales. Net profit may be taken as before tax or

after tax., but net profit after tax is preferred. It is calculated as follows:

Net Profit after Tax × 100

Net Sales

Significance. This ratio shows relationship between net profit and net sales. Objectives of net profit ratio is to

determine the over all efficiency of the business. Higher the net profit ratio, the better the business. This ratio

helps in comparing the performance over various years. An increase in the net profit ratio over the previous year

shows improvement in the operational efficiency.

3. Operating Profit Ratio. The ratio is calculated as operating profit divided by net sales. Operating profit is

excess of sales over operating cost. Operating cost includes cost of goods sold and operating expenses (i.e.,

administrative expenses and selling and distributing expenses). It is calculated as follows:

Operating Profit × 100

Net Sales

Operating cost = Gross profit – Operating expenses (office and administration expenses + Selling and distribution

expenses)

Significance. This ratio indicates the relationship between operating profit and net sales. This ratio shows

efficiency of operating business as non-operating incomes and non-operating expenses are not considered.

Indirectly it reveals the relationship between operating cost and prices. By comparing this ratio over several

years, trends in operating profit can be examined.

4. Operating Ratio. It may be defined as a ratio which indicates operating cost as a percentage of total sales.

Operating ratio is calculated as operating cost divided by net sales. Formula is as follows:

Operating Cost × 100

Net Sales

Operating cost = Cost of goods sold + Operating expenses

Significance. This ratio indicates the relationship between operating cost and net sales. This ratio

shows operating efficiency of the business. Lower the ratio, better the efficiency. This ratio is just

opposite of operating profit ratio. This ratio helps in controlling the operating cost of the business.

5. Return on Investment (ROI). This ratio is also known as return on capital employed. It shows the relationship

between the profit earned (before interest and tax) and the capital employed to earn such profit. It is considered

an indicator of overall profitability. This ratio is calculated as follows:

= profit before interest and Tax (PBIT) × 100

Capital Employed

Calculation of Capital Employed

(i) Fixed Assets + Investments + Current Assets – Current Liabilities

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(ii) Paid up Capital + Reserves and Surplus + Long-term loans – Fictitious assets or Miscellaneous Expenditure

Class: XII Accountancy Ratio Analysis P.No.:2

Significance. This ratio judges the overall performance and efficiency of the business it show efficiently the

resources invested in the business are being used. ROI is a fair measure of the profitability of any firm, which

can be compared with the terms of the same industry as well as with the firms of other industries. This ratio is

also used to compare the profitability and efficiency over various years.

6. Return on Equity (ROE). This ratio is also known as return on shareholders’ investment. This ratio shows hoe

much net profit a firm has earned with the use of Rs. 100 of shareholders’ funds. Regarding this ratio analysts

have two different concepts of equity. According to one concept equity means shareholders’ fund, some analysts

use equity shareholders’ funds. The seconds concept is used to calculate this ratio in this book. Both the formula

are: (i) Return on Shareholder’s Funds

= Net Profit after T ax (PAT) × 100

Shareholders’ Funds

Shareholders Funds = Equity Share Capital + Preference Share Capital + Reserves and surplus – Fictitious assets

(like preliminary expenses etc.)

(ii) Return on Equity Shareholder’s Funds

= Net Profit after Tax – Preference Dividend × 100

Equity Shareholders’ Funds

Equity Shareholders Funds = Equity Share Capital + Reserves and Surplus – Fictitious assets (like preliminary

expenses etc.)

7. Current Ratio. It is also knows as working capital ratio. It is the ratio of total current assets and current

liabilities. Current assets are those assets which are converted into cash during the ordinary course of business.

Current liabilities are those liabilities which are repayable within a year’s time. It is calculated as follows:

= Current Assets

Current Liabilities

Current Assets : Cash + Bank + debtors + B/R + Accrued Income + stock + Prepaid Expenses + Marketable or

short-term investment.

It is to be noted that loose tools is not considered a current asset for the purpose of this ratio, although it may be

classified as current asset in the Balance Sheet of a company.

Current Liabilities: = Creditors + B/P + Outstanding expenses + Bank overdraft + Income received in advance +

provision for tax + Proposed Dividend + Unclaimed Dividend and any other liability payable within a year.

Significance. This ratio is used to judge the short-term financial position or liquidity of the concern. The current

ratio measures the ability of the firm to meet its current liabilities. Higher the current ratio the greater the short

term solvency. 2:1 is considered ideal current ratio. However, a very high current ratio will indicate idleness of

working capital only.

8. Quick Ratio. It is also called Liquid ratio or acid-test ratio. It is a ratio between quick assets and current

liabilities. Quick or liquid assets includes those current assets which can easily and readily be converted into

cash. Thus these includes cash in hand, cash at bank, debtors, B/R, accrued income and marketable securities. It

is calculated as follows:

= Quick Assets or Liquid Assets

Current Liabilities

Quick Assets = Current Assets or Liquid Assets

Current Liabilities

Quick Assets = Current Assets – (Stock + Prepaid expenses)

Significance. The quick ratio is a fairly stringent measure of liquidity. It is based on those current assets which

are highly liquid. A quick ratio of 1:1 is considered satisfactory. Higher the quick ratio better the short-term

financial position.

9. Debt – Equity Ratio. It is a ratio between long-term debts and equity. For the purse of this ratio, the meaning of

equity is shareholders’ funds. Some of the analysis consider it as a ratio between external liabilities (short-term

as well as long-term) and owners’ funds. It is calculated as follows:

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= Debt(long – term)

Equity (Shareholders’ funds)

Class: XII Accountancy Ratio Analysis P.No.:3

Significance. This ratio judges the long-term financial position and soundness of the long-term financial policies

of the firm. In general lower the debt equity ratio the higher the degree of protection enjoyed by the lenders. A

debt equity ratio of 2:1 may be considered satisfactory in India.

10. Debt to Total Funds Ratio. It is also knows as solvency ratio. It is a ratio between long-term debt and total

long-term funds (i.e., capital employed). It is calculated as follows:

= Debt (long term)

Total Long term funds (Debt + Equity)

Significance. This ratio measures the long-term financial position and soundness of long-term financial policies.

It shows the proportion of long term funds which is raised by way of debt. A higher proportion is not considered

good. 2:3 or 0.67 is acceptable in India.

11. Interest Coverage Ratio. It is a ratio between ‘profit earned before interest and tax’ and interest on long-term

loans. This ratio indicates the number of times interest (on long-term loans) is covered by the profits available

for payment of it. This ratio is also known as ‘times interest earned ratio’. It is calculated as follows:

= Profit before Interest and Tax

Interest on Long-Term Debt

Significance. This ratio indicates how many times the profit covers the interest. It measures the margin of

safety for lenders and debenture holders. A high interest coverage ratio means that the firm can easily meet its

interest burden even if earning before interest and tax suffer a considerable loss due to adverse business

conditions.

12. Fixed Assets Turnover Ratio. It is a ratio between sales and fixed assets. It is expressed in times.

= Net Sales

Net Fixed Asset

Significance. This ratio measures the efficiency with which fixed assets are employed. A high ratio indicates a

high degree of efficiency in the utilization of fixed assets and a low ratio represents insufficient use of assets.

13. Capital Turnover Ratio. It is a ratio between sales and capital employed. Capital employed consist of long-

term funds including debts. The ratio indicates the times by which the capital employed is used to generate sales.

It is calculated as follows:

= Sales

Capital Employed

Significance. This ratio shows the number of times the capital has been rotated in the process of doing business.

Higher the ratio, better the efficiency in the utilization of capital. However, too high ratio may indicate over

trading resulting in the shortage of funds.

14. Stock Turnover Ratio.

STR = Cost of Goods sold

Average stock

Cost of goods sold = Opening stock + Net Purchase of raw material + Direct expenses – Closing stock.

Cost of Goods sold = Net sales – Gross profit

Average stock = Opening stock + Closing Stock

2

Significance. This ratio measures how fast the stock is moving through the firm and generating sales. This ratio

reflects the efficiency of inventory management. Higher the ratio, the more efficient management of inventories

and vice-versa. A high inventory turnover may be caused by a low level of inventory which may result in

frequent stock-outs and loss of sales and customer goodwill.

15. Debtor Turnover Ratio.

DTR = Net Credit Sale

Average creditors

Average Collection Period

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= 365/12/52

DTR

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