GENERAL ACCOUNTING PRINCIPLES

Accounting Ratios
Ratio Analysis: a ratio is a quotient of two numbers and the relation expressed between two accounting
figures is known as “accounting ratio”.

It is a very powerful analytical tool useful for measuring performance of an organisation. It concentrates
on the interrelationship among the figures appearing in the financial statement. Ratio analysis allows
interested parties like shareholders, investors, creditors, government and analysts to make an
evaluation of certain aspects of a firm’s performance. Ratio normally pinpoints a business firm’s
strengths and weaknesses in two ways.

⮚ Ratio provides an easy way to compare present performance with the past.

⮚ Ratios depicts the areas in which a particular business is competitively advantaged or

disadvantaged through comparison of ratios of other businesses of the same size within the
same industry.

The ratio analysis is made under six broad categories follows:

Liquidity Ratio: liquidity is defined as the ability to realize value in money, the most liquid of assets. It
refers to the ability to pay in cash, the obligation that is due. The important ratios in measuring short-
term solvency are:

⮚ Current ratio

⮚ Quick ratio

Current Ratio: the ratio measures the solvency of the company in the short term. Current assets are
those assets which can be converted into cash within a year. Current liabilities and provisions are those
liabilities that are payable within a year. Eg: cash, bank deposits, debtors, bill of exchange, stock,
outstanding income, prepaid expenses.

Current Ratio = Current assets, loans & Advances/current liabilities & provisions

Eg. Cash = $15 million, Marketable securities = $20 million

Inventory = $25 million, Short-term debt = $15 million

Accounts payables = $15 million

Current Ratio = (15 +20+25)/(15+15) = 2.0

A current ratio of 2:1 indicates a highly solvent position.

Quick ratio: is used as a measure of the company’s ability to meet its current obligations. Since bank
overdraft is secured by the inventories, the other current assets must be sufficient to meet other
current liabilities. Eg: cash, bank deposits, debtors, bill of exchange, outstanding income.

Quick Ratio = Quick assets, loans & Advances-inventories/Current liabilities & provisions-bank
overdraft

A quick ratio of 1:1 indicates a highly solvent position.

A quick asset is always a current asset but vice-versa is not true. A current asset may or may not be a
quick asset.
Capital Employed = Rs.10,00,000

Fixed Assets = Rs.7,00,000

Fixed assets are like land, machinery, etc.

Current Assets = Capital Employed + Current Liabilities - Fixed Assets = Rs.10,00,000 + Rs.1,00,000 -
Rs.7,00,000

= Rs.4,00,000

Current Assets

= Inventory + Trade Receivables + Cash and Cash Equivalents

= Rs.50,000 + Rs.30,000 + Rs.20,000

= Rs.1,00,000

Current Liabilities

= Short-term Borrowings + Trade Payables + Provision

for Tax

= Rs.3,000 + Rs.13,000 + Rs.4,000

= Rs.20,000

Quick Assets

= Trade Receivables + Cash and Cash Equivalents

= Rs.30,000 + Rs.20,000

= Rs.50,000

Capital Employed = Rs.10,00,000

Fixed Assets = Rs.7,00,000

Current Liabilities = 1,00,000

Current Assets = Capital Employed + Current

Liabilities - Fixed Assets = Rs.10,00,000
+ Rs.1,00,000 - Rs.7,00,000

= Rs.4,00,000

Quick Ratio = 2:1

Let Quick Assets be = Rs.20,000

Current Liabilities = Rs.10,000

i. Purchase of goods for Cash- Reduce

Reason: This transaction will result in a decrease in cash and increases in stock. Liquid Asset will
decrease due payment for goods purchased.

Example: Purchase of goods Rs.5,000 for cash

Quick Assets = Rs.20,000 - Rs.5,000

(Cash) = Rs.15,000
ii. Purchase of goods on Credit- Reduce

Reason: Purchase of goods on credit will result in an increase in Current Liabilities and no change in
Quick Assets.

Example: Purchase of goods on Credit Rs.5,000

Current Liabilities = Rs.10,000 + Rs.5,000 (Creditors) = Rs.15,000

iii. Sale of goods for Rs.10,000- Improve

Reason: Sale of goods will result in increase in Quick Assets by the amount Rs.10,000 in the form of
either in cash or debtor. This transaction will result in no change in current liabilities.

iv. Sale of goods costing Rs.10,000 for Rs.11,000- Improve

Reason: This transaction will increase the Quick Assets by Rs.11,000 in the form of either in cash or
debtors but no effect on the Current Liabilities.

Quick Assets after sale of goods = Rs.20,000 + Rs.11,000 = Rs.31,000

 GENERAL ACCOUNTING PRINCIPLES

Examples of Ratio Analysis Categories

The various kinds of financial ratios available may be broadly grouped into the following six silos, based
on the sets of data they provide:

1. Liquidity Ratios

Liquidity ratios measure a company's ability to pay off its short-term debts as they become due, using
the company's current or quick assets. Liquidity ratios include the current ratio, quick ratio, and working
capital ratio.

2. Solvency Ratios

Also called financial leverage ratios, solvency ratios compare a company's debt levels with its assets,
equity, and earnings, to evaluate the likelihood of a company staying afloat over the long haul, by paying
off its long-term debt as well as the interest on its debt. Examples of solvency ratios include: debt-equity
ratios, debt-assets ratios, and interest coverage ratios.

3. Profitability Ratios

These ratios convey how well a company can generate profits from its operations. Profit margin, return
on assets, return on equity, return on capital employed, and gross margin ratios are all examples
of profitability ratios.

4. Efficiency Ratios

Also called activity ratios, efficiency ratios evaluate how efficiently a company uses its assets and
liabilities to generate sales and maximize profits. Key efficiency ratios include: turnover ratio, inventory
turnover, and days' sales in inventory.

5. Coverage Ratios

Coverage ratios measure a company's ability to make the interest payments and other obligations
associated with its debts. Examples include the times interest earned ratio and the debt-service
coverage ratio.

6. Market Prospect Ratios

These are the most commonly used ratios in fundamental analysis. They include dividend yield, P/E
ratio, earnings per share (EPS), and dividend payout ratio. Investors use these metrics to predict
earnings and future performance.
KEY TAKEAWAYS
• Ratio analysis compares line-item data from a company's financial statements to reveal insights
regarding profitability, liquidity, operational efficiency, and solvency.

• Ratio analysis can mark how a company is performing over time, while comparing a company to
another within the same industry or
sector.

• While ratios offer useful insight into a

company, they should be paired with
other metrics, to obtain a broader
picture of a company's financial health.

Depreciation is for tangible items like machines,

etc and amortization is for loans.

Indirect Expenses = Operating Expenses + Non-

operating Expenses
= 2,10,000 + 1,90,000
= 4,00,000

Operating Cost = Operating Expenses + Cost of goods sold

= 2,10,000 + 10,50,000
= 12,60,000

Operating Profit = Gross Profit - Operating Expenses

= 8,50,000 - 2,10,000
= 6,40,000

Operating Profit = Net Sales - Cost of goods sold - Operating Expenses

= 19,00,000 - 10,50,000 - 2,10,000
= 6,40,000

Gross Margin and Operating Margin

The income statement contains information about company sales, expenses, and net income. It also
provides an overview of earnings and the number of shares outstanding used to calculate earnings per
share (EPS). These are some of the most popular data points analysts use to assess a company’s
profitability.

Gross profit as a percent of sales is referred to as gross margin. It is calculated by dividing gross profit by
sales. For example, if gross profit is $80,000 and sales are $100,000, the gross profit margin is 80%. The
higher the gross profit margin, the better, as it indicates that a company is keeping a higher proportion
of revenues as profit rather than expenses.

Operating profit as a percentage of sales is referred to as operating margin. It is calculated by dividing

operating profit by sales. For example, if the operating profit is $60,000 and sales are $100,000, the
operating profit margin is 60%.

Leverage ratio/Solvency Ratio: the long-term financial stability of the firm may be considered as
dependent upon its ability to meet all its liabilities, including those not currently payable.

Debt Equity ratio: the ratio indicates the relationship between loan funds and net worth of the
company, which is known as ‘gearing’ (business becomes risky in high gear). If the proportion of the
debt to equity is low, a company is said to be low-geared, and vice-versa.

Debt Equity Ratio = Long term Debt/shareholders funds

Assume a company has $100,000 of bank lines of credit and a $500,000 mortgage on its property. The
shareholders of the company have invested $1.2 million. Here is how you calculate the debt to equity
ratio.

D/E ratio = ($100,000 + $500,000)/ $ 12,00,000

= 0.5

Interpreting Gearing Ratios

A high gearing ratio typically indicates a high
degree of leverage, although this does not
always indicate a company is in poor financial
condition. Instead, a company with a high
gearing ratio has a riskier financing structure
than a company with a lower gearing ratio.

EBIT i.e. Earnings Before Interest, Tax and

Dividend

 GENERAL ACCOUNTING PRINCIPLES

A debt-equity ratio of 2:1 is the norm accepted by financial institutions for financing of projects. Higher
debt-equity ratio of 3:1 may be permitted for highly capital intensive industries like fertilizers, power
etc. the higher the gearing the more volatile the return to the shareholders.

Shareholders Equity Ratio: it represents the relationship between the shareholders funds and the total
assets. Shareholder’s funds represent both equity and preference capital plus reserves and surplus less
accumulated losses. It is assumed that larger the proportion of the shareholder’s equity, the stronger is
the financial position of the firm.

Shareholders Equity ratio = Shareholders Equity/Total Assets (tangible)

Total Assets = Equity share capital + Reserve & Surplus + Preferential Share Capital - Fictitious Assets
+ Loss/Debt + Current Liabilities

Shareholder Equity = Total Assets - Total Liabilities

A company’s total assets are reported at $150,000 and his total liabilities are $50,000. Based on the
accounting equation, we can assume the total equity is $100,000. calculate shareholder’s equity ratio.

Shareholders Equity ratio = $100,000/$150,000 = .67

Long term Debt to shareholders Net worth ratio: the ratio compares long-term debt to the net worth
of the firm i.e., the capital and free reserves less intangible assets. It gives a factual idea of the assets
available to meet the long-term liabilities.

Long term Debt/Shareholder’s Net Worth

Capital Gearing Ratio: it is the proportion of fixed interest bearing funds to equity shareholders funds:
the fixed interest bearing funds include debentures, long term loans and preference share capital.

The equity shareholders funds include equity share capital, reserves and surplus.

It indicates the vulnerability of earnings available for equity shareholders. It shows the firm is operating
on trade on equity.

Fixed interest bearing funds/equity shareholders fund

Fixed Assets to long-term funds ratio: the ratio indicates the proportion of long term funds deployed in
fixed assets. Fixed assets represent the gross fixed assets minus depreciation provided on this till the
date of calculation. The higher the ratio indicates the safer the funds available in case of liquidation.
Fixed Assets/Long term funds

Proprietary ratio: it expresses the relationship between shareholder’s net worth and total assets.

Proprietary ratio = Shareholders net Worth/total assets

Net Worth = Equity share capital + preference share capital + reserves – fictitious assets

Total assets = fixed assets + current assets – fictitious assets

A high proprietary ratio is indicative of a strong financial position of the business. The higher the ratio,
the better it is.

Interest Cover: it shows how many times interest charges are covered by funds that are available for
payment of interest.

Interest Cover = Profit before interest, depreciation and tax (EBIT)/interest

A very high ratio indicates that the firm is conservative in using debt and a very low ratio indicates
excessive use of debt.

Assets Management Ratio: measure how effectively the firm employs its resources. These ratios are
also called activity or turnover ratios which involve comparison between the level of sales and
investment in various accounts inventories, debtors, fixed assets, etc. assets management ratio are used
to measure the speed with which various accounts are converted into sales or cash.

Inventory Turnover Ratio: a considerable amount of a company’s capital may be tied up in the financing
of raw material, work-in-process and finished goods. It is important to ensure that the level of stocks is
kept as low as possible, consistent with the need to fulfill customers orders in time.

Cost of goods sold/average inventory

Average Inventory = (opening stock + closing stock)/2

the higher the stock turnover rate or the lower stock turnover period the better.
 • Eg. : Donny furniture company reported cost of goods sold on its income statement of
$1,000,000. Donny’s beginning inventory was $3,000,000 and its ending inventory was
$4,000,000. Donny’s turnover is calculated like this:

Inventory Turnover Ratio: $1,000,000/($3,000,000+ $4,000,000)/2 = 0.29.

Inventory ratio: the level of inventory in a company may be assessed by the inventory ratio, which
measures how much has been tied up in inventory.

Inventory ratio = Inventory/current Assets x 100

Debtors Turnover Ratio: which measures whether the amount of resources tied up in debtors is
reasonable and whether the company has been efficient in converting debtors into cash.

Debtors Turnover Ratio = Credit sales/average Debtors

The higher the ratio, the better the position.

Creditors Turnover ratio: the term creditors include trade creditors and bills payable.

Creditors Turnover ratio = Credit purchases/average creditors

Debtors/Creditors Collection period: average debtors collection period measures how long it takes to
collect amounts from debtors.

Debtors Collection period = Average debtors/credit sales x 365

Creditors Collection period = Average creditors/credit purchase x 365

Bad debts to sales ratio : this ratio indicates the efficiency of the credit control procedures of the
company. Its level will depend on the type of business.

Bad debts to sales ratio = Bad debts/sales x 100

Fixed Assets turnover ratio: the ratio of the accumulated depreciation provision to the total of fixed
assets at cost might be used as an indicator of the average age of the assets.

Fixed Assets turnover ratio = Sales/Fixed Assets

Profitability ratios:
The purpose of study and analysis of profitability ratios are to help assess the adequacy of profits earned
by the company and also to discover whether profitability is increasing or declining. The profitability of
the firm is the net result of a large number of policies and decisions.
Gross profit Margin: the gross profit represents the excess of sales proceeds during the period under
observation over their cost, before taking into account administration, selling and distribution and
financing charges. The ratio measures the efficiency of the company’s operation and compares with the
previous years.

Sales-Cost of Goods Sold/Sales x 100

Gross Margin and Operating Margin

The income statement contains information about company sales, expenses, and net income. It also
provides an overview of earnings and the number of shares outstanding used to calculate earnings per
share (EPS). These are some of the most popular data points analysts use to assess a company’s
profitability.

Gross profit as a percent of sales is referred to as gross margin. It is calculated by dividing gross profit by
sales. For example, if gross profit is $80,000 and sales are $100,000, the gross profit margin is 80%. The
higher the gross profit margin, the better, as it indicates that a company is keeping a higher proportion
of revenues as profit rather than expenses.

Operating profit as a percentage of sales is referred to as operating margin. It is calculated by dividing

operating profit by sales. For example, if the operating profit is $60,000 and sales are $100,000, the
operating profit margin is 60%.

Net Profit Margin: the ratio is designed to focus attention on the net profit margin arising from business
operations before interest and tax is deducted. This ratio reflects net profit margin on the total sales
after deducting all expenses but before deducting interest and taxation.

Net Profit Margin = Net profit before interest and tax/ Sales x 100

Cash profit Ratio: measures the cash generation in the business as a result of the operation expressed in
terms of sales.

Cash profit/Sales x 100, (cash profit = net profit + depreciation)

Return on total Assets: the profitability of the firm is measured by establishing relation of net profit
with the total assets of the organisation. This ratio indicates the efficiency of utilization of assets in
generating revenue. Disposable income is that income which is available for spending after paying taxes.

Net profit after tax/total assets x 100

Return on Equity: the ratio indicates measure of profitability, the efficiency in use of assets in achieving
sales and measure of leverage.

Net profit margin x total assets turnover ratio x total assets of net worth or
Net Income\Shareholders Equity

Return on Capital Employed: this ratio is also called as return on investment.

Return on Capital Employed = Net profit/capital employed

Return on net worth: the ratio expresses the net profit in terms of the equity shareholders funds. It
indicates the return on the funds employed by equity shareholders.

Net profit after interest and tax/ net worth x 100

Net worth = equity capital + reserve and surplus

Operating ratio: this ratio of all operating expenses to sales is the operating ratio.

Material cost ratio = material consumed/sales x 100

Labour cost ratio = labour cost/sales x 100

Factory overhead ratio = factory expenses/ sales x 100

Administrative expenses ratio = administrative expenses/ sales x 100

Operating ratio = cost of goods sold + operating expenses/net sales x 100

Market Based ratio: relates the firm’s stock price to its earning and book value per share. The ratio gives
management an indication of what investors think of the company’s past performance and future
prospects.

Earning per share: is one of the important measures of economic performance of a corporate entity.
The flow of capital to the companies under the present imperfect capital market conditions would be
made on the evaluation of EPS.

Net profit after tax and preference Dividend/ no. of Equity shares

Cash earning per share: net profit + depreciation/ no. of equity shares

Dividend payout ratio: indicates the extent of the net profits distributed to the shareholders as
dividend. A high payout signifies a liberal distribution policy and a low payout reflects conservative
distribution policy.

Dividend per share/Earning per share

Dividend Yield ratio: this ratio reflects the % yield that an investor receives on this investment at the
current market price of the shares. This measure is useful for investors who are interested in yield per
share rather than capital appreciation.
Dividend Per Share/Market price x 100

Price earning ratio: it measures the no. of times the earning per share discounts the market price of an
equity share.

Current market price of equity share/ earning per share

This ratio indicates how much an investor is prepared to pay per rupee of earnings. The ratio helps to
ascertain the value of equity share.