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CHAPTER 13: Accounting Ratios

Ratio is an arithmetical expression of relationship between two interdependent or related items. Ratios when calculated on the basis of accounting information are called accounting Ratios.

Objectives of Ratio Analysis

1. To simplify the accounting information
2. To assess the operating efficiency of the business.
3. To help in comparative analysis
4. To analyse the profitability of the business.

Advantages of Ratio Analysis

1. Useful for forecasting
2. Useful tool for analysis of financial statements.
3. Useful in locating the weak areas.

Types of Ratios

1. Liquidity Ratios: To meet its commitments, business needs liquid funds. The ability of the business to pay the amount due to stakeholders as and when it is due is known as liquidity, and the ratios calculated to measure it are known as ‘Liquidity Ratios’. These are essentially short-term in nature.
2. Solvency Ratios: Solvency of business is determined by its ability to meet its contractual obligations towards stakeholders, particularly towards external stakeholders, and the ratios calculated to measure solvency position are known as ‘Solvency Ratios’. These are essentially long-term in nature
3. Activity (or Turnover) Ratios: This refers to the ratios that are calculated for measuring the efficiency of operations of business based on effective utilisation of resources. Hence, these are also known as ‘Efficiency Ratios’.
4. Profitability Ratios: It refers to the analysis of profits in relation to revenue from operations or funds (or assets) employed in the business and the ratios calculated to meet this objective are known as ‘Profitability Ratios’.

 

Liquidity Ratios:

(a) Current Ratio

Current Ratio = Current Assets : Current Liabilities or Current Assets / Current Liabilities

Current assets include current investments, inventories, trade receivables (debtors and bills receivables), cash and cash equivalents, short-term loans and advances and other current assets such as prepaid expenses, advance tax and accrued income, etc.

Current liabilities include short-term borrowings, trade payables (creditors and bills payables), other current liabilities and short-term provisions.

Example 1:

From the following information, calculate current ratio.

Trade receivables (debtors)	1, 00,000	Bills payable	20,000
Prepaid Expenses	10,000	Sundry Creditors	40,000
Cash and cash equivalents	30,000	Debentures	2,00,000
Short term investments	20,000	Inventories	40,000
Machinery	7,000	Expenses Payable	40,000

Solution:

Current Ratio = Current Assets / Current Liabilities = 2, 00,000 / 1, 00,000 = 2 : 1
Current Assets = Trade Receivables (sundry Debtors) + prepaid Expenses + cash and cash Equivalents + short term Investments + inventories
= 1,00,000 + 10,000 + 30,000 + 20,000 + 40,000 = 2,00,000
Current Liabilities: trade payables (Bills Payable + sundry creditors) + expenses payable
= 20,000 + 40,000 + 40,000 = 1, 00,000

(b) Quick Ratio/Liquid Ratio

 It is the ratio of quick (or liquid) asset to current liabilities. It is expressed as Quick ratio = Quick Assets: Current Liabilities or Quick Assets / Current Liabilities

Example 2:

Calculate ‘Liquidity Ratio’ from the following information:

 Current liabilities = Rs. 50,000
 Current assets = Rs. 80,000
 Inventories = Rs. 20,000
 Advance tax = Rs. 5,000
 Prepaid expenses = Rs. 5,000

Solution:

Liquidity Ratio = Liquid Assets/Current Liabilities
Liquidity Assets = Current assets − (Inventories + Prepaid expenses + Advance tax)
= Rs. 80,000 − (Rs. 20,000 + Rs. 5,000 + Rs. 5,000) = Rs. 50,000
Liquidity Ratio = Rs. 50,000 / 50,000 = 1 : 1.

Example 3:

X Ltd., has a current ratio of 3.5 : 1 and quick ratio of 2 : 1. If excess of current assets over quick assets represented by inventories is Rs. 24,000, calculate current assets and current liabilities.

Solution:

Current Ratio = 3.5 : 1  Quick Ratio = 2 : 1
Let Current liabilities = x
Current assets = 3.5x and
Quick assets = 2x
Inventories = Current assets − Quick assets
24,000 = 3.5x − 2x
24,000 = 1.5x
Current Liabilities = Rs. 16,000
Current Assets = 3.5x = 3.5 × Rs. 16,000 = Rs. 56,000.

Verification:

Current Ratio = Current assets : Current liabilities
= Rs. 56,000 : Rs. 16,000
= 3.5: 1
Quick Ratio = Quick assets : Current liabilities
= Rs. 32,000 : Rs. 16,000 = 2 : 1

Solvency Ratios

(a) Debt-Equity Ratio: Debt-Equity Ratio measures the relationship between long-term debt and equity. If debt component of the total long-term funds employed is small, outsiders feel more secure.

Debt-Equity Ratio = Long term Debts / Shareholders' Funds

Where:

 Shareholders’ Funds (Equity) = Share capital + Reserves and Surplus + Money received against share warrants
 Share Capital = Equity share capital + Preference share capital

Or

 Shareholders’ Funds (Equity) = Non-current assets + Working capital − Non-current liabilities Working Capital = Current Assets − Current Liabilities

 

Example 4:

From the following information calculate Debt equity Ratio:-

Share capital:	10,000 shares of 10 each	1,00,000 debentures	75,000
General Reserve	45000	Long term provision	25,000
Surplus	30,000	Outstanding Expenses	10,000

Solution:

Debt to equity ratio = Debt / Equity (shareholder funds) = 1,00,000 / 1,75,000 = 0.57 : 1
Debt = Debentures + Long term provisions = 75,000 + 25,000 = 1,00,000
Equity = Share Capital + General Reserve + Surplus = 1,00,000 + 45,000 + 30,000 = 1,75,000

(b) Total Assets to Debt Ratio This ratio measures the extent of the coverage of long-term debts by assets

Total assets to Debt Ratio = Total assets/Long-term debts

Example 5:

Shareholders’ funds Rs. 1,40,000
Total Debts (Liabilities) Rs. 18,00,000
Current Liabilities = Rs. 2,00,000.

Calculate total assets to debt ratio.

Solution:

Total Assets to debt ratio = Total Assets / Long term Debts
= 32,00,000 / 16,00,000 = 2 : 1
Long term debts = total debts (Liabilities) − Current Liabilities
= 18,00,000 − 2,00,000 = 16,00,000
Total assets = shareholder funds + total debts (liabilities)

(c) Proprietary Ratio: Proprietary ratio expresses relationship of proprietor’s (shareholders) funds to net assets and is calculated as follows:

Proprietary Ratio = Shareholders, Funds / Capital employed (or net assets)

Significance: Higher proportion of shareholders’ funds in financing the assets is a positive feature as it provides security to creditors. This ratio can also be computed in relation to total assets instead of net assets (capital employed)

(d) Interest Coverage Ratio: It is a ratio which deals with the servicing of interest on loan. It is a measure of security of interest payable on long-term debts. It expresses the relationship between profits available for payment of interest and the amount of interest payable.

It is calculated as follows:

Interest Coverage Ratio = Net Profit before Interest and Tax / Interest on long-term debts

Significance: It reveals the number of times interest on long-term debts is covered by the profits available for interest. A higher ratio ensures safety of interest on debts.

 

Example 6:

From the following details, calculate interest coverage ratio:

Net Profit after tax Rs. 60,000; 15% Long-term debt 10,00,000; and Tax rate 40%.

Solution:

Net Profit after Tax = Rs. 60,000
Tax Rate = 40%
Net Profit before tax = Net profit after tax × 100/ (100 − Tax rate)
= Rs. 60,000 × 100/(100 − 40)
= Rs. 1,00,000
Interest on Long-term Debt = 15% of Rs. 10,00,000 = Rs. 1,50,000
Net profit before interest and tax = Net profit before tax + Interest
= Rs. 1,00,000 + Rs. 1,50,000 = Rs. 2,50,000
Interest Coverage Ratio = Net Profit before Interest and Tax/Interest on long-term debt
= Rs. 2,50,000/Rs. 1,50,000
= 1.67 times

Activity (or Turnover) Ratio

These ratios indicate the speed at which, activities of the business are being performed. The activity ratios express the number of times assets employed. Higher turnover ratio means better utilisation of assets and signifies improved efficiency and profitability, and as such is known as efficiency ratios.

(a) Inventory Turnover Ratio: It determines the number of times inventory is converted into revenue from operations during the accounting period under consideration. It expresses the relationship between the cost of revenue from operations and average inventory

The formula for its calculation is as follows:

Inventory Turnover Ratio = Cost of Revenue from Operations / Average Inventory

Example 7:

From the following information, calculate inventory turnover ratio:

 Inventory in the beginning = 18,000
 Inventory at the end = 22,000
 Net purchases = 46,000
 Wages = 14,000
 Revenue from operations = 80,000
 Carriage inwards = 4,000

Solution:

Inventory Turnover Ratio = Cost of Revenue from Operations / Average Inventory
Cost of Revenue from Operations = Inventory in the beginning + Net Purchases + Wages + Carriage inwards − Inventory at the end
= Rs. 18,000 + Rs. 46,000 + Rs. 14,000 + Rs. 4,000 − Rs. 22,000 = Rs. 60,000
Average Inventory = Inventory in the beginning + Inventory at the end / 2
= Rs. 18,000 + Rs. 22,000/ 2 = Rs. 20,000
∴ Inventory Turnover Ratio = Rs. 60,000/ Rs. 20,000 = 3 Times

(b) Trade Receivables Turnover Ratio: It expresses the relationship between credit revenue from operations and trade receivable. It is calculated as follows:

Trade Receivable Turnover ratio = Net Credit Revenue from Operations / Average Trade Receivable

Where Average Trade Receivable = (Opening Debtors and Bills Receivable + Closing Debtors and Bills Receivable)/2

Example 8:

Calculate the Trade receivables turnover ratio from the following information:

 Total Revenue from operations 4,00,000
 Cash Revenue from operations 20% of Total Revenue from operations
 Trade receivables as at 1.4.2014 40,000
 Trade receivables as at 31.3.2015 1,20,000

Solution:

Trade Receivables Turnover Ratio = Net Credit Revenue from Operations / Average Trade Receivables
Credit Revenue from operations = Total revenue from operations − Cash revenue from operations
Cash Revenue from operations = 20% of Rs. 4,00,000
= Rs. 4,00,000 × 20 / 100 = Rs. 80,000
Credit Revenue from operations = Rs. 4,00,000 − Rs. 80,000 = Rs. 3,20,000
Average Trade Receivables = Opening Trade Receivables + Closing Trade Receivables / 2
= Rs. 40,000 + Rs. 1,20,000 / 2 = Rs. 80,000
= Net Credit Revenue Form Operations / Average Inventory
= Rs. 3,20,000 / Rs. 80,000 = 4 times.

(c) Trade Payable Turnover Ratio: Trade payables turnover ratio indicates the pattern of payment of trade payable. As trade payable arise on account of credit purchases, it expresses relationship between credit purchases and trade payable.

It is calculated as follows:

 Trade Payables Turnover ratio = Net Credit purchases / Average trade payable
 Where,
  Average Trade Payable = (Opening Creditors and Bills Payable + Closing Creditors and Bills Payable)/2
  Average Payment Period = No. of days/month in a year ÷Trade Payables Turnover Ratio

Example 9:

Calculate the Trade payables turnover ratio from the following figures:

 Credit purchases during 2014-15 = 12,00,000
 Creditors on 1.4.2014 = 3,00,000
 Bills Payables on 1.4.2014 = 1,00,000
 Creditors on 31.3.2015 = 1,30,000
 Bills Payables on 31.3.2015 = 70,000

Solution:

Trade Payables Turnover Ratio = Net Credit Purchases / Average Trade Payables
Average Trade Payables = Creditors in the beginning + Bills payables in the beginning + Creditors at the end + Bills payables at the end / 2
= Rs. 3,00,000 + Rs. 1,00,000 + Rs. 1,30,000 + Rs. 70,000 2 = Rs. 3,00,000
∴ Trade Payables Turnover Ratio = Rs. 12,00,000 / Rs. 3,00,000 = 4 times

Example 10:

From the following information, calculate –

1. Trade receivables turnover ratio
2. Average collection period
3. Trade payable turnover ratio

Given:

Revenue from Operations	8,75,000
Creditors	90,000
Bills receivable	48,000
Bills payable	2,000
Purchases	4,20,000
Trade debtors	59,000

Solution:

1. Trade Receivables Turnover Ratio = Net Credit Revenue from operation / Average Trade Receivable
   = Rs. 8, 75,000 / (Rs. 59,000 + Rs. 48,000) = 8.18 times
2. Average Collection Period = 365 / Trade Receivables Turnover Ratio = 365 / 8.18 = 45 days
3. Trade Payable Turnover Ratio = Purchases / Average Trade Payables
   = Purchases / Creditors + Bills payable
   = 4,20,000 / 90,000 + 52,000
   = 4,20,000 / 1,42,000 = 2.96 times

(d) Working Capital Turnover Ratio: It reflects relationship between revenue from operations and net assets (capital employed) in the business.

Working capital turnover ratio = Net Revenue from Operation / Working Capital

Profitability Ratios

Profitability ratios are calculated to analyse the earning capacity of the business which is the outcome of utilisation of resources employed in the business. There is a close relationship between the profit and the efficiency with which the resources employed in the business are utilised.

(a) Gross Profit Ratio: Gross profit ratio as a percentage of revenue from operations is computed to have an idea about gross margin. It is computed as follows:

Gross Profit Ratio = Gross Profit / Net Revenue of Operations × 100

Example 11:

Following information is available for the year 2014-15, calculate gross profit ratio:

Revenue from Operations: Cash	25,000
Credit	75,000
Purchases: Cash	15,000
Credit	60,000
Carriage Inwards	2,000
Salaries	25,000
Decrease in Inventory	10,000
Return Outwards	2,000
Wages	5,000

Solution:

Revenue from Operations = Cash Revenue from Operations + Credit Revenue from Operation
= Rs.25, 000 + Rs.75, 000 = Rs. 1,00,000
Net Purchases = Cash Purchases + Credit Purchases − Return Outwards
 = Rs. 15,000 + Rs. 60,000 − Rs. 2,000 = Rs. 73,000
Cost of Revenue from = Purchases + (Opening Inventory − Closing Inventory) + operations Direct Expenses
= Purchases + Decrease in inventory + Direct Expenses
= Rs. 73,000 + Rs. 10,000 + (Rs. 2,000 + Rs. 5,000)
= Rs. 90,000
Gross Profit = Revenue from Operations − Cost of Revenue from Operation
= Rs. 1,00,000 − Rs. 90,000 = Rs. 10,000
Gross Profit Ratio = Gross Profit/Net Revenue from Operations × 100
= Rs.10,000/Rs.1,00,000 × 100 = 10%.

(b) Operating Ratio: It is computed to analyse cost of operation in relation to revenue from operations.

It is calculated as follows:

Operating Ratio = (Cost of Revenue from Operations + Operating Expenses)/ Net Revenue from Operations × 100

(c) Operating Profit Ratio: It is calculated to reveal operating margin. It may be computed directly or as a residual of operating ratio. It is calculated as under:

Operating Profit Ratio = Operating Profit/ Revenue from Operations × 100

Where,

Operating Profit = Revenue from Operations − Operating Cost

Example 12:

Given the following information:

Revenue from Operations	3,40,000
Cost of Revenue from Operations	1,20,000
Selling expenses	80,000
Administrative Expenses	40,000

Calculate Gross profit ratio and Operating ratio.

Solution:

Gross Profit = Revenue from Operations − Cost of Revenue from Operations
= Rs. 3,40,000 − Rs. 1,20,000
= Rs. 2,20,000
Gross Profit Ratio = Gross Profit / Revenue from operation × 100
= Rs. 2,20,000 / Rs. 3,40,000 × 100 = 64.71%
Operating Cost = Cost of Revenue from Operations + Selling Expenses + Administrative Expenses
= Rs. 1,20,000 + 80,000 + 40,000 = Rs. 2,40,000
Operating Ratio = Operating Cost / Net Revenue from Operations × 100
= Rs. 2,40,000 / Rs. 3,40,000 x 100 = 70.59%

(d) Net Profit Ratio: It relates revenue from operations to net profit after operational as well as non-operational expenses and incomes.

It is calculated as under:

Net Profit Ratio = Net profit / Revenue from Operations × 100

(e) Return on Capital Employed or Investment: Capital employed means the long-term funds employed in the business and includes shareholders’ funds, debentures and long-term loans.

Capital employed may be taken as the total of non-current assets and working capital. Profit refers to the Profit before Interest and Tax (PBIT) for computation of this ratio.

Thus, it is computed as follows:

Return on Investment (or Capital Employed) = Profit before Interest and Tax / Capital Employed × 100