CHAPTER 5 (BOOK II)
ACCOUNTING RATIOS
Ratio analysis is an important tool of financial statement analysis. A ratio is a relationship of two or more
numbers and can be expressed as a fraction, proportion, percentage and a number of times.
➢ Objectives of Ratio Analysis
1. To know the areas of the business which need more attention
2. To provide a deeper analysis of the profitability, liquidity, solvency and efficiency levels in the business
➢ Advantages of Ratio Analysis
1.It helps the business in identifying the problem areas as well as the bright areas of business.
2. It enables the firm to do its own SWOC analysis (Strength, Weakness, Opportunity and Challenges).
➢ Limitations of Ratio Analysis
1. Lack of ability to resolve problems.
2. Lack of universally accepted standard levels.
➢ Types of Ratio
1. Liquidity Ratios
2. Solvency Ratios
3. Activity Ratios
4. Profitability Ratios
1) LIQUIDITY RATIO :- It refers to the ratio calculated to measure the short term solvency of the
business.
Types of Liquidity Ratio:-
There are two types of Liquidity ratio
i) Current Ratio
ii) Quick Ratio
i) Current Ratio:- It is the proportion of current assets to current liabilities
Current Ratio = Current Assets
Current Liabilities
Current assets includes stock, debtors, bills receivable, cash and cash equivalents, current investments, short
term loans and advances and outstanding income.
ii) Quick Ratio: It is also called as liquid ratio. It is the ratio of quick assets to current liabilities.
Quick ratio = Quick Assets
Current Liabilities
Quick Assets= Current assets – Inventories – Prepaid expenses – Advance tax paid.
2) SOLVENCY RATIO :- are the ratios calculated to determine the ability of the business to repay its debts
in the long run.
Types of Solvency Ratio:
i) Debt Equity Ratio
ii) Proprietary Ratio
iii) Debt to Capital Employed Ratio
iv) Interest Coverage Ratio
i) Debt Equity Ratio: It is a ratio which measures the relationship between long term debt and equity.
Debt Equity Ratio = Long term debts
Shareholders fund
Long term debts= Debentures + Long term borrowings
Shareholders’ funds (equity) = Equity share capital + Preference Share Capital + Reserves & Surplus
OR
Shareholders’ funds= Non current assets + Current assets – Non current Liabilities– Current Liabilities.
ii) Proprietary Ratio: It refers to the ratio which measures the relationship between shareholders fund and
capital employed
Proprietary Ratio= Shareholders fund
Capital Employed
Capital Employed= Shareholders fund + Long term borrowings
OR
= Non current assets + Current assets – Current liabilities.
iii) Debt to Capital Employed Ratio:- It is a ratio which measures the relationship between long term debt
and capital employed.
Debt to Capital Employed Ratio= Long term debts
Capital Employed
iv) Interest Coverage Ratio:- It is a ratio which measures the relationship of interest on long term debt over
net profit before interest and tax.
Interest Coverage Ratio= Net Profit before interest and tax
Interest on long term debt
3) ACTIVITY RATIO/ TURNOVER RATIO:- These ratios indicate the speed at which the activities of
the business are being performed. They express the number of time assets employed, is turned into sales
during an accounting period.
Types of Activity Ratio
i) Inventory Turnover
ii) Trade receivable Turnover
iii) Trade payable Turnover
iv) Net assets Turnover
v) Fixed assets Turnover
vi) Working capital Turnover
i) Inventory Turnover Ratio:- It is also known as stock turnover ratio.
Inventory Turnover Ratio= Cost of Revenue from operations
Average Inventory
Cost of Revenue from operations= Revenue from operations – Gross Profit
OR
Cost of Revenue from operations= Opening Stock + Purchases(-Returns) + Direct Expenses – Closing Stock
Average Inventory= Opening stock + Closing stock / 2
Note:- If only opening stock is given in the question, then opening stock should be considered as average
inventory or vice versa.
ii) Trade Receivables Turnover Ratio:-
Trade Receivables Turnover Ratio= Net Credit Revenue from Operations
Average Trade Receivable
Average Trade Receivable = (Opening Debtors and Bills Receivable + Closing Debtors and Bills Receivable) / 2
Note:- 1) Net Credit Revenue from operations means Credit sales
2) If only opening trade receivables is given in the question, then opening trade receivable should be
considered as average trade receivable or vice versa.
iii) Trade Payable Turnover Ratio:-
Trade Payables Turnover ratio = Net Credit purchases
Average trade payable
Average Trade Payable= (Opening Creditors and Bills Payable + Closing Creditors and Bills Payable)/2
Note:- If only opening trade payable is given in the question, then opening trade payable should be
considered as average trade payable or vice versa.
iv) Net Assets Turnover Ratio:- It is also known as capital employed or investment turnover ratio.
Net Assets Turnover ratio = Revenue from Operations
Net Assets
OR
= Revenue from Operations
Capital Employed
v) Fixed Assets Turnover Ratio:-
Fixed assets turnover Ratio = Net Revenue from Operations
Net Fixed Assets
vi) Working Capital Turnover Ratio:-
Working Capital Turnover Ratio = Net Revenue from Operations
Working Capital
4) Profitability Ratio:- These ratios are calculated to analyze the earning capacity of the business.
These ratios include
i) Gross Profit Ratio:-
Gross Profit Ratio = Gross Profit x 100
Net Revenue from operations
Gross Profit= Revenue from operations – Cost of Revenue from operation
ii) Operating Ratio:-
Operating Ratio= Operating Cost x 100
Net Revenue from Operations
OR
= Cost of Revenue from Operations + Operating Expenses X 100
Net Revenue from Operations
iii) Operating Profit Ratio:-
Operating Profit Ratio= Operating Profit x 100
Revenue from operations
Operating Profit= Revenue from operation- Operating Cost
iv) Net Profit Ratio:-
Net Profit Ratio= Net Profit x 100
Revenue from operations
Note: Net profit means profit after tax
v) Return on capital employed Ratio:-
Return on capital employed = Profit before interest and tax x 100
Capital employed
vi) Return on Shareholders fund:-
Return on Shareholders fund = Profit before tax x 100
Share holders fund
vii) Earnings per share:-
Earnings per share = Profit available to equity shareholders
Number of equity share
Profit available to equity shareholders = profit after tax – dividend on preference share
viii) Book value per share:-
Book value per share = Equity shareholders fund
Number of equity shares
ix) Dividend payment Ratio:-
Dividend payment Ratio = Dividend per share
Earnings per share
Dividend per share = Amount of dividend
No of equity share
x) Price or Earnings Ratio :-
Price or Earnings Ratio = Market price of a share
Earnings per share
