MEANING OF KEY TERMS USED IN THE CHAPTER

1. Ratio It is an arithmetical expression of relationship between two

interdependent or related items.

2. Accounting Ratio Accounting Ratio means ratio calculated on the basis of

accounting information.

3. Pure Ratio It is a ratio expressed as quotient. For example, 2 : 1.

4. Percentage It is a ratio expressed in percentage. For example, 25%.

5. Times It is a ratio expressed in number of times. For example, 3 Times.

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6. Fraction It is a ratio expressed as fraction. For example, or .75.
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7. Liquidity Ratios These ratios measure the ability of the enterprise to meet its
short-term financial commitments. These include: Current Ratio
and Quick Ratio/Liquid Ratio/Acid Test Ratio.

8. Solvency Ratios These ratios measure long-term financial position of the enterprise.
These include: Debt to Equity Ratio; Total Assets to Debt Ratio;
Proprietary Ratio and Interest Coverage Ratio.

9. Activity or Turnover Ratios These ratios measure efficiency in use of assets of the enterprise
in generating sales. These include: Inventory Turnover Ratio;
Trade Receivables Turnover Ratio; Trade Payables Turnover
Ratio, Working Capital Turnover Ratio.

10. Profitability Ratios These ratios show the profitability of the enterprise. These include:
Gross Profit Ratio; Operating Ratio; Operating Profit Ratio;
Net Profit Ratio and Return on Investment (ROI).

C H A P T E R S U M M A RY

• Accounting Ratio is a mathematical expression of the relationship between two related or interdependent
items or group of items shown in the financial statements.

• Ratio Analysis is the process of computing, determining and presenting the relationship of related or
interdependent items or group of items in the financial statements. It is an important technique of financial
analysis.

• Objectives of Ratio Analysis

1. To assess the earning capacity, financial soundness and operating efficiency of an enterprise.
2. To simplify the accounting information.
3. To help in comparative analysis.

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• Uses of Ratio Analysis: Ratio Analysis is useful in:
1. Analysis of financial statements.

2. Assessing the profitability of the business.

3. Assessing the liquidity or short-term solvency of the business.

4. Assessing the long-term solvency of the business.

5. Assessing the operating efficiency of the business.

6. Intra-firm and inter-firm comparison.

7. Locating the weak areas of the business.

• Limitations of Ratio Analysis

1. Qualitative Factors are Ignored: Ratio analysis is a technique of quantitative analysis and thus, ignores
qualitative factors, which may be important in decision-making.

2. Lack of Standard Ratio: There is almost no single standard ratio against which the actual ratio may be
measured and compared.

3. False Results if Based on Incorrect Information: Conclusions drawn may be misleading if ratios are based
on incorrect accounting information.

4. May not be Comparable: Ratios may not be comparable if different firms follow different accounting
policies and procedures.

• Classification of Accounting Ratios

1. Liquidity Ratios: (i) Current Ratio; and (ii) Quick Ratio.

2. Solvency Ratios: (i) Debt to Equity Ratio; (ii) Proprietary Ratio; (iii) Total Assets to Debt Ratio; and

(iv) Interest Coverage Ratio.

3. Activity Ratios: (i) Inventory Turnover Ratio; (ii) Trade Receivables Turnover Ratio; (iii) Trade Payables
Turnover Ratio; and (iv) Working Capital Turnover Ratio.

4. Profitability Ratios: (i) Gross Profit Ratio; (ii) Operating Ratio; (iii) Operating Profit Ratio; (iv) Net Profit
Ratio; and (v) Return on Investment.

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 Table Showing Summary of Accounting Ratios
Description of the Ratio Formula Significance How Expressed Remarks

I. LIQUIDITY RATIOS
1. Current Ratio Current Assets Current Assets = Current Investments + Inventories
This ratio shows short-term financial
Current Liabilities soundness of the business. Higher Pure Ratio (Excluding Stores and Spares and Loose
ratio means better capa­city to meet its Tools) + Trade Receivables (Net of
Provision for Doubtful Debts) + Cash and
current obligation.
Cash Equivalents + Short-term Loans
The ideal current ratio is 2 : 1. In case it is and Advances + Other Current Assets +
very high it shows the idleness of funds. Short-term Investments
Current Liabilities = Short-term Borrowings + Trade Payables
+ Other Current Liabilities + Short-term
Provisions.
2. Liquid Ratio/Acid Test Liquid Assets or Quick Assets Liquid Ratio is a fairly stringent measure Pure Ratio Quick Assets = Current Assets – Inventories – Prepaid Expenses
Ratio/Quick Ratio Current Liabilities of liquidity. It is based on those current Current Liabilities as per Current Ratio.
assets which are highly liquid, i.e., can be Note: Inventories and prepaid expenses are not considered as
converted into Cash and Cash Equiva-
Quick Assets.
lents quickly.
Quick Ratio of 1 : 1 is considered as
ideal. Higher the Quick Ratio better the

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short-term financial position.
II. SOLVENCY RATIOS
Debt
1. Debt to Equity Ratio Equity (Shareholders’ Funds) This ratio assesses the long-term Debt = Long-term Borrowings, (i.e., debentures, mortgage loans,
Pure Ratio
financial position and soundness of public deposits) + Long-term Provisions
enter­prises. In general, lower the Debt Equity (Shareholders’ Funds) = Share Capital + Reserves and Surplus
to Equity Ratio higher the degree of Or
protection enjoyed by the lenders. Non-current Assets (Property, Plant and Equipment + Intangible
Assets + Non-current (Trade) Investments + Long-term Loans and
Advances) + Working Capital – Non-current Liabilities (Long-term
Borrowings + Long-term Provisions).
Working Capital = Current Assets – Current Liabilities

2. Total Asset to Debt Ratio Total Assets This ratio measures the safety margin Pure Ratio, Total Assets = Non-current Assets (Property, Plant and Equipment
Debt available to lenders of long-term debts. e.g., 2 : 1 + Intangible Assets + Non-current Investments + Long-term
It measures the extent to which debt is Loans and Advances) + Current Assets [Current Investments +
being covered by assets. Inventories (including Stores and Spares and Loose Tools) + Trade
Receivables + Cash and Cash Equivalents + Short-term Loans and
Advances + Other Current Assets]
Debt = Long-term Borrowings + Long-term Provisions
 3. Proprietary Ratio Shareholders’ Funds or This ratio shows the extent to which total Fraction Shareholders’ Funds = Share Capital + Reserves and Surplus
Proprietors’ Funds or Equity assets have been financed by the propri- Shareholders’ Funds = Non-Current Assets + Working Capital
Total Assets etor. Higher the ratio, higher the safety – Non-Current Liabilities
margin for lenders and creditors. Total Assets as per Total Assets to Debt Ratio.

4. Interest Coverage Ratio Profit before Interest and Tax This ratio shows how many times the Times Profit before Interest and Tax = Profit after Tax + Tax + Interest
Interest on Long-term Debt interest charges are covered by the profits
available to pay interest. Higher the ratio,
more secure the lender is in respect of
payment of interest regularly.

III. ACTIVITY RATIOS/TURNOVER RATIOS

1. Inventory (Stock) Cost of Revenue from This ratio measures how fast Inventory Times Average Inventory or Stock =
Operations or is moving and generating sales. Higher
Turnover Ratio Cost of Goods Sold
the ratio, more efficient management of Opening Inventory or Stock + Closing Inventory or Stock
Average Inventory (Stock) 2
inventories and vice versa.

2. Trade Receivables or Debt- Credit Revenue from This ratio shows efficiency in the col- Times Trade Receivables means debtors plus bills receivable.
ors’ Turnover Ratio Operations lection of amount due from trade Provision for Doubtful Debts is not deducted.

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Average Trade Receivables receivables. Higher the ratio, better it is Average Trade Receivables =
since it indicates that debts are being Opening Trade Receivables + Closing Trade Receivables
collected more quickly. 2

3. Trade Payables or Creditors’ Net Credit Purchases It shows the number of times the creditors Times Trade Payables means creditors plus bills payable.
Turnover Ratio Average Trade Payables are turned over in relation to purchases.
Average Trade Payables =
A high turnover ratio or shorter payment
Opening Trade Payables + Closing Trade Payables
period shows the availability of less credit
2 .
or early payments.

4. Working Capital Turnover Revenue from Operations This ratio shows the number of times Times Working Capital = Current Assets – Current Liabilities
Ratio Working Capital working capital has been employed Current Assets = As per Current Ratio
in the process of carrying on business. Current Liabilities = As per Current Ratio.
Higher the ratio, better the efficiency in
the utilisation of working capital.
 IV. PROFITABILITY RATIOS
1. Gross Profit Ratio Gross Profit This ratio indicates the relationship % Gross Profit = Revenue from Operations – Cost of Revenue from Operations
 100
Revenue from Operations between gross profit and net sales. Cost of Revenue from Operations
Higher the Ratio, lower the cost of = Opening Inventory (excluding Stores and Spares and Loose Tools) + Net Purchases
Or goods sold. + Direct Expenses – Closing Inventory (excluding Stores and Spares and Loose
Tools) Or
Operating Cost Revenue from Operations – Gross Profits
 100 Or
Revenue from Operations
Cost of Materials Consumed + Purchases of Stock-in-Trade + Changes in Inventories
of Finished Goods, WIP and Stock-in-Trade + Direct Expenses.
If direct expenses are not given, assume them to be nil.
2. Operating Ratio Cost of Revenue from Operations This ratio is calculated to assess % Cost of Revenue from Operations
+ Operating Expenses the operational efficiency of the = Opening Inventory (excluding Stores and Spares and Loose Tools) + Net Purchases
× 100
Revenue from Operations business. A decline in the operating + Direct Expenses – Closing Inventory (excluding Stores and Spares and Loose
ratio, is better because it means Tools) Or
Or Revenue from Operations – Gross Profit
higher margin, and thus, more profit.
Operating Cost Or
 100
Revenue from Operations Cost of Revenue from Operations = Cost of Materials Consumed + Purchases of
Stock-in-Trade + Changes in Inventories of Finished Goods, WIP and Stock-in-Trade
+ Direct Expenses.
If Direct Expenses are not given, assume them to be nil.

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Operating Expenses = Employees Benefit Expenses + Depreciation and Amortisation
Expenses + Other Expenses (Other than Non-operating Expenses)
Revenue from Operations = Sales – Sales Return
3. Operating Profit Ratio Operating Profit The objective of computing this % Operating Profit
 100 = Net Profit (Before Tax) + Non-operating Expenses – Non-operating Income
Revenue from Operations ratio is to determine the operational
efficiency of management. Or
= Gross Profit + Other Operating Income – Other Operating Expenses
Non-operating Expenses = Interest on Long-term Borrowings + Loss on Sale of Fixed
Assets or Non-current Assets
Non-operating Income = Interest received on investments + Gain (Profit) on Sale of
Fixed Assets or Non-current Assets
4. Net Profit Ratio Profit after Tax It indicates overall efficiency of the % Profit after Tax
 100 business. Higher the net profit ratio,
Revenue from Operations = Gross Profit + Other Income – Indirect Expenses – Tax
better the business.
5. Return on Investment Profit before Interest, It assesses the overall performance % Capital Employed: Liabilities Approach: Share Capital + Reserves and Surplus
or Return on Capital Tax and Dividend of the enterprise. It measures, how + Long-term Borrowings + Long-term Provisions
 100 Assets Approach: Non-Current Assets (Tangible Assets + Intangible Assets)
Employed Capital Employed efficiently the resources entrusted to
the business are used. + Non-current Investments + Long-term Loans and Advances) + Working Capital.
Working Capital = Current Assets – Current Liabilities
(Assume that all Non-current Investments are Trade Investments)
Note: 1. Non-operating Assets do not form part of Capital Employed, e.g., Non-
Trade Investments, Capital Work-in-progress, etc.
2. Interest on Non-trade Investments should be deducted from Profit
before Interest, Tax and Dividend.