JHA COACHING CLASSES CLASS XIITH

ACCOUNTING RATIOS
Definition : Accounting Ratio is a study of mathematical relationship among the various financial
data/factors/components & information.
It is technique or tool for measuring performance of a business concern.

Objectives :
I. Estimation & computation of financial results & positions.
II. Determination of Solvency of the Concern.
III. Formulation of Policies.
IV. Judgement of managerial performance & profitability.
V. Intra & Inter firm comparison.

Advantages :
I. Simplification & analysis of Accounting data according to desired usage.
II. Useful in assessment of activities , profitability & solvency of the concern.
III. Helps in comparison (Inter & Intra) & suggests future line of action i.e. re-formulation of
business policies.

Disadvantages :
I. Lack of market standards (in many cases).
II. Window Dressing – Ratio may be affected with Window Dressing of data leading to ---- false
result or information.
III. Qualitative factors , Price – Level changes & very uncertain events leading to affect economic
condition are ignored & thus ratios are not realistic.

TYPES OF RATIOS

Functional classification

LIQUIDITY SOLVENCY RATIOS ACTIVITIY RATIO PROFITABILITY

RATIOS RATIO

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JHA COACHING CLASSES CLASS XIITH

1. LIQUIDITY RATIOS / SHORT TERM SOLVENCY

These are the ratios which shows the ability of the firm to meet its short term financial obligation.

i. CURRENT RATIO OR WORKING CAPITAL RATIO :

𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑨𝒔𝒔𝒆𝒕𝒔
 Current Ratio =
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒕𝒊𝒆𝒔

 Standard is 2:1 which is Ideal;

 Current Assets are Cash & Cash equivalents or any item which can be converted into Cash &
Cash equivalents within 12 months period.
 Current Assets include - Current Investments , Short term Investment & Marketable
Securities , Inventories (except Stores & Spares & Loose tools) , Trade Receivables (Net of
PBDD) , Cash & Cash equivalents , Short term Loans & Advances , Other Current Assets
(confined to Prepaid expenses , Accrued Incomes & Advance Tax) .
 Current Liabilities – They are payable within a period of 12 months.
 They include - Short Term Borrowings , Trade Payables (S/C + B/P) , Other Current
Liabilities (Current maturities of LT debts , Interest accrued & due or not due on
borrowings , Calls in Advance, O/S expenses & Unclaimed Dividend, etc.) , Short term
Provisions (PFT)
 WORKING CAPITAL :
Working Capital = Current Assets – Current Liabilities
 Effect of a transaction on Current Ratio --- Refer class discussion properly.

ii. LIQUID RATIO / QUICK RATIO / ACID TEST RATIO :

This ratio measures the ability of the concern to meet its short term financial obligation i.e. its
Current Liabilities but only through its Liquid / Quick Assets.
𝑳𝒊𝒒𝒖𝒊𝒅 𝒐𝒓 𝑸𝒖𝒊𝒄𝒌 𝑨𝒔𝒔𝒆𝒕𝒔
 Liquid Ratio =
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔

 Liquid Assets = Current Assets – Inventories – Prepaid Expenses.

 Ideal ratio is 1:1 .

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JHA COACHING CLASSES CLASS XIITH
2. SOLVENCY RATIO OR LONG-TERM SOLVENCY RATIO
These ratios show the ability of the concern to pay its Long Term Liabilities when they become due.
Following are the important Solvency Ratios :
i. Debt to Equity Ratio;
ii. Total Assets to Debt Ratio ;
iii. Proprietary Ratio ;
iv. Interest Coverage Ratio.

i. DEBT TO EQUITY RATIO :

It is the relationship between Long term external debts & internal equities.
𝑫𝒆𝒃𝒕 (𝑳𝒐𝒏𝒈 𝑻𝒆𝒓𝒎 𝑫𝒆𝒃𝒕𝒔)
 Debt to Equity Ratio =
𝑬𝒒𝒖𝒊𝒕𝒚 𝒐𝒓 𝑺𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓𝒔 𝑭𝒖𝒏𝒅

 Debt = Long Term Borrowing (Debentures + Public Deposit + Mortgage Loan) + Long Term
Provisions.
 Long Term Borrowing & Long Term Provisions should be payable after 12 months.
 Equity / Shareholders Fund
= Equity Share Capital + Preference Share Capital + Reserve & Surplus – Fictitious Assets –
Profit or Loss A/c Dr. Balance.
OR
= Total Assets (excluding Fictitious Assets) – Total Debts (External)
OR
= Non Current Assets + Working Capital – Non Current Liabilities
 Ideal Ratio is 2:1.

ii. TOTAL ASSETS TO DEBT RATIO :

This shows relationship between Total Assets and Long Term Debts of the organization.
It measures that to what extent lenders of the Long Term Debts are safeguarded by the assets of
the firm.
𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔
 Total Assets to Debt Ratio =
𝑳𝒐𝒏𝒈 𝑻𝒆𝒓𝒎 𝑫𝒆𝒃𝒕𝒔

 Total Assets = Non Current Assets + Current Assets.

 Ideal Ratio is 1:1.

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JHA COACHING CLASSES CLASS XIITH
iii. PROPRIETARY RATIO
It exhibits the relationship between Proprietors Fund and the Total Assets of the organization.
𝑺𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓𝒔 𝑭𝒖𝒏𝒅 𝒐𝒓 𝑷𝒓𝒐𝒑𝒓𝒊𝒆𝒕𝒐𝒓𝒔 𝑭𝒖𝒏𝒅 𝒐𝒓 𝑬𝒒𝒖𝒊𝒕𝒚
 Proprietary Ratio =
𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔

 Proprietary Ratio can be expressed as (i) Fractional Number or (ii) in terms of %.

 Proprietary Ratio in Fraction × 100 = Proprietary Ratio in % .
 If Balance Sheet is given then “ Equity” can be computed either by Liability Approach or by
Assets Approach , the answer will be same .
 But when Balance Sheet is not given , we should compute “Equity” by one method only
which is more clearly related to given information.

iv. INTEREST COVERAGE RATIO OR DEBT SERVICE RATIO :

𝑬𝑩𝑰𝑻 𝒐𝒓 𝑷𝑩𝑰𝑻
 Interest Coverage Ratio = = …times
𝑭𝒊𝒙𝒆𝒅 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑪𝒉𝒂𝒓𝒈𝒆𝒔 𝒊.𝒆(𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒐𝒏 𝑳𝒐𝒏𝒈 𝑻𝒆𝒓𝒎 𝑫𝒆𝒃𝒕)

 Earnings Before Interest & Tax (EBIT) = Profit After Tax (PAT) + Interest .
 This ratio indicates how many times Fixed Interest can be paid out of profit .
This ratio signifies Margin of Safety for Long Term Lenders of Debt. Higher the ratio , better
is Margin of Safety.
 6 to 7 times of this ratio is considered Ideal.

3. ACTIVITY / TURNOVER / EFFICIENCY / PERFORMANCE / SPEEDITY RATIO :

Activity Ratios indicate that how rapidly available resources of the firm (such as Receivables ,
Inventory , Working Capital , Fixed Assets , etc.) are used again & again to generate revenue from
operation.
They are mainly :
i. Inventory Turnover Ratio;
ii. Trade Receivable Turnover Ratio;
iii. Trade Payable Turnover Ratio;
iv. Working Capital Turnover Ratio.

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JHA COACHING CLASSES CLASS XIITH

i. INVENTORY TURNOVER RATIO OR STOCK TURNOVER RATIO :

It reflects the efficiency of Inventory Management . It shows that how many times the fund
invested in Inventory are used / rotated / repeated , i.e. goods are sold or revenue is generated
from operation .
 High ratio means more sale ;
 Very high ratio means overtrading ;
 Low ratio signifies over-investment in stock.
𝑪𝒐𝒔𝒕 𝒐𝒇 𝑹𝒆𝒗𝒆𝒏𝒖𝒆 𝒇𝒓𝒐𝒎 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒐𝒏 𝒐𝒓 𝑪𝒐𝒔𝒕 𝒐𝒇 𝑮𝒐𝒐𝒅𝒔 𝑺𝒐𝒍𝒅
 Inventory Turnover Ratio = =...Times
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚
𝑶𝒑𝒆𝒏𝒊𝒏𝒈 𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 𝑪𝒍𝒐𝒔𝒊𝒏𝒈 𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚
 Average Inventory =
𝟐

 Cost of Revenue from Operation or Cost Of Goods Sold (COGS)

= Revenue from Operation – Gross Profit
OR
Revenue from Operation + Gross Loss
OR
Opening Inventory + Net Purchase + Direct Expenses + Closing Inventory
[Here Inventory does not include Stores & Spares & Loose Tools]

 For a Manufacturing Concern :

Cost of Revenue from Operation or Cost Of Goods Sold (COGS)
= Cost of Material Consumed + Purchase of Stock in Trade + Change in Inventories of
Finished Goods, W.I.P. & Stock in Trade + Direct Expenses.
 If Opening Inventory > Closing Inventory (ADD IT)
 If Closing Inventory > Opening Inventory (DEDUCT IT)
 If Direct Expenses are not given , assume it NIL.
 Generally Gross Profit is a % on Revenue from Operation (i.e. Sales)
 When Revenue from Operation is given but Cost of Revenue from Operation can’t be
calculated due to lack of information then for calculating ratio , Revenue from Operation
is used.

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JHA COACHING CLASSES CLASS XIITH
 Average Age of Inventories / Inventory Holding Period :
𝟑𝟔𝟓 𝟏𝟐
Average Age of Inventories = or
𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝑹𝒂𝒕𝒊𝒐 𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝑹𝒂𝒕𝒊𝒐

= …… Days or No. of Months

ii. TRADE RECEIVABLE TURNOVER RATIO / DEBTOR’S TURNOVER RATIO :

This ratio indicates how speedily our Debtors & Bills Receivable are collected.
Higher the ratio , the better is debts collection management . No set standard can be laid down
because it varies on nature of Industry & Sales policy of Management .
𝑵𝒆𝒕 𝑪𝒓𝒆𝒅𝒊𝒕 𝑹𝒆𝒗𝒆𝒏𝒖𝒆 𝒇𝒓𝒐𝒎 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒐𝒏
 Trade Receivable Turnover Ratio = = ….Times
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑻𝒓𝒂𝒅𝒆 𝑹𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆
𝑶𝒑𝒆𝒏𝒊𝒏𝒈(𝑫𝒆𝒃𝒕𝒐𝒓𝒔 𝑩.𝑹) 𝑪𝒍𝒐𝒔𝒊𝒏𝒈(𝑫𝒆𝒃𝒕𝒐𝒓𝒔 𝑩.𝑹)
 Average Trade Receivable =
𝟐

 Net Credit Revenue from Operation = Credit Revenue from Operation – Sale Return .
OR
Net Credit Revenue from Operation = Revenue from Operation – Cash Revenue from
Operation.
 Debt Collection Period Or Average Collection Period :
𝟑𝟔𝟓
Debt Collection Period = = No. of Days.
𝑻𝒓𝒂𝒅𝒆 𝑹𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝑹𝒂𝒕𝒊𝒐
OR
𝟏𝟐
= = No. of Days.
𝑻𝒓𝒂𝒅𝒆 𝑹𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝑹𝒂𝒕𝒊𝒐

iii. TRADE PAYABLE TURNOVER RATIO / CREDITOR’S TURNOVER RATIO :

This ratio shows the credit period enjoyed by us from our creditors of goods.
Slow creditors velocity is favourable to the firm.
𝑵𝒆𝒕 𝑪𝒓𝒆𝒅𝒊𝒕 𝑷𝒖𝒓𝒄𝒉𝒂𝒔𝒆
 Trade Payable Turnover Ratio = = …. Times
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑻𝒓𝒂𝒅𝒆 𝑷𝒂𝒚𝒂𝒃𝒍𝒆𝒔
𝑶𝒑𝒆𝒏𝒊𝒏𝒈 (𝑺.𝑪 𝑩.𝑷) 𝑪𝒍𝒐𝒔𝒊𝒏𝒈 (𝑺.𝑪 𝑩.𝑷)
 Average Trade Payable =
𝟐

 Net Credit Purchase = Net Purchase – Cash Purchase

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JHA COACHING CLASSES CLASS XIITH
 Average Payment Period / Average Age of Payables
𝟑𝟔𝟓
Average Payment Period = = No. of days
𝐓𝐫𝐚𝐝𝐞 𝐏𝐚𝐲𝐚𝐛𝐥𝐞𝐬 𝐓𝐮𝐫𝐧𝐨𝐯𝐞𝐫 𝐑𝐚𝐭𝐢𝐨

OR

𝟏𝟐
= = No. of Months
𝐓𝐫𝐚𝐝𝐞 𝐏𝐚𝐲𝐚𝐛𝐥𝐞𝐬 𝐓𝐮𝐫𝐧𝐨𝐯𝐞𝐫 𝐑𝐚𝐭𝐢𝐨

iv. WORKING CAPITAL TURNOVER RATIO :

It signifies the number of times a unit of rupees invested in working capital (CA - CL) produces
revenue from operation.
𝐑𝐞𝐯𝐞𝐧𝐮𝐞 𝐟𝐫𝐨𝐦 𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐨𝐧
 Working Capital Turnover Ratio = = … Times.
𝐖𝐨𝐫𝐤𝐢𝐧𝐠 𝐂𝐚𝐩𝐢𝐭𝐚𝐥

 A high ratio means efficient application of Working Capital & a low ratio indicates improper
use of working capital.
 In absence of Revenue from Operation this ratio is calculated from Cost of Revenue from
Operation i.e. COGS

4. PROFITABILITY RATIOS OR INCOME RATIOS :

These ratios measures the efficiency or success of the business in terms of Profits in relation to
Capital Employed.
The important Profitability Ratios can be categorised as flows :
i. Gross Profit Ratio ;
ii. Operating Ratio ;
iii. Operating Profit Ratio ;
iv. Net Profit Ratio ;
v. Return on Investment.

 ALL THESE RATIOS ARE EXPRESSED IN TERMS OF PERCENTAGE (%)

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JHA COACHING CLASSES CLASS XIITH
i. GROSS PROFIT RATIO :
This ratio shows relationship between Gross profit & Net Revenue from Operation .
𝐆𝐫𝐨𝐬𝐬 𝐏𝐫𝐨𝐟𝐢𝐭
 Gross Profit Ratio = × 100
𝐑𝐞𝐯𝐞𝐧𝐮𝐞 𝐟𝐫𝐨𝐦 𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐨𝐧

 Gross Profit = Revenue from Operation – Cost of revenue from Operation.

 Cost of revenue from Operation = Opening Inventories + Net Purchase + Direct Expenses -
Closing Inventories .
[Here inventories do not include Spare Parts & Loose Tools]
OR
Cost of revenue from Operation or COGS = Revenue from Operation – Gross Profit .
OR
Cost of revenue from Operation or COGS = Revenue from Operation + Gross Loss .
 For a Manufacturing concern
Cost of revenue from Operation = Cost of Material Consumed + Purchase of “ Stock-in-
Trade” + Change in Inventories of Finished Goods , W.I.P.
& “Stock- in-Trade” + Direct Expenses.

ii. OPERATING RATIO / OPERATING COST RATIO

Operating Ratio shows the proportion of Cost of Revenue from Operation (COGS) & Operating
expenses to Revenue from Operation .
𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐂𝐨𝐬𝐭
 Operating Ratio = × 100
𝐑𝐞𝐯𝐞𝐧𝐮𝐞 𝐟𝐫𝐨𝐦 𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐨𝐧

 Operating Cost = Cost of Revenue from Operation + Operating Expenses – Operating

Income.
 Cost of Revenue from Operation – As discussed earlier .
 Operating Expenses = Employees Benefit Expenses + Office / Administrative / Selling &
Distribution Expenses + Depreciation & Amortisation + Discount Allowed + Bad Debts +
Interest on Short Term Loan.
 Operating Income. = Cash Discount Received + Trading Commission Received.
[Non Operating Expenses & Non Operating Incomes are ignored here ]

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JHA COACHING CLASSES CLASS XIITH
iii. OPERATING PROFIT RATIO :
This is a measure between Operating Profit & Revenue from Operation.
𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐏𝐫𝐨𝐟𝐢𝐭
 Operating Profit Ratio = × 100 .
𝐑𝐞𝐯𝐞𝐧𝐮𝐞 𝐟𝐫𝐨𝐦 𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐨𝐧

 Operating Profit = Net Profit before Tax + Non Operating Expenses – Non operating Income
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 + Loss by fire + Income tax + Charity & Donation etc.
 Non Operating Incomes = Interest / Dividend received on Investment + Profit on sale of
Fixed Assets or Non Current Assets .

 Relationship between Operating Profit Ratio & Operating Ratio

Both ratios are Complementary to each other .i.e.
Operating Profit Ratio (%) + Operating Ratio (%) = 100 % .
So , if one ratio is given , other will be calculated by deducting from 100 %.

iv. NET PROFIT RATIO :

This shows relationship between Net Profit & Revenue from Operation .
𝐍𝐞𝐭 𝐏𝐫𝐨𝐟𝐢𝐭 𝐚𝐟𝐭𝐞𝐫 𝐓𝐚𝐱
 Net Profit Ratio = × 100 .
𝐑𝐞𝐯𝐞𝐧𝐮𝐞 𝐟𝐫𝐨𝐦 𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐨𝐧

 Net Profit = Revenue from Operation – Cost of revenue from Operation – Operating
Expenses – Non Operating Expenses + Non Operating Income – Tax .
OR
Net Profit = Gross Profit – Indirect Expenses & Losses + Other Incomes – Tax .
 Indirect Expenses & Losses may include Office Expense , Selling & Distribution Expenses ,
Administrative Expenses , Interest on Long Term Borrowing & Loss by Fire etc.

v. RETURN ON CAPITAL EMPLOYED / RETURN ON INVESTMENT (ROI) :

ROI denotes relationship of PBIT with Capital Employed .
Here , Return means PBIT & Investment means Capital Employed.
𝐍𝐞𝐭 𝐏𝐫𝐨𝐟𝐢𝐭 𝐛𝐞𝐟𝐨𝐫𝐞 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 ,𝐓𝐚𝐱 & 𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅
 ROI = × 100 .
𝐂𝐚𝐩𝐢𝐭𝐚𝐥 𝐄𝐦𝐩𝐥𝐨𝐲𝐞𝐝

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JHA COACHING CLASSES CLASS XIITH
Capital Employed may be computed by any of the following two methods :-
 METHOD-I LIABILITIES APPROACH
Capital Employed = Shareholders Fund + Non Current Liabilities .
= [Equity Share Capital + Preference Share Capital + Reserve &
Surplus – Fictitious Assets – P/L Dr. Balance] + [Long Term
Borrowings + Long Term Provisions]

 METHOD-II ASSETS APPROACH

Capital Employed = Non Current Assets (Tangible + Intangible) + Non Current
Investments + Long Term Loans & Advances + Working Capital
 Assume that all Non Current Investments are Trade Investments .
 Interest on Non – Trade Investments should be deducted from Profit before Interest,
Tax & Dividend .

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