ACCOUNTANCY

Chapter 10: Accounting Ratios

ACCOUNTANCY ACCOUNTING RATIOS
FINANCIAL STATEMENTS OF THE COMPANY

ACCOUNTING RATIOS
Introduction to Accounting Ratio and Ratio Analysis

Meaning of Ratio, Accounting Ratio and Understanding Ratio Analysis:

● Meaning of Ratio: It is an arithmetical expression of relationship between two interdependent or
related items.

Meaning of Accounting Ratio:

i. It is a ratio which is calculated on the basis of accounting information.
ii. It can be expressed as an arithmetical relationship between two accounting variables.
iii. It is a relationship that exists between figures shown in a Balance Sheet, Statement of
Profit and Loss or any other statements or reports prepared by the organisation.

● Forms of Expressing Ratios: Following are the various forms of expressing the accounting
ratio:
i. Pure: As per this form, ratio is expressed as a quotient.
ii. Percentage: As per this form, ratio is expressed as a percentage.
iii. Times: As per this form, ratio is expressed in number of times a particular figure is when
compared to another figure.
iv. Fraction: As per this form, ratio is expressed in fraction.

● Meaning of Ratio Analysis:

i. It is a study of relationship among various financial factors in a business.
ii. It is a technique of analysing the financial statements with the help of accounting ratio.
iii. It is a process of determining and interpreting relationships between items of financial
statements to provide a meaningful understanding of the financial performance and
position of an enterprise.

● Objectives of Ratio Analysis:

i. It simplifies understanding of financial information presented in the financial statement.
ii. It helps in determining short-term and long-term solvency of the business.
iii. It helps in assessing the operating efficiency of the business.
iv. It analyses profitability of the business.
v. It helps in comparative analysis which can be either intra-firm or inter firm comparisons.
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FINANCIAL STATEMENTS OF THE COMPANY

● Advantages of Ratio Analysis:

i. Tool for analysis of Financial Statements: It helps the users of financial statements to
analyse the financial position of an enterprise. Such users can be bankers, investors,
creditors, etc. who are concerned about the performance of an enterprise.
ii. Simplifies Accounting Data: It simplifies understanding of accounting information
presented in the financial statement. Calculation of ratios summarises briefly the results
of detailed and complicated information.
iii. Assessment of Operating Efficiency of Business: Operating efficiency can be determined
by assessing and evaluating liquidity, solvency and profitability of an enterprise.
Calculation of ratios helps in determining and evaluating such aspects
iv. Assists in Forecasting: Calculation, analysis and comparison of ratios helps in business
planning and forecasting. This is because the trend of ratios being calculated acts as a guide
for future planning.
v. Identifies Weak Areas: Calculation and analysis of various ratios help to identify and
interpret the favourable and unfavourable ratios which can are used to identify the weak
areas or unfavourable factors in the enterprise. Enterprise can then work upon such areas
or factors to improve the performance.
vi. Facilitates Inter-firm and Intra-firm Comparison: When a firm compares its performance
with that of other firms or with its industry standards in general, it is known as Inter-firm
Comparison or Cross Sectional Analysis. On the other hand, if the performance of different
units is belonging to the same firm is to be compared, it is known as Intra-firm Comparison.
Accounting ratios are widely used for such comparisons.

● Limitations of Ratio Analysis:

i. Reliability of Ratios: Since, ratios are calculated based on the financial information, if the
information available is not correct ratios calculated using such information will also be
incorrect. Therefore, such ratios are not completely reliable to make any future decisions
for an enterprise.
ii. Only Quantitative Factors considered: Calculation of ratios takes into consideration only
quantitative factors and all the related qualitative factors are ignored, which may be
important for future decision making of an enterprise.
iii. No Standard Ratio: In order to determine whether a ratio is favourable or adverse, there
should be a standard with which the ratio can be compared. However, there is no single
standard against which the ratio can be compared.
iv. Non Comparable: It is possible that different firms belonging to the same industry may
follow different policies and procedures for the purpose of accounting. The amounts
computed using such different policies and procedures will also be different. Therefore,
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FINANCIAL STATEMENTS OF THE COMPANY
ratios calculated by such firms will not be comparable as the information used in
calculating such ratios by the different firms is not the same.
v. Price Level Changes Ignored: It is necessary to understand that comparability of the ratios
depends upon the change in the price levels. However, such change in price levels is not
considered in accounting variables from which ratios are computed.
vi. Window Dressing: If the accounts are manipulated in order to window dress the financial
performance and position of the business, the information available for computing ratios
will not be accurate. This will lead to incorrect ratios being computed which in turn will
affect the decisions taken based on analysis of such incorrect ratios.
vii. Personal Bias: Since, preparation of financial statements is highly influenced by personal
judgments, accounting ratios computed based on such information is also not free from
such limitation.

● Types of Ratios: Ratios are classified based on following aspects:

i. Liquidity (short-term solvency): These are the ratios which show the ability of the
enterprise to meet its short-term financial obligations. It includes:
a. Current Ratio
b. Quick Ratio
ii. Solvency (long-term solvency): These are the ratios which assess the long-term financial
position of the enterprise. They assess the ability to meet the long-term financial
obligations of the enterprise. It includes:
a. Debt to Equity Ratio
b. Total Assets to Debt Ratio
c. Proprietary Ratio
d. Interest Coverage Ratio
iii. Activity/Turnover: These are the ratios which show how efficiently the enterprise
resources are being used for the business operations. It includes:
a. Inventory Turnover Ratio
b. Trade Receivables Turnover Ratio
c. Trade Payables Turnover Ratio
d. Working Capital Turnover Ratio
iv. Profitability: These ratios show the profitability of the enterprise. It includes:
a. Gross Profit Ratio
b. Operating Ratio
c. Operating Profit Ratio
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d. Net Profit Ratio
e. Return on Investment

Liquidity (Short-term Solvency) Ratios

Meaning and Computation of Current Ratio:

● Understanding Current Ratio:

a. It is a ratio which calculates the relationship between the current assets and current
liabilities.
b. It is a liquidity ratio that measures the ability of the enterprise to pay its short-term
financial obligations i.e., current liabilities.
c. It helps to identify whether the enterprise will be able to meet its short-term financial
obligations when they become due for payment.
d. It is expressed as a pure ratio.
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
e. Formula: 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑅𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
f. Ideal Ratio: 2 : 1. High Current Ratio means better liquidity but too high current ratio means
poor operational efficiency.

● Understanding Current Assets, Current Liabilities, Operating Cycle and Working Capital in
computing current ratio:
a. Current Assets: These are the assets that are either in the form of Cash and Cash
Equivalents or can be converted into Cash and Cash Equivalents within 12 months from
the date of Balance Sheet or within the period of operating cycle. It includes the following
items:
• Short-term loans and advances,
• Current Investments,
• Inventories (excluding Loose Tools and Stores and Spares),
• Trade Receivables (bills receivable and sundry debtors less provision for doubtful
debts),
• Cash and Cash Equivalents (cash in hand, cash at bank, cheques/drafts in hand, etc.)
• Other Current Assets (prepaid expenses, interest receivable, etc.)

b. Current Liabilities: These are the liabilities that are repayable within 12 months from the
date of Balance Sheet or within the period of operating cycle. It includes the following
items:
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FINANCIAL STATEMENTS OF THE COMPANY
• Short-term borrowings,
• Short-term provisions,
• Trade Payables (bills payable and sundry creditors),
• Other Current Liabilities (current maturities of long term debts, interest accrued but
not due, interest accrued and due, outstanding expenses, unclaimed dividend, calls-in-
advance, etc.)
c. Operating Cycle: It is the time between the acquisition of assets for processing and their
realisation into Cash and Cash Equivalents. In case the normal operating cycle cannot be
identified, it is assumed to be a period of 12 months.
d. Working Capital: Where working capital is given, value of current assets and current
liabilities can be ascertained using the given current ratio. Working Capital is the excess of
Current Assets over Current Liabilities which is expressed as follows:
Working Capital= Current Assets - Current Liabilities; Or
Current Assets = Working Capital + Current Liabilities ; Or
Current Liabilities = Current Assets - Working Capital
● Steps to be taken to determine the effect of a transaction on Current Ratio:
Step 1: Amounts of Current Assets and Current Liabilities are to be assumed.
Step 2: Consider the effects of a transaction and put it in the assumed amounts of Current
Assets and Current Liabilities. After accommodating such effect in the assumed amounts, new
amounts of Current Assets and Current Liabilities are to be calculated.
Step 3: Using these new amounts new ratio is to be calculated. Such new/revised ratio is to
be compared with old ratio to determine its effect on the Current Ratio, i.e., increase,
decrease or no change in the ratio.

Meaning and Computation of Quick or Acid Test Ratio:

● Understanding Liquid or Quick or Acid Test Ratio:
a. It is a liquidity ratio which measures the ability of the enterprise to meet its short-term
financial obligations, i.e., Current Liabilities.
b. It is a relationship of liquid assets with current liabilities.
c. It is an indicator of short-term debt paying capacity of an enterprise and is therefore, a
better indicator of liquidity.
d. A high Liquid Ratio compared to Current Ratio may indicate understocking while a low
Liquid Ratio indicates overstocking.
e. It is expressed as a pure ratio.
f. Formula:
ACCOUNTANCY ACCOUNTING RATIOS
FINANCIAL STATEMENTS OF THE COMPANY
𝐿𝑖𝑞𝑢𝑖𝑑 𝑜𝑟 𝑄𝑢𝑖𝑐𝑘 𝑅𝑎𝑡𝑖𝑜
𝐿𝑖𝑞𝑢𝑖𝑑 𝑜𝑟 𝑄𝑢𝑖𝑐𝑘 𝑅𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
g. Standard Ratio: 1 : 1.

● Understanding Liquid Assets and Current Liabilities for Quick Ratio:

i. Liquid Assets: These are those assets that are either in the form of Cash and Cash
Equivalents or can be converted into Cash and Cash Equivalent in a very short time. These
are considered as the most liquid assets. Such assets are shown under the head 'Current
Assets' in the Balance Sheet and therefore includes:
• Short-term Loans and Advances,
• Current Investment,
• Trade Receivables,
• Cash and Cash Equivalents
• Other Current Assets except Prepaid Expenses.
• *Inventories and Prepaid expenses are not included in Liquid assets because
inventories takes time to convert in cash and cash equivalents and prepaid expenses
are something that has already been paid in advance and cannot be converted into
cash.
ii. Current Liabilities: These are the liabilities that are repayable within 12 months from the
date of Balance Sheet or within the period of operating cycle. It includes the following
items:
• Short-term borrowings,
• Short-term provisions,
• Trade Payables (bills payable and sundry creditors),
• Other Current Liabilities (current maturities of long term debts, interest accrued but
not due, interest accrued and due, outstanding expenses, unclaimed dividend, calls-in-
advance, etc.)
● Difference between Current Ratio and Quick Ratio:
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FINANCIAL STATEMENTS OF THE COMPANY

Solvency {Long-term Solvency) Ratios

Meaning and Computation of Debt-to-Equity Ratio:

● Understanding Debt-to Equity Ratio:

a. It is a relationship between long-term external equities, i.e., external debts (includes long-
term borrowings and long-term provisions) and internal equities (Shareholders' Funds) of
the enterprise.
b. It measures the proportion of external funds and shareholder's invested in the company.
c. It assesses long-term financial soundness of the enterprise and indicates the extent to
which the enterprise depends on borrowed funds for its business.
d. It is expressed as a Pure Ratio.
e. Formula
𝐷𝑒𝑏𝑡
𝐷𝑒𝑏𝑡 𝑡𝑜 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 =
𝐸𝑞𝑢𝑖𝑡𝑦 (𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟 ′ 𝑠 𝐹𝑢𝑛𝑑𝑠)
● Understanding Long-term Borrowings and Long-term Provisions for computing Debt-Equity
Ratio:
a. Long term Borrowings:
• It is shown as long-term borrowings under Non-current Liabilities if they are payable
after 12 months from the date of Balance Sheet or after the operating cycle period.
• If an amount of borrowings out of Long Term Borrowings is payable within 12 months
from the date of Balance Sheet or operating cycle period, then such amount is shown
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FINANCIAL STATEMENTS OF THE COMPANY
under 'Current Maturities of Long Term Debts' under Current Liabilities and will not be
considered while calculating Debt to Equity ratio.
b. Long term Provisions: It is classified or shown as Non-current liabilities if they are payable
after 12 months from the date of Balance Sheet or after the period of Operating Cycle.
They are to be considered while computing Debt to Equity ratio.

Debt = Long-term Borrowings + Long-term Provisions

Or
= Total Debt - Current Liabilities
Or
= Capital Employed - Equity*

Equity = Share Capital + Reserves & Surplus

= Non-Current Assets#
+ Working Capital$
- Non Current Liabilities (Long-term Borr. + Long-term Prov.) Or
= Total Assets - Total Debt

*Capital Employed = Debt + Equity or Non-Current Assets + Working Capital -- Fictitious

Assets
#Non-Current Assets = Tangible Assets + Intangible Assets + Non-Current Trade
Investments + Long-term Loans and Advances.
$Working Capital = Current Assets - Current Liabilities

Negative Balance in Statement of Profit & Loss (Deficit, i.e. Debit Balance) is deducted to
compute Shareholders' Funds.

Meaning and Computation of Total Assets to Debt Ratio:

● Understanding Total Assets to Debt Ratio:

a. It is a relationship between total assets and long-term debts of the enterprise.
b. It measures the extent to which debt (Long-term) is covered by the assets.
c. It measures the 'Safety Margin' available to the lenders of the long-term debts.
d. A higher ratio means higher safety for lenders and a lower ratio means lower safety for
lenders.
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FINANCIAL STATEMENTS OF THE COMPANY
e. It is expressed as a Pure Ratio.
f. Formula:
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 𝑡𝑜 𝑑𝑒𝑏𝑡 𝑅𝑎𝑡𝑖𝑜 =
𝐷𝑒𝑏𝑡 (𝐿𝑜𝑛𝑔 − 𝑡𝑒𝑟𝑚 𝐷𝑒𝑏𝑡𝑠)
● Total Assets and Debts for computing Total Assets to Debt Ratio:

a. Total Assets: These include Non-current and Current assets as follows:

● Non-Current Assets: This will include:
• Fixed assets (tangible and intangible assets),
• Non-Current Investments,
• Long term Loans and Advances.
● Current Assets: This will include:
• Current Investments,
• Inventories (including spare parts and loose tools),
• Trade Receivables,
• Cash and Cash Equivalents,
• Short-term Loans and Advances,
• Other Current Assets.
b. Debts: This will include:
• Long-term Borrowings,
• Long-term Provisions

Meaning and Computation of Proprietary Ratio:

● Understanding Proprietary Ratio:

a. It is a relationship between proprietor's fund and total assets.
b. It shows the financial strength of the entity.
c. It is used to measure the proportion of totals assets financed by Proprietors' Funds.
d. It is an important ratio for the creditors as it helps them identify the portion of
shareholders' funds in the total assets employed in the firm and also the safety margin
available to them.
e. A very high ratio indicates improper mix of proprietors' funds and loan funds that results
in lower return on investment. A higher ratio means adequate safety for creditors and
lenders. On the other hand, lower ratio means inadequate safety for creditors and lenders.
f. It can be expressed either as 'Pure Ratio' or a 'Percentage Ratio'.
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FINANCIAL STATEMENTS OF THE COMPANY
g. Formula:
𝑃𝑟𝑜𝑝𝑟𝑖𝑒𝑡𝑜𝑟 ′ 𝑠 𝐹𝑢𝑛𝑑𝑠 𝑜𝑟 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ′ 𝐹𝑢𝑛𝑑𝑠 𝑜𝑟 𝐸𝑞𝑢𝑖𝑡𝑦
𝑃𝑟𝑒𝑝𝑟𝑖𝑒𝑡𝑎𝑟𝑦 𝑅𝑎𝑡𝑖𝑜 =
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
● Proprietors' Funds and Total Assets for computing Proprietary ratio:
i. Proprietors' Funds: This can be computed using either of the 2 approaches available as
follows:
• Liabilities Approach: In this approach,
Proprietors' funds = Share Capital (Equity + Preference) + Reserves and Surplus.
• Assets Approach: In this approach,
Proprietors' funds = Non-current Assets + Working Capital ( i.e. Current Assets - Current
Liabilities) - Non-current Liabilities.
ii. Total Assets: This includes:
I. Non-Current Assets: This will include:
• Fixed assets (tangible and intangible assets),
• Non-Current Investments,
• Long term Loans and Advances.
II. Current Assets: This will include:
• Current Investments,
• Inventories (including spare parts and loose tools),
• Trade Receivables,
• Cash and Cash Equivalents,
• Short-term Loans and Advances,
• Other Current Assets

Meaning and Computation of Interest Coverage Ratio:

● Understanding Interest Coverage Ratio:

a. It is a relationship between Net Profit before Interest and Tax and Interest on Long Term
Debts.
b. It is calculated to ascertain the amount of profit available to cover interest on long term
debts.
c. For lenders a higher Interest Coverage Ratio is considered better as it signifies a higher
margin to meet interest cost.
d. Formula:
ACCOUNTANCY ACCOUNTING RATIOS
FINANCIAL STATEMENTS OF THE COMPANY
𝑃𝑟𝑜𝑓𝑖𝑡 𝑏𝑒𝑓𝑜𝑟𝑒 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑇𝑎𝑥
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐶𝑜𝑣𝑒𝑟𝑎𝑔𝑒 𝑅𝑎𝑡𝑖𝑜 =
𝐼𝑛𝑡𝑟𝑒𝑠𝑡 𝑜𝑛 𝐿𝑜𝑛𝑔 − 𝑇𝑒𝑟𝑚 𝐷𝑒𝑏𝑡
e. It is expressed in number of times

Activity Ratios

Meaning and Computation of Inventory Turnover Ratio:

● Understanding Inventory Turnover Ratio:
a. It is a relationship between Cost of Revenue from Operations, i.e., Cost of Goods Sold and
average inventory carried during that period.
b. It ascertains whether the investment in stock is appropriate and that only the required
amount is invested in stock.
c. It measures the number of times an enterprise sells and replaces its inventory and
therefore, it is an activity as well as efficiency ratio that measures efficiency of inventory
management.
d. A high ratio shows that more sales are being produced by a rupee of investment in the
inventories. On the other hand, a low ratio means inefficient use of investment in inventory,
over investment in stocks, etc. A very high ratio indicates overtrading which may result in
working capital shortage. Only an optimum Inventory Turnover Ratio ensures adequate
working capital and helps firm ear a reasonable margin.
e. Formula:
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 𝐹𝑟𝑜𝑚 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑠 (𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑅𝑎𝑡𝑖𝑜 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
● Understanding Cost of Revenue from Operations, Direct Expenses and Average Inventory
for computing Inventory Turnover Ratio:
a. Cost of Revenue from Operations (Cost of Goods Sold): It is computed as follows:
Cost of Revenue from Operations = Revenue from Operations Gross Profit
Or
Cost of Revenue from Operations = Revenue from Operations + Gross Loss
Or
Cost of Revenue from Operations= Opening Inventory
+ Net Purchases
+ Direct Expenses
- Closing Inventory
In case of manufacturing Entity:
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FINANCIAL STATEMENTS OF THE COMPANY
Cost of Revenue from Operations = Cost of Materials Consumed
+ Purchases of Stock-in-Trade
+ Changes in Inventories of Finished Goods, WIP & Stock-
in-Trade
+ Direct Expenses
b. Direct Expenses: Such an item will be shown separately in the Note to Accounts and may
be in form of Employees Benefit Expenses and/or Other Expenses. In case if no direct
expenses are given, it is assumed that direct expenses are ni l.
c. Average Inventory: It is calculated as follows:
Average Inventory = (Opening Inventory + Closing Inventory) + 2

Meaning and Computation of Trade Receivables Turnover Ratio:

● Understanding Trade Receivables Turnover ratio:
a. It is the relationship between Credit Revenue from Operations ( i.e., Net Credit Sales) and
Average Trade Receivables ( i.e., Average of debtors and bi lls receivable of the year).
b. It indicates the number of times trade receivables are turned over in a year in relation to
credit sales.
c. It identifies how quickly trade receivables are converted into Cash and Cash Equivalents
and therefore, indicates the efficiency in collection of amounts due against trade
receivables.
d. A higher ratio shows that debts are collected more promptly and a lower ratio shows
inefficiency in collection or increased credit period or more investment in debtors.
e. It should be computed keeping in mind that provision for doubtful debts is not deducted
from trade receivables since the purpose is to calculate the number of days for which sales
are tied up in trade receivables and not to ascertain realizable value of debtors.
f. Formula:
𝐶𝑟𝑒𝑎𝑖𝑡 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 𝑓𝑟𝑜𝑚 𝑂𝑝𝑟𝑎𝑡𝑖𝑜𝑛𝑠 (𝑁𝑒𝑡 𝐶𝑟𝑒𝑑𝑖𝑡 𝑆𝑎𝑙𝑒𝑠)
𝑇𝑟𝑎𝑑𝑒 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑅𝑎𝑡𝑖𝑜 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑟𝑎𝑑𝑒 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠
g. It is expressed in Times
Note 1: Credit Revenue from Operations ( i.e., Net Credit Sales)= Credit Sales - Sales Return
Or Revenue from Operations - Cash Revenue from Operations
𝑂𝑝𝑒𝑛𝑖𝑛𝑔 𝑇𝑟𝑎𝑑𝑒 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠+𝐶𝑙𝑜𝑠𝑖𝑛𝑔 𝑇𝑟𝑎𝑑𝑒 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠
Note 1: Average Trade Receivables =
2
Or Average Trade Rec. = (Opening Debtors + Closing Debtors + Opening B/R + Closing B/R

● Understanding Average Collection Period or Debt Collection Period:

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FINANCIAL STATEMENTS OF THE COMPANY
a. It is a ratio which provides an approximation of the average time that it takes to collect
debtors.
b. It is computed by dividing 365 (days) or 12 (months) by the Trade Receivables Turnover
Ratio.
c. Formula
365
𝐷𝑒𝑏𝑡 𝐶𝑜𝑙𝑙𝑒𝑐𝑡𝑖𝑜𝑛 𝑃𝑒𝑟𝑖𝑜𝑑 =
𝑇𝑟𝑎𝑑𝑒 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑅𝑎𝑡𝑖𝑜
Or
12
𝐷𝑒𝑏𝑡 𝐶𝑜𝑙𝑙𝑒𝑐𝑡𝑖𝑜𝑛 𝑃𝑒𝑟𝑖𝑜𝑑 =
𝑇𝑟𝑎𝑑𝑒 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑅𝑎𝑡𝑖𝑜
d. It is expressed in number of days or months

Meaning and Computation of Trade Payables Turnover ratio:

● Understanding Trade Payables Turnover Ratio:
a. It is a relationship between the net credit purchases and total payables or average
payables.
b. It identifies the number of times the creditors are turned over in relation to credit
purchases.
c. A high ratio indicates that the enterprise is not availing a full credit period, which boosts
up the credit worthiness of the enterprise. On the other hand, a low ratio or longer
payment period indicates that creditors are not paid in time or increased credit period.
d. Formula:
e. It is expressed in Times
𝑁𝑒𝑡 𝐶𝑟𝑎𝑑𝑖𝑡 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠
𝑇𝑟𝑎𝑑𝑒 𝑃𝑎𝑦𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑅𝑎𝑡𝑖𝑜 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑟𝑎𝑑𝑒 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠
(𝑂𝑝𝑒𝑛𝑖𝑛𝑔 𝑇𝑟𝑎𝑑𝑒 𝑃𝑎𝑦𝑏𝑙𝑒𝑠 + 𝐶𝑙𝑜𝑠𝑖𝑛𝑔 𝑇𝑟𝑎𝑑𝑒 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠
𝑁𝑜𝑡𝑒: 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑟𝑎𝑑𝑒 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠 =
2
Or Average Trade Payables = (Opening Creditors + Closing Creditors + Opening B/P + Closing
B/P) ÷ 2

● Understanding Average Payment Period or Average Age of Payables:

a. It shows the credit period enjoyed by the enterprise in paying creditors.
b. Formula
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑟𝑎𝑑𝑒 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 𝑃𝑒𝑟𝑖𝑜𝑑 = × 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑀𝑜𝑛𝑡ℎ𝑠/𝐷𝑎𝑦𝑠
𝑁𝑒𝑡 𝐶𝑟𝑒𝑑𝑖𝑡 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠
𝑀𝑜𝑡ℎ𝑠 𝑜𝑟 𝐷𝑎𝑦𝑠 𝐼𝑛 𝑎 𝑌𝑒𝑎𝑟 ( 12 / 365 )
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 𝑃𝑒𝑟𝑖𝑜𝑑 = = ⋯ 𝑀𝑜𝑡ℎ𝑠/𝐷𝑎𝑦𝑠
𝑇𝑟𝑎𝑑𝑒 𝑃𝑎𝑦𝑏𝑙𝑒𝑠 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑅𝑎𝑡𝑖𝑜
ACCOUNTANCY ACCOUNTING RATIOS
FINANCIAL STATEMENTS OF THE COMPANY
Meaning and Computation of Working Capital Turnover ratio:
● Understanding Working Capital Turnover Ratio:
a. It is a relationship between working capital and revenue from operations.
b. It shows the number of times a unit of Rupee invested in working capital produces sales.
c. It helps to ascertain whether or not working capital has been effectively used in
generating revenue.
d. A higher ratio is considered as an ideal ratio whereas a very high ratio indicates
overtrading.
e. Formula:
𝑅𝑒𝑣𝑒𝑛𝑢𝑒 𝑓𝑟𝑜𝑚 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑠
𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑅𝑎𝑡𝑖𝑜 =
𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
Or
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 𝐹𝑟𝑜𝑚 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑠
𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑅𝑎𝑡𝑖𝑜 =
𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
f. It is expressed in number of times

● Understanding Revenue from Operations and Working Capital for computing Working
Capital Turnover Ratio:
a. Revenue from Operations:
• It is the revenue earned by the company from its Operating Activities.
• If the amount of Revenue from Operations is not given, it may be calculated on the
basis of Cost of Revenue from Operations i.e., Cost of Goods Sold.

b. Working Capital: It is calculated using following formula: Working Capital = Current

Assets - Current Liabilities
Profitability Ratios

Meaning and Computation of Gross Profit Ratio:

● Understanding Gross Profit Ratio:
a. It is a relationship between the Gross Profit and Revenue from Operations ( i.e., Net
Sales).
b. A change either in Revenue from Operations ( i.e., Net Sales) or Cost of Revenue from
Operations ( i.e., Cost of goods sold) or both will have an impact on this ratio.
c. It shows the average margin on goods sold.
d. It determines the efficiency with which production and/or purchase operations and
selling operations are carried on.
ACCOUNTANCY ACCOUNTING RATIOS
FINANCIAL STATEMENTS OF THE COMPANY
e. It is a reliable guide for fixing selling prices.
f. It is useful in determining the efficiency of trading activities.
g. It can be compared with ratio of earlier years or with that of other firms to compare
the efficiency and growth of business
h. Formula:

● Understanding Gross Profit and Cost of Revenue from Operations for computing Gross
Profit Ratio:
a. Gross Profit: It is calculated as follows:
Gross Profit= Revenue from Operations ( i.e. Net Sales)
- Cost of Revenue from Operations (COGS)

b. Cost of Revenue from Operations: It is calculated using the following:

Cost of Revenue from Operations= Opening Inventory (excl. Spare parts & loose tools)
+ Net Purchases
+ Direct Expenses
- Closing Inventory (excl. Spare parts & loose tools)
Or
Cost of Revenue from Operations = Cost of Materials Consumed
+ Purchases of Stock-in-Trade
+ Change in Inventories of FG, WIP & SIT
+ Direct Expenses
Or
Cost of Revenue from Operations = Revenue from Operations Gross Profit

● Reasons for increase or decrease in Gross Profit Ratio:

i. Increase: This ratio increases because of the following reasons:
a. If the selling price increases and the cost of revenue from operations is constant.
b. If the Cost of revenue from operations decreases and the selling price is constant.
c. If there exists a combination of above two situations.

ii. Decrease: This ratio decreases if the above reasons are reversed.
ACCOUNTANCY ACCOUNTING RATIOS
FINANCIAL STATEMENTS OF THE COMPANY
Meaning and Computation of Operating Ratio:
● Understanding Operating Ratio:
a. It is a relationship between Operating Costs and Revenue from Operations.
b. It is the proportion of Cost of Revenue from Operations and Operating Expenses to
Revenue from Operations.
c. It helps in assessing the operational efficiency of an entity.
d. It shows the percentage of Revenue from Operations that is absorbed by the Cost of
Revenue from Operations and Operating Expenses.
e. A low operating ratio is better because it leaves higher profit margin to meet non-
operating expenses, pay dividend, etc. On the other hand, a high operating ratio
indicates decline in efficiency.
f. Formula:

g. It is expressed in percentage

● Understanding Cost of Revenue from Operations, Operating Expenses and Operating

Cost for computing Operating Ratio:
a. Cost of Revenue from Operations: It is calculated using the following:
Cost of Revenue from Operations= Opening Inventory (excl. Spare parts & loose tools)
+ Net Purchases
+ Direct Expenses
- Closing Inventory (excl. Spare parts & loose tools)
Or
Cost of Revenue from Operations = Cost of Materials Consumed
+ Purchases of Stock-in-Trade
+ Change in Inventories of FG, WIP & SIT
+ Direct Expenses
Or
Cost of Revenue from Operations = Revenue from Operations Gross Profit
b. Operating Expenses: It is calculated using the following:
ACCOUNTANCY ACCOUNTING RATIOS
FINANCIAL STATEMENTS OF THE COMPANY
Operating Expenses = Employee Benefit Expenses
+ Depreciation & Amortization Expenses
+ Other Expenses (Other than Non-Operating Expenses)
Or
Operating Expenses= Office Expenses+ Administrative Expenses
+ Selling & Distribution Expenses
+ Employee Benefit Expenses
+ Depreciation & Amortization Expenses
c. Operating Cost: It is calculated using the following:
Operating Cost = Cost of Materials Consumed + Purchases of Stock-in-Trade
+ Changes in Inventories of Finished Goods, WIP and Stock-in-
Trade
+ Employees Benefit Expenses
+ Depreciation and Amortization Expenses
+ Other Expenses (other than Non-operation Expenses

Meaning and Computation of Operating Profit Ratio:

● Understanding Operating Profit Ratio:
a. It is the relationship between Operating Profit and Revenue from Operations i.e., Net
Sales.
b. It determines the operational efficiency of the business.
c. An increase in the ratio shows improvement in the operational efficiency of the entity.
d. Formula:

e. It is expressed in Percentage
● Understanding Operating Profit for computing Operating Profit Ratio: It is computed
using the following formula:
Operating Profit = Gross Profit + Other Operating Income -Other Operating Expenses
Or
Operating Profit = Net Profit (Before Tax ) + (Non-operating Expense/Losses) -(Non-
Operating Incomes)
Or
ACCOUNTANCY ACCOUNTING RATIOS
FINANCIAL STATEMENTS OF THE COMPANY
Operating Profit = Revenue from Operations Operating Cost
Relationship between Operating Profit and Operating Ratio
Operating Ratio + Operating Profit Ratio = 100

Meaning and Computation of Net Profit Ratio:

● Understanding Net Profit Ratio:
a. It is a relationship between Net Profit and Revenue from Operations i.e., Net Sales.
b. It helps in determining the operational efficiency of the business.
c. It indicates the actual status of business, as higher the Net Profit Ratio, better the
business.
d. An increase in the ratio over the past period shows improvement in the operational
efficiency.
e. A decline in the ratio over the past period shows a fall in the operational efficiency.
f. It facilitates comparison of operation efficiency with that of industry standards.
g. Formula:

f. It is expressed in Percentage

● Understanding Net Profit for computing Net Profit Ratio: This is calculated using the
following formula:
Net Profit = Revenue from Operations - Cost of Revenue from Operations -
Operating
Expenses - Non-Operating Expenses+ Non-Operating Income - Tax.

Meaning and Computation of Return on Investment or Capital Employed:

● Understanding Return on Capital Employed and Investment: Following are the points of
Objective and Significance of Return on Capital Employed and Investment:
a. It shows the relationship between Net Profit/Earnings before interest and tax with
capital employed.
b. It measures how efficiently the resources of the business are being used.
c. It is a fair measure of the profitability of any concern with the result that the
performance of different industries can be compared.
d. It indicates whether the company or business is giving satisfactory returns.
e. It assesses the overall performance of the enterprise.
ACCOUNTANCY ACCOUNTING RATIOS
FINANCIAL STATEMENTS OF THE COMPANY
f. Formula:

g. It is expressed in Percentage

● Understanding Capital Employed for computing Return on Investment: It is computed

either using the Liabilities Approach or Assets Approach. Under both the approaches,
amount of capital employed remains the same.
i. Liabilities Approach: Under this method, it is computed by adding
Shareholders' Funds (Share Capital & Reserves and Surplus)* and
Non-current Liabilities (Long-term Borrowings and Long-term Provisions).
*if balance of Statement of P&L is negative, it is to be deducted to calculate
shareholders' funds.
ii. Assets Approach: Under this method, it is computed by adding
Non-current Assets ( i.e. Fixed assets-Tangible & Non-Tangible,
Non-current Trade Investments and Long-term Loans and Advances) and
Working Capital i.e., Current Assets - Current Liabilities
ACCOUNTANCY ACCOUNTING RATIOS
FINANCIAL STATEMENTS OF THE COMPANY
ACCOUNTANCY ACCOUNTING RATIOS
FINANCIAL STATEMENTS OF THE COMPANY

Important Questions
Multiple Choice questions-
Question 1. The two basic measures of operational efficiency of a company are

(a) Inventory Turnover Ratio and Working Capital Turnover Ratio

(b) Liquid Ratio and Operating Ratio

(c) Liquid Ratio and Current Ratio

(d) Gross Profit Margin and Net Profit Margin

Question 2. Acid Test ratio comes under:

(a) Liquidity ratio

(b) Solvency ratio

(c) Profitability ratio

(d) Activity ratio

Question 3. Current assets are those assets which are convertible into cash within:

(a) One month

(b) 6 months

(c) 12 months

(d) none of these

Question 4. Which of the following is not considered in the ratio analysis as per guidance
notes?

(a) Fixed Assets

(b) Share capital

(c) Other Non-current Assets

(d) Non-current Assets

Question 5. Which of the following will increase the current ratio where it is 2 : 1 ?

(a) Payment to creditors

ACCOUNTANCY ACCOUNTING RATIOS
FINANCIAL STATEMENTS OF THE COMPANY
(b) Conversions of receivables into cash

(c) Purchase of goods on credit

(d) Purchase of goods for cash

Question 6. Long term solvency ratio is judged by which of the following ratio?

(a) Debt equity ratio

(b) Total assets turnover ratio

(c) Liquidity ratios

(d) Operating ratio

Question 7. Which of the following ratios provide solvency position of a business in the
long run?

(a) Liquidity Ratios

(b) Solvency ratios

(c) Profitability ratios

(d) Turnover ratios

Question 8. In debt equity ratio, debt refers to

(a) Short term debts

(b) Total debts

(c) Shareholder’s funds

(d) Long term borrowings and long term debts

Question 9. Which of the following transactions will increase debt equity ratio which is 1 :
2?

(a) Issue of shares for cash

(b) Redemption of preference shares

(c) Redemption of debentures

(d) Conversion of debentures into shares

Question 10. Interest coverage is equal to

ACCOUNTANCY ACCOUNTING RATIOS
FINANCIAL STATEMENTS OF THE COMPANY
(a) Interest after interest but before tax / interest on debt

(b) Interest before interest and tax / interest on debt

(c) Interest after interest and debt / interest on debt

(d) Interest on debt / Interest before interest and tax

Very Short Questions-

1. What will be the effect on current ratio if a bills payable is discharged on maturity?
2. Debt Equity Ratio of a company is 1:2. Purchase of a Fixed asset for ₹ 5,00,000 on long
term deferred payment basis will increase, decrease or not change the ratio?
3. It is a simple arithmetical expression of relationship between two figures. Name the
term.
4. The liquidity of a business firm is measured by its ability to satisfy its long-term
obligations as they become due. Name a ratio used for this purpose.
5. X Ltd. has a Debt-Equity Ratio at 3 : 1. According to the management it should be
maintained at 1 : 1. What is the choice to do so?
6. How the solvency of a business is assessed by Financial Statement Analysis?
7. What will be operating profit if operating ratio is 88.94?

Short Questions-
1. What do you mean by Ratio Analysis?
2. What are the various types of ratios?
3. What relationships will be established to study:
a. Inventory Turnover
b. Trade Receivables Turnover
c. Trade Payables Turnover
d. Working Capital Turnover
4. The liquidity of a business firm is measured by its ability to satisfy its long-term obligations
as they become due. What are the ratios used for this purpose?
5. The average age of inventory is viewed as the average length of time inventory is held
by the firm for which explain with reasons.
Long Questions-
1. What are liquidity ratios? Discuss the importance of current and liquid ratio.

2. How would you study the solvency position of the firm?

ACCOUNTANCY ACCOUNTING RATIOS
FINANCIAL STATEMENTS OF THE COMPANY
3. What are important profitability ratios? How are these worked out?

4. Current liabilities of a company are ₹ 75,000. If current ratio is 4:1 and liquid ratio is
1:1, calculate value of current assets, liquid assets and inventory.

5. Handa Ltd. has inventory of ₹ 20,000. Total liquid assets are ₹ 1, 00,000 and quick ratio
is 2:1. Calculate current ratio.

Assertion Reasons-
1. For two statements are given-one labelled Assertion and the other labelled Reason. Select
the correct answer to these questions from the codes (a), (b), (c) and (d) as given below.

a. Assertion and Reason both are correct and Reason is the correct explanation of assertion

b. Assertion and Reason both are correct but Reason is not correct explanation of assertion

c. Only Assertion is correct.

d. Reason is correct but Assertion is not correct

Assertion [A]:While calculating the Current Ratio, Loose Tools and Stores & Spares are not
included in the current asset.

Reason [R]: Loose Tools and Stores & Spares are not held for sale or conversion into cash.

2. For two statements are given-one labelled Assertion and the other labelled Reason. Select
the correct answer to these questions from the codes (a), (b), (c) and (d) as given below.

a. Assertion and Reason both are correct and Reason is the correct explanation of assertion

b. Assertion and Reason both are correct but Reason is not correct explanation of assertion

c. Only Assertion is correct

d. Reason is correct but Assertion is not correct

Assertion [A]: If Current Ratio is 2 : 1. Current maturity of long-term debts i.e. Redemption of
debentures in the current year, will increase the Current Ratio.

Reason [R]: Current assets will decrease and there is no impact on current liabilities.

Case Study Questions-

MCQ Answers-
ACCOUNTANCY ACCOUNTING RATIOS
FINANCIAL STATEMENTS OF THE COMPANY
1. Answer: (a) Inventory Turnover Ratio and Working Capital Turnover Ratio
2. Answer: (a) Liquidity ratio
3. Answer: (c) 12 months
4. Answer: (c) Other Non-current Assets
5. Answer: (a) Payment to creditors
6. Answer: (c) Liquidity ratios
7. Answer: (b) Solvency ratios
8. Answer: (d) Long term borrowings and long term debts
9. Answer: (b) Redemption of preference shares
10. Answer: (b) Interest before interest and tax / interest on debt
Very Short Answers-
1. Answer: The current ratio will increase

2. Answer: Increased

3. Answer: Ratio

4. Answer: Current Ratio.

5. Answer: To increase the equity or reduce the debt.

6. Answer: With the help of solvency ratios

7. Answer: Operating Profit = 100 – 88.94 = 11.06

Short Answers-
1. It is a quantitative analysis of data present in a financial statement. It shows the
relationship between items present in Balance sheet and the Income Statement. It helps
in calculating operational efficiency, solvency and determining profitability of a firm. Ratio
is a statistical measure which helps in comparing relationship between two or more
figures. Analyzing ratio presents vital pieces of information to accounting users about the
firm’s financial position, performance and viability. It also helps in setting up new policies
and framework by the management.

2. Ratios can be classified into two types:

(a) Traditional Classification: Traditional classification is based on the financial

statements such as Balance Sheet and P & L Account. The ratios are divided on the basis
of accounts of financial statements and are as follows:

i. Income Statement Ratios such as Gross Profit Ratios.

ii. Balance Sheet Ratios such as Debt Equity Ratio, Current Ratio.
ACCOUNTANCY ACCOUNTING RATIOS
FINANCIAL STATEMENTS OF THE COMPANY
iii. Composite Ratio: Ratios that contain elements from both Trading and P & L
Account.

(b) Functional Classification: These ratios are based on the functional need of
calculating ratios. These ratio help calculate the solvency, liquidity, profitability and
financial performance of a business. Such ratios are:

i. Liquidity Ratio: Ratios used to determine solvency of short term.

ii. Solvency Ratio: Ratios used to determine solvency of long term.

iii. Activity Ratio: Ratios used for determining operating efficiency of the business.
These ratios are related to sales and cost of goods sold.

iv. Probability Ratio: Ratios used to determine financial performance and viability of
the firm.

3.
a. Inventory Turnover Ratio: This ratio is a relationship between cost of goods sold and the
average inventory maintained during a particular time period. It determines the efficiency with
which a firm is able to manage its inventory.

b. Trade Receivables Turnover Ratio: Debtors turnover ratio is also known as Receivables
Turnover Ratio is a measure used to check how quickly a credit sale is converted into cash. It
shows efficiency of a business firm in collecting debts from customers.

c. Trade Payables Turnover Ratio: It is also known as Creditor’s turnover ratio or account
payable turnover ratio and is a liquidity ratio that measures the average number of times a firm
pays its creditors in the course of an accounting period. It is used to measure short term
liquidity of the firm.
ACCOUNTANCY ACCOUNTING RATIOS
FINANCIAL STATEMENTS OF THE COMPANY

d. Working Capital Turnover Ratio: Working capital turnover ratio is used to measure the
efficiency of a company in using its working capital to support the sales. It is a ratio where firms
operations are funded and the corresponding revenue generated from business is calculated.

4. A firm’s liquidity is measured by its capability to pay long term dues. These dues include
principal amount payment on due date and interest payment on regular basis. Long term
solvency of a firm can be determined by the following ratios:

a. Debt-Equity Ratio: This ratio shows the relationship between owner funds (equity) and
borrowed funds (debt). A lower debt-equity ratio provides more security to the people who are
lending to the business. It also shows that a company is able to meet long term dues or
responsibilities.

b. Total Assets to Debt Ratio: It is based on the relationship between total assets and long term
loans. It shows what percentage of company’s total assets are financed by creditors. A higher
total assets to debt ratio makes the firm able to meet long term requirements and provides more
security to lenders.

c. Interest Coverage Ratio: This ratio is used to determine the easiness with which a company
is able to pay interest on the outstanding debts. It is calculated by dividing earnings before
interest and taxes with interest payments. Having a higher interest coverage ratio means that
company is able to meet its obligations skilfully.
ACCOUNTANCY ACCOUNTING RATIOS
FINANCIAL STATEMENTS OF THE COMPANY

5. Inventory Turnover Ratio: This ratio is a relationship between cost of goods sold and the
average inventory maintained during a particular time period. It determines the efficiency with
which a firm is able to manage its inventory.

It shows the average length for which firm holds the inventory.

Long Answers-
1. For determining the short-term solvency of a business liquidity ratios are essential. There
are two types of liquidity ratios:

(a) Current Ratio: This ratio deals with the relationship between current assets and liabilities.
It is calculated as:

Current assets are those assets which can be easily converted into cash whereas Current
liabilities are liabilities that need to paid within that accounting period.

Importance of Current Ratio: Current ratio helps in determining a firm’s ability to pay off the
current liabilities on time. If there is more of current assets as compared to current liabilities, it
provides a source of security to the creditors. The ideal ratio is 2:1 (Current Assets: Current
Liabilities).

(b) Liquid Ratio: It deals with the relationship between liquid assets and current liabilities.
This ratio determines if the firm has sufficient funds for paying off the current liabilities on an
immediate basis. It can be calculated as:
ACCOUNTANCY ACCOUNTING RATIOS
FINANCIAL STATEMENTS OF THE COMPANY

Importance of Liquid Ratio: It is helpful in determining if a firm has funds that can be
sufficient to pay off liabilities. It does not include stock or prepaid expenses as both these are not
easily converted to cash. A ratio of 1:1 is ideal for maintaining the liquid ratio.

2. A firm’s solvency position can be best studied with the help of group of ratios called as
Solvency Ratios. These ratios measure the financial position of the firm by measuring its
ability to pay long term liabilities, these long term liabilities include principal amount
payments on due date and interest payments on a regular basis. Following ratios are used
to determine long term solvency of a business.

(a) Debt-Equity Ratio: This ratio shows the relationship between owner funds (equity) and
borrowed funds (debt). A lower debt-equity ratio provides more security to the people who are
lending to the business. It also shows that a company is able to meet long term dues or
responsibilities.

(b) Total Assets to Debt Ratio: It is based on the relationship between total assets and long
term loans. It shows what percentage of company’s total assets are financed by creditors. A
higher total assets to debt ratio makes the firm able to meet long term requirements and
provides more security to lenders.

(c)Interest Coverage Ratio: This ratio is used to determine the easiness with which a company
is able to pay interest on the outstanding debts. It is calculated by dividing earnings before
interest and taxes with interest payments. Having a higher interest coverage ratio means that
company is able to meet its obligations skilfully.
ACCOUNTANCY ACCOUNTING RATIOS
FINANCIAL STATEMENTS OF THE COMPANY
(d) Proprietary Ratio: This ratio shows the relationship between Total Assets and
Shareholders fund. It is helpful in revealing the financial position of a business. A higher ratio
ensures a greater degree of security for creditors. It is shown as:

3. Profitability ratios are calculated on the basis of profit earned by a business. This ratio
gives a percentage which is used to assess the financial condition of a business:

a. Return on Assets: This ratio measures the earning per rupee from assets which are
invested in the company. A higher profit ratio is good for the company.

Return on Assets = Net Profit ÷ Total Assets

b. Return on Equity: This ratio deals with measuring profitability of equity fund that is
invested by the company. It also measures how owner’s funds are utilized profitably to
generate company revenues. A high ratio represents the better position of a company.

Return on Equity = Profit after Tax ÷ Net worth

Where Net worth = Equity share capital, and Reserve and Surplus

c. Earnings per share: This ratio helps in measuring profitability from an ordinary
shareholder’s viewpoint. A high ratio represents a well off company.

Earnings per share = Net Profit ÷ Total no of shares outstanding

d. Dividend per share: This ratio measures the amount of dividend that is distributed by
the company to its shareholders at the end of an accounting period. A high ratio
represents that the company is having surplus cash.

Dividend per share = Amount Distributed to Shareholders ÷ No of Shares outstanding

e. Price Earnings Ratio: A profitability ratio that is used by an investor to check for share
price of the company which can be undervalued or overvalued. It also indicates an
expectation about the company’s earning and payback period for the investors.

Price Earnings Ratio = Market Price of Share ÷ Earnings per share

f. Return on capital employed: This ratio is all about the returns earned by the
company from the funds invested in the business by its owners. A high ratio is
indicative of a better position for the company.

Return on capital employed = Net Operating Profit ÷ Capital Employed × 100

ACCOUNTANCY ACCOUNTING RATIOS
FINANCIAL STATEMENTS OF THE COMPANY

g. Gross Profit: Gross profit ratio or GP ratio is a profitability ratio that deals with the
relationship between gross profit and the total net sales revenue. This ratio is used to
evaluate the operational performance of the business.

h. Net Profit: This is a profitability ratio that deals with relationship between net profit
after tax and net sales. It is calculated by dividing the net profit (after tax) by net sales.

4. f
ACCOUNTANCY ACCOUNTING RATIOS
FINANCIAL STATEMENTS OF THE COMPANY

5.
ACCOUNTANCY ACCOUNTING RATIOS
FINANCIAL STATEMENTS OF THE COMPANY

Assertion Reason Answer-

1. (a) Assertion and Reason both are correct and Reason is the correct explanation of
assertion.

2. (c) Only Assertion is correct.