SOLVENCY RATIOS (LONG TERM SOLVENCY)

Long term solvency ratios denote the ability of the organization to repay the loan and interest.
When an organization's assets are more than its liabilities is known as solvent organization.
Solvency indicates that position of an enterprise where it is capable of meeting long term
obligations.

Important Ratios In Test Of Solvency

(1) Debt-equity ratio; (2) Proprietary ratio.

(3) Total Assets to Debt Ratio (4) Interest Coverage Ratio

(1) Debt – Equity Ratio :

It shows the relationship between long-term external equities (ie., external debts) and internal equities
(ie., shareholder's funds) of the enterprise. It is computed to assess the long-term financial soundness of
the enterprise.
External equities /debts are the liabilities of the enterprise to outsiders. It includes long term borrowings
and long term provisions. They can be found in Balance Sheet as' Non-current liabilities' under the head
'Equity & liabilities'.
(1) Debt – Equity Ratio (contd...):
❖ Long term liability / Provision – where payable after 12 months from the date of
B/S or after the period of operating cycle. (Current Maturities of Long-Term Debt
are CL and therefore are not added to long term debt)
Debt
Debt – Equity Ratio =
Equity (Shareholder's Fund)

❖ Debts = Long-term borrowing + Long-term provisions (or)

= Total Debt – Current Liabilities (or)
= Capital Employed – Equity
CE = Debt + Equity (both equity & preference shares ) (or)
= Non – Current Assets + Working Capital – Fictitious Assets
❖ Equity = Share capital + Reserves and Surplus (or)
= Non-Current Assets + Non current Trade Investments + Long term
loans and Advances + Working capital – Non current liabilities (0r)

= Total Assets – Total Debts.

(1)Debt – Equity Ratio (contd...):

❖ Ideal Ratio: 2:1 is considered as best but it should not be more than this.
❖ A high ratio means that the enterprise is depending more on borrowings or
external debts as compared to shareholder's fund. Thus lenders are at
higher risk.
ILLUSTRATION : ACCOUNTING RATIOS

PRACTICE SUMS : Let’s Do It …….

(2)Total Assets to Debt Ratio :

❖ It shows the relationship between Total Assets and Long -Term debts of the
enterprise.
Total Assets
TOTAL ASSETS TO DEBT RATIO =
Debt (Long – Term Debt)
(2) TOTAL ASSETS TO DEBT Ratio (contd...):
❖ Total Assets = Fixed Assets (Tangible and Intangible) + Non Current
Investment + Long Term Loans and Advances + Current
Assets
Debts = Long-term borrowing + Long-term provisions
Current Assets = Current Investment + Inventories (including spare parts &
loose tools) + Trade Receivables + Cash & Cash equivalents
+ Short Term loans & Advances + Other current assets
❖ Significance: It measures the safety margin available to the providers of long
term loans. It measures the extent to which debt (Long-Term) is covered by
the assets of the enterprise.
❖ Ideal Ratio: No ideal ratio but a high ratio indicates higher safety to lenders and low ratio
represents risky position.
ACCOUNTING RATIOS
ILLUSTRATION :

PRACTICE SUMS : Let’s Do It……

(3) Proprietary Ratio :
❖ It shows the relationship between Proprietors’ Funds/shareholders’ Funds
and Total Assets of the business
Proprietary Ratio = Shareholder's fund / Equity
Total Assets
❖ Proprietary Ratio may be expressed either as 'Pure Ratio' or as 'Percentage’
❖ Proprietary Fund can be calculated either from Liabilities Side Approach or
Assets Side Approach.
a) Liabilities Side Approach : Share Capital ( Eq + Pref ) + Reserves & Surplus
b) Assets Side Approach : Non-Current Assets + WC (CA -CL) – Non current
liabilities
❖ Significance: It measures the proportion of total assets financed by the
Proprietors of the business. It shows the safety margin available to the
lenders of the business as they can ascertain the portion of the shareholders
fund in the total assets employed in the business.
(3) Proprietary Ratio (contd..) :
❖ Ideal Ratio: No ideal ratio but a high ratio indicates higher safety to lenders
and low ratio represents risky position from lender’s point of view. A low
ratio may discourage the unsecured lenders extending credit to the firm as
in case of liquidation they are likely to lose their money.

ILLUSTRATION : ACCOUNTING RATIOS

PRACTICE SUMS : Let’s Do It …….

(4) Interest Coverage Ratio :

❖ This ratio establishes relationship between the Net Profit before Interest &
Tax and interest payable on long term debts (Fixed Interest Charges)
Profit Before Interest & Tax
Interest Coverage Ratio = = ….Times
Interest on Long Term Debt
(4) Interest Coverage Ratio (contd...):

❖ Since interest is a charge on profit, net profit taken to calculate this ratio is
before interest & tax.
❖ Objective & Significance-Objective is to ascertain the amount of profit
available to cover the interest charge. It determines ease with which a
company can pay interest expense on outstanding debt.
❖ Parties interested in this ratio are debenture holders and lenders of long
term credit.
❖ High Ratio is better for lenders as it indicates higher safety margin.

ILLUSTRATION : ACCOUNTING RATIOS

PRACTICE SUMS : Let’s Do It……

ACTIVITY RATIOS (PERFORMANCE / TURNOVER RATIO)

❖ These ratios measure how well / effectively the resources of the enterprise
have been used by it. In other words, These ratios measure the efficiency of
asset management and measure the effectiveness with which an enterprise
uses resources at its disposal.

Important Activity Ratios

●(1) Inventory Turnover ratio; (2) Trade Receivable Turnover ratio.

●(3) Trade Payable Turnover Ratio (4) Working Capital Turnover Ratio
●(5) Investment (Net Assets) Turnover Ratio (6) Fixed Assets Turnover Ratio

1.Inventory Turnover Ratio :

It is also called as Stock turnover ratio. This ratio is a relationship between the
Cost of goods sold i.e, Cost of Revenue form Operations during a particular
period of time and the Cost of average inventory during a particular period.
(1) Inventory Turnover Ratio(contd..) :
❖ It is expressed in number of times
Cost of Revenue from Operation (COGS)
Inventory Turnover Ratio = = ….Times
Average Inventory

❖ Cost of Goods Sold = Opening Stock + Net Purchases + Direct Expenses – Closing
Stock
OR
= Sales/Revenue from Operations – Gross Profit
OR
= Sales / Revenue from Operation + Gross loss

❖ In case of Manufacturing Concern:

Cost of Revenue from Operations = Cost of Material Consumed + Net Purchases of Stock
in Trade + Changes in inventories of Finished Goods, Work in Progress and Stock-in-Trade
+ Direct Expenses
(1) Inventory Turnover Ratio(contd..) :

❖ Cost of Material Consumed = Raw Material Purchased + Changes in

inventory of Raw Material Changes in inventory = Opening Inventory –
Closing Inventory

Average Inventory = Opening Inventory + Closing Inventory

2
❖ Significance : It measures the efficiency of inventory management. This ratio
indicates whether investment in stock is within proper limit or not. It shows
the number of times amount invested in inventory is rotated.
❖ This shows how quickly inventory is sold. Generally higher ratio is considered
better but very high ratio shows over trading and low ratio means
accumulation of stock or over- investment in stock.

ILLUSTRATION : ACCOUNTING RATIOS

PRACTICE SUMS : Let’s Do It……

(2) Trade Receivables Turnover Ratio :

It shows the relationship between Net Credit Sales i.e., Net Credit Revenues from Operations
and Average Debtors/Average Trade Receivables (Debtors + Bills Receivables).
It is expressed in number of times
Credit Revenue from Operation (Net Credit Sales)
Trade Receivable Ratio = = ….Times
Average Trade Receivables

Credit Revenue from Operation = Credit Sales – Sales Return

OR
= Revenue from Operation – Cash revenue from operation
Average Trade Receivable = Opening Receivable ( Debtors + B/R)+ Closing Receivables
2
Trade Receivables here is the amount computed before deduction of provision for bad
& doubtful Debts

Significance : It shows how quickly trade receivables are converted to cash & cash equivalents.
Shows the efficiency in collection of amounts due against the trade receivables.
(2) Trade Receivables Turnover Ratio (contd..) :
A higher ratio is better since it shows that debts are collected promptly. A low ratio indicates
the inefficiency in collection or increased credit period .

❖ Debt Collection Period / Average Collection Period

❖ It shows an average period for which credit revenue from operation remains outstanding or
average credit period enjoyed by the Trade Receivables. It is computed in days or mont
❖ 365
Debt Collection Period = = …..No. of Days
Trade Receivable Turnover Ratio
12 = ……No. of Months
=
Trade Receivable Turnover Ratio

ILLUSTRATION : ACCOUNTING RATIOS

PRACTICE SUMS : Let’s Do It……

(3) Trade Payables Turnover Ratio :

It shown the relationship between Net Credit Purchases and Average Creditors/Average Trade
Payables (Creditors + Bills Payable).
It is expressed in number of times
Net Credit Purchases
Trade Payable Ratio = = ….Times
Average Trade Payables

Net Credit Purchases = Credit Purchases – Purchases Return

Average Trade Receivable = Opening Payables ( Creditors + B/P)+ Closing Payables
2

Significance : This ratio indicated the number of times the Trade Payables are turned over in
relation to credit purchases over a year. This shows how quickly cash is paid to Trade Payables
(2) Trade Payable Turnover Ratio (contd..)
Generally lower ratio indicates that more credits are available for a longer
period. A higher ratio indicates that the enterprise is not availing full credit
period. This boosts up the credit worthiness of the enterprise.
● Average Payment Period/ Average Age of Payables
365 = …..No. of Days
Average Payment Period =
Trade Payable Turnover Ratio
12
= ……No. of Months
= Trade Payable Turnover Ratio

ILLUSTRATION : ACCOUNTING RATIOS

PRACTICE SUMS : Let’s Do It……

(4) Working Capital Turnover Ratio :

It establishes the relationship between Net Working Capital and Revenue from Operations i.e.,
Net Sales. It shows the number of times a unit of rupee invested in WC produces sales. It is
expressed in number of times
WC Turnover Revenue from Operation / Cost of Revenue from Operation*
= ….Times
Ratio = Working Capital

* Where Revenue from Operation is not given, it can be calculated from Cost of RFO (COGS)
Working Capital = CA – CL
Revenue from Operation means Revenue from Operating Activities, thus will include net sales
& commission for Non-Finance companies and Interest earned, dividend, profit on sale of
securities etc, in case of Finance Companies.
Significance : Ascertains whether or not WC has been effectively used in generating revenue.
A higher ratio indicates efficient use of working capital.
A higher ratio is better but a very high ratio indicates overtrading – the WC being inadequate
for the scale of operations. ACCOUNTING RATIOS
ILLUSTRATION :
Let’s Do it…..
PRACTICE SUMS :
(5) Net Assets or Capital Employed Turnover Ratio :
It reflects relationship between revenue from operations and net assets (capital employed)
in the business. Higher turnover means better activity and profitability.

Net Assets or Capital Revenue from Operation

Employed Turnover ratio =
Capital Employed

(6) Fixed Assets Turnover Ratio :

Revenue from Operation

Fixed Assets Turnover ratio =
Net Fixed Assets
Significance : High turnover of capital employed, working capital and fixed assets is a good
sign and implies efficient utilization of resources. It reflects efficient utilization resulting in
higher liquidity and profitability in the business.

ILLUSTRATION : ACCOUNTING RATIOS

PRACTICE SUMS : Let’s Do it…..

 PROFITABILITY RATIOS

Efficiency of a business is evaluated by profitability of the

enterprise. “Profitability” refers to the financial performance of
the business.

Important Profitability Ratios

(1) Gross Profit ratio; (2) Operating ratio;

(3) Operating Profit Ratio (4) Net Profit Ratio;
(5) Return on Investment (ROI) / Return on Capital Employed Ratio.
(6) Return on Net Worth (RONW) (7) Earnings per share
(8) Book value per share (9) Dividend payout ratio
(10) Price earning ratio.
(1) Gross Profit Ratio :

Gross Profit
Gross Profit Ratio = X 100 =…%
Net Revenue From Operations

●Revenue from Operation means revenue earned by the enterprise from its
operating activities. It has already been discussed in previous slides.
●Gross Profit = Revenue from Operation (ROF) – Cost of ROF (COGS)

●Cost of ROF (COGS) is also discussed in earlier slides.

●Significance : It indicates gross margin on products sold. It also indicates the
margin available to cover operating expenses, non-operating expenses, etc.
Change in gross profit ratio may be due to change in selling price or cost of
revenue from operations or a combination of both. A low ratio may indicate
unfavorable purchase and sales policy. Higher gross profit ratio is always a good
sign.
(2) Operating Ratio :

Cost of RFO + Operating Expenses

Operating Ratio = X 100 =…%
Net Revenue from Operations

●Operating Expenses : These are those costs which are incurred for operating
activities of the business. Eg being employee benefits expenses and other
expenses. Thus,
● Operating Expenses = Employee Benefit Expenses + Depreciation / Amortization + Other
Expenses (other than non operating expenses such as
interest/dividend paid loss/gain on sale of F.A etc)
( OR )
= Office expenses + Administrative expenses + selling & Distribution
expenses + Employee Benefit expenses + Depreciation /
amortization expenses
●Significance : Used to assess the operational efficiency of the business. Shows
the percentage of RFO that is absorbed by cost of ROF and Operating Expenses.
Lower Operating Ratio leaves higher profit Margin to meet non-operating
expenses. A rise in the operating ratio indicates decline in efficiency.
(3) Operating Profit Ratio :

Operating Profit
Operating Ratio = X 100 =…%
Net Revenue from Operation

Operating Profit = GP + Other operating Income – other operating expenses

(OR)

= NPBT (before tax) + Non – Operating Expenses/ Losses – Non

Operating Incomes
(OR)
= RFO – Operating Cost
Significance : It helps to analyse the performance of business and throws light on the
operational efficiency of the business. It is very useful for inter-firm as well as intra-firm
comparisons. Lower operating ratio is a very healthy sign.

It is to be noted that Operating Ratio & Operating Profit Ratio are complementary to
Each other & thus, if one of the two ratios is deducted from 100 , another ratio is
Obtained.
Operating Ratio (%) + Operating Profit Ratio (%) = 100
Eg: if OPR = 15% , then OR = 85%
(4) Net Profit Ratio :

Net Profit after Tax

Net Profit Ratio = X 100 =…%
Net Revenue of Operations

● Net Profit = RFO – Cost of RFO – Operating Expenses – Non Operating

Expenses + Non – Operating Income – Tax

●Significance : It is an indicator of overall efficiency of the business. It is the

main variable in computation of Return on Investment. It reflects the overall
efficiency of the business, assumes great significance from the point of view of
investors. An increase in ratio over the previous period or intra firm
comparison shows improvement in operational efficiency of the enterprise and
decline means otherwise.
(5) Return on Investment (ROI) or Return on Capital Employed
(CE) Ratio :

It explains the overall utilisation of funds by a business enterprise. Capital employed

means the long-term funds employed in the business and includes shareholders’ funds,
debentures and long-term loans. Alternatively, capital employed may be taken as the total
of non-current assets and working capital.

Net Profit before Interest, Tax & Dividend

ROI / ROCE Ratio = X 100 =…%
Capital Employed

Capital Employed can be computed either from the Liability Side Approach or Asset Side
Approach.
Significance : It reveals the efficiency of the business in utilisation of funds entrusted to it
by shareholders, debenture-holders and long-term loans. For inter-firm comparison,
return on capital employed funds is considered a good measure of profitability. It also
helps in assessing whether the firm is earning a higher return on capital employed as
compared to the interest rate paid.
Note : Non- operating assets are excluded while determining CE & therefore,
Income from such assets (income from non-trade investments) are also excluded
From profit.
(6) Return on Shareholder's Funds :

Return on Net Profit after Tax

Shareholder’s Fund = X 100 =…%
Shareholder’s Fund

This ratio is very important from shareholders’ point of view in assessing whether their
investment in the firm generates a reasonable return or not. It should be higher than the
return on investment otherwise it would imply that company’s funds have not been
employed profitably.

(7) Earning Per Share :

Profit Available to Equity Shareholders

EPS =
Number of Equity Shares

Profit available to equity shareholders is PAT – Dividend on Preference Shares

Significance : This ratio is very important from equity shareholders point of view and
also for the share price in the stock market. This also helps comparison with other to
ascertain its reasonableness and capacity to pay dividend.
(8) Book Value Per Share:

Book Value Per Equity Shareholder’s Fund

Share = X 100 =…%
Number of Equity Shares

● Equity shareholders Fund = Shareholder's Fund – Preference Share Capital

This ratio is again very important from equity shareholders point of view as
it gives an idea about the value of their holding and affects market price of
the shares.
(9) Dividend Pay Out Ratio :

Dividend Per Share

DPR =
EPS

This refers to the proportion of earning that are distributed to the

shareholders. This reflects company’s dividend policy and growth in
owner’s equity.
(10) Price / Earning Ratio :

Market Price of a Share

P/E Ratio =
EPS
It reflects investors expectation about the growth in the firm’s earnings
and reasonableness of the market price of its shares. P/E Ratio vary from
industry to industry and company to company in the same industry
depending upon investors perception of their future.

ILLUSTRATION : ACCOUNTING RATIOS

PRACTICE SUMS : Let’s Do It……