BBA (WOW) MANAGEMENT ACCOUNTING

Module – 2
Ratio Analysis
(Theory)

A ratio is a simple arithmetical expression of the relationship of one number to another.

“A ratio is an expression of the quantitative relationship between two numbers.”
A financial ratio is the relationship between two accounting figures expressed
mathematically. A ratio can be expressed as percentage by multiplying the ratio by 100.
It can also be represented as times.

RATIO ANALYSIS
Ratio analysis is one of the most powerful tools of financial analysis. It is the process of
establishing & interpreting various ratios for helping in making decisions. It means a
better understanding of financial strengths & weaknesses of a firm.

USES AND IMPORTANCE OF RATIO ANALYSIS

1) Utility to shareholders: Ratio Analysis helps in decision making as it provides

valuable information from inferences. It enables in planning and forecasting as
ratios are prepared for a number of years. It is far communicative to the users of
financial statements. It brings about control in organization as it enables correcting
deviations.
2) Utility to investors: For the assessment of the viability of financial statements, an
investor can study the long term solvency and profitability ratios. These ratios help to
decide whether to invest in a particular company or not.
3) Utility to Creditors: creditors and suppliers are interested to know the firm’s ability
to meet short term obligations; hence they can study the liquidity ratios of the firm
before extending credit.
4) Utility to employees: the employees are interested in knowing about their fringe
benefits and job security. The profitability ratios related to sales to understand
about their wages and other benefits.
5) Utility to government: various ratios calculated enable the government to
understand a company’s short term financial, long-term solvency & profitability
position of a firm, to formulate the policies, acts, plans and procedures.

CLASSIFICATION OF RATIOS
A. Traditional Classification / Statement Ratios
(a) Balance Sheet Ratios: These ratios deal with the relationship between two
items appearing in the balance sheet; e.g. current ratio, debt equity ratio,
etc.
(b) Profit & Loss Account Ratios: this type of ratios show the relationship

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between two items which are in the profit and loss account only; e.g. gross
profit ratio, net profit ratio etc.
(c) Composite Ratios: These ratios show the relationship between items one of
which is taken from profit and loss account and the other from the balance
sheet; e.g. rate of return on capital employed, debtors turnover ratio, stock
turnover ratio, etc.

B. Functional Classification
(a) Profitability Ratios
(b) Turnover / Activity Ratios
(c) Financial Ratios
(i) Short – Term Financial / Liquidity Ratios
(ii) Long – Term Financial / Solvency Ratios

A. PROFITABILITY RATIOS:
Profit is considered essential for the survival of the business. Profits are a useful
measure of overall efficiency of a business. Profits to the management are test of
efficiency and a measure of control; to owners a measure of worth of their
investors; to creditors a margin of safety; etc. Profitability ratios are calculated
either in relation to sales or investment.
The following are the profitability ratios:
1. Gross-Profit Ratio
2. Operating Ratio
3. Operating Profit Ratio
4. Individual Expenses Ratio
5. Total Operating Expenses Ratio
6. Net Profit Ratio
7. Interest Coverage Ratio
8. Fixed Dividend Coverage Ratio
9. Equity Dividend Coverage Ratio
10. Debt Servicing Coverage Ratio
11. Return On Investment (ROI) / Return on Capital Employed / Overall Profitability
Ratio
12. Return On Equity Capital
13. Return On Shareholders’ Investment / Net Worth
14. Return On Average Capital Employed
15. Earnings Per Share
16. Dividend Yield Ratio
17. Dividend Pay – Out Ratio / Pay – Out Ratio
18. Retained Earnings Ratio
19. Price- Earning Ratio Or P/E Ratio (Earnings Yield Ratio)

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1. GROSS PROFIT RATIO: This ratio measures the relationship of gross profit to net
sales and is represented as a percentage. This ratio indicates the extent to which
selling price of goods per unit can be reduced without resulting in losses or the
efficiency with which a firm produces its products. Higher the ratio, the better is the
result.

Gross Profit Ratio =𝑮𝒓𝒐𝒔𝒔 𝑷𝒓𝒐𝒇𝒊𝒕 ∗ 𝟏𝟎𝟎

𝑵𝒆𝒕 𝑺𝒂𝒍𝒆𝒔

Gross Profit = Net Sales – Cost of Goods Sold.

2. OPERATING RATIO: Operating ratio establishes the relationship between cost of

goods sold and operating expenses with sales of the firm. It indicates the percentage
of net sales that is consumed by operating cost. Higher the ratio, the less favourable
it is, it would leave a small operating profit to cover interest, income tax, dividend
and reserves.

Operating Ratio = 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑪𝒐𝒔𝒕 ∗ 𝟏𝟎𝟎

𝑵𝒆𝒕 𝑺𝒂𝒍𝒆𝒔

Operating Cost = cost of goods sold + operating expenses.

3. OPERATING PROFIT RATIO:

𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑷𝒓𝒐𝒇𝒊𝒕 𝒃𝒆𝒇𝒐𝒓𝒆 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 & 𝒕𝒂𝒙

Operating Profit Ratio = ∗
𝟏𝟎𝟎
𝑵𝒆𝒕 𝑺𝒂𝒍𝒆𝒔
Operating Profit = Net Sales – Operating Cost.

4. EXPENSES RATIO: Expenses ratios indicate the relationship of various expenses to

net sales. The lower the ratio, the greater is the profitability and vice versa.

(i) Cost of Goods Sold Ratio =𝑪𝒐𝒔𝒕 𝒐𝒇 𝑮𝒐𝒐𝒅 𝑺𝒐𝒍𝒅 ∗ 𝟏𝟎𝟎

𝑵𝒆𝒕 𝒔𝒂𝒍𝒆𝒔

Cost of Goods sold = Opening stock + Purchases + Direct Expenses – Closing Stock
OR
Cost of goods sold = Net Sales – Gross Profit
(ii) Administration & Office Expenses Ratio =
Administration & Office Expenses *100
Net Sales

(iii) Selling & Distribution Expenses Ratio =

Selling & Distribution Expenses * 100
Net Sales
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(iv) Non – Operating Expenses Ratio = 𝑵𝒐𝒏−𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑬𝒙𝒑𝒆𝒏𝒔𝒆 ∗ 𝟏𝟎𝟎

𝑵𝒆𝒕 𝑺𝒂𝒍𝒆𝒔

5. TOTAL OPERATING EXPENSES RATIO: The total operating expenses ratio

indicates the relationship between all the expenses and the net sales. The lower the
ratio, the greater will be the profitability and vice versa.

Operating Expenses Ratio = 𝑻𝒐𝒕𝒂𝒍 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑬𝒙𝒑𝒆𝒏𝒔𝒆𝒔

∗ 𝟏𝟎𝟎
𝑵𝒆𝒕 𝑺𝒂𝒍𝒆𝒔

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6. NET PROFIT RATIO: This ratio establishes a relationship between net profits (after
taxes) and indicates the efficiency of the management in manufacturing,
administrative, selling & other activities of the firm. Higher the ratio better is the
profitability.

𝑵𝒆𝒕 𝑷𝒓𝒐𝒇𝒊𝒕 𝒂𝒇𝒕𝒆𝒓 𝑻𝒂𝒙𝒆𝒔

Net Profit Ratio = ∗ 𝟏𝟎𝟎
𝑵𝒆𝒕 𝑺𝒂𝒍𝒆𝒔

7. INTEREST COVERAGE RATIO: This ratio is used to test debt servicing capacity
of a firm. This ratio is also known as Coverage Ratio or Fixed Charges Cover or
Times Interest Earned. This ratio indicates the number of times interest is covered
by the profits. The higher the ratios safer are the long-term creditors. If the ratio is
6 to 7 times then it is considered to be good.

Interest Coverage Ratio = Earnings before interest & tax

Total Fixed Interest Charges

8. FIXED DIVIDEND COVERAGE RATIO: This ratio is used to test dividend paying
capacity of a firm. This ratio indicates the number of times dividend is covered by
the profits. The higher the ratio the more satisfied are the shareholders. If the ratio
is 3 to 4 times then it is considered as a good ratio for the company.
Preference Dividend Coverage Ratio = 𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝒂𝒇𝒕𝒆𝒓 𝑻𝒂𝒙
𝑷𝒓𝒆𝒇𝒆𝒓𝒆𝒏𝒄𝒆 𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅

9. EQUITY DIVIDEND COVERAGE RATIO: This ratio is used to test dividend paying
capacity of a firm. This ratio indicates the number of times dividend is covered by the
profits. The higher the ratio the more satisfied are the shareholders. If the ratio is 3
to 4 times then it is considered as a good ratio for the company.

𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝐴𝑓𝑡𝑒𝑟 𝑇𝑎𝑥 − 𝑃𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑

𝐸𝑞𝑢𝑖𝑡𝑦 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝐶𝑜𝑣𝑒𝑟𝑎𝑔𝑒 𝑅𝑎𝑡𝑖𝑜 =
𝐸𝑞𝑢𝑖𝑡𝑦 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑

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10. DEBT SERVICING COVERAGE RATIO: This ratio is used to test the capacity of a
firm in paying its annual interest to long term creditors as well as its capacity to repay
the instalment of the Loan term borrowings in a financial year.

Debt Servicing Coverage Ratio = Earnings Before Interest & Tax

Interest + Principal Repayment
(1- T)

11. RETURN ON INVESTMENT (ROI) / RETURN ON CAPITAL EMPLOYED /

OVERALL PROFITABILITY RATIO

Return on Investment = OPBIT / EBIT

Capital Employed

OPBIT – Operating Profit before Interest &

Tax EBIT – Earnings before Interest & Tax

Capital employed is done in two ways:

A) Liabilities Approach B) Assets Approach

Liabilities Approach = Equity Share Capital + Preference Share Capital + Reserves & Other
Undistributed Profits + Long Term Loans & Debentures – Fictitious Assets – Non – operating
Assets.
Fictitious Assets are preliminary expenses; discount on issue of shares & debentures;
underwriting commission, etc.
Non – operating/ Non – Trading Assets = Long Term Investments

Assets Approach = Net Fixed Assets + Net working Capital

Net working Capital = Current Assets – Current Liabilities

12. RETURN ON SHAREHOLDERS’ INVESTMENT / NET WORTH: This ratio studies

the relationship between net profits (after interest & tax) and the proprietors’ funds.
Shareholders’ funds consist of equity share capital, preference share capital, capital
reserves, revenue reserves, accumulated profits, reserves for contingencies, sinking
funds, etc. The accumulated losses and deferred expenses should be deducted from
shareholders’ funds. As this ratio reveals how well the resources of a firm are being
used, higher the ratio better are the result.

Return on Shareholders’ Investment / Net Worth Ratio = 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝐴𝑓𝑡𝑒𝑟 𝑇𝑎𝑥 ∗ 100
𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝘍𝑠𝐹𝑢𝑛𝑑𝑠

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13. RETURN ON EQUITY CAPITAL: Ordinary shareholders are the real owners as
they assume the highest risk in the company & the rate of dividend varies with the
availability of profits. Equity Shareholders’ funds consists of equity share capital,
capital reserves, revenue reserves, accumulated profits, reserves for contingencies,
sinking funds, etc. The accumulated losses and deferred expenses should be deducted
from shareholders’ funds. Higher the ratio, the better it is.

Return on Equity Capital = Earnings after Tax–Preference Dividend X

100
Equity Shareholders’ Funds

14. RETURN ON AVERAGE CAPITAL EMPLOYED

Return on Average Capital Employed=𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝒃𝒆𝒇𝒐𝒓𝒆 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒂𝒏𝒅 𝑻𝒂𝒙

𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝑬𝒎𝒑𝒍𝒂𝒐𝒚𝒆𝒅

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑

𝑂𝑝𝑒𝑛𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑 + 𝐶𝑙𝑜𝑠𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑
=
2
OR

Average Capital Employed = Closing Capital Employed – ½ current year’s profits

OR

Average Capital Employed = Opening Capital Employed + ½ current year’s profits

15. EARNINGS PER SHARE: The earnings per share is a good measure of profitability
and when compared with other companies, it gives view of the comparative earnings
power of a firm.
Earnings Per Share (EPS) = Earnings after tax – Preference dividend
No of Equity Shares

16. DIVIDEND YIELD RATIO: This ratio is calculated to evaluate the relationship
between dividend per share paid and the market value of the share.

Dividend Yield Ratio = Dividend Per Equity Share X 100

Market Price Per Share

Dividend Per Share = Dividend Paid to Shareholders

Number of shares

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17. DIVIDEND PAY – OUT RATIO / PAY – OUT RATIO: It is calculated to find the extent
to which earnings per share have been retained in the business, because ploughing
back of profits enables a company to grow & pay more dividends in future.

𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑃𝑒𝑟 𝐸𝑞𝑢𝑖𝑡𝑦 𝑆ℎ𝑎𝑡𝑒

Dividend Pay – Out Ratio =𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑃𝑒𝑟 𝑆𝐻𝑎𝑟𝑒
OR

Dividend Pay – Out Ratio = 𝑇𝑜𝑡𝑎𝑙 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑃𝑎𝑖𝑑 𝑡𝑜 𝐸𝑞𝑢𝑖𝑡𝑦 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 *

100 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝐴𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑡𝑜 𝐸𝑞𝑢𝑖𝑡𝑦 Shareholders

Dividend Pay – Out Ratio = 100 – Retained Earnings Ratio

18. RETAINED EARNINGS RATIO

Retained Earnings Ratio = Retained Earnings per share x 100

Earnings Per Share

OR

Retained Earnings Ratio = Total Retained Earnings x 100

Earnings Available to Equity Shareholders

19. PRICE EARNING RATIO OR P/E RATIO (EARNINGS YIELD RATIO):

It is calculated to make an estimate of appreciation in the value of a share of a company

and is used by investors to decide whether or not to buy shares in a particular company.

Price Earnings Ratio (P/E Ratio) = Market Price per Equity Share
Earnings per Share

TURNOVER / EFFICIENCY / ACTIVITY RATIOS: Funds are invested in various assets in

business to make sales & earn profits. The efficiency with which assets are managed directly
affects the volume of sales. The better the management of assets higher will be the sales &
profit. Activity ratios measure the efficiency with which a firm manages its resources. These
are called as turnover ratios because they indicate the speed with which assets are converted
into sales.

To measure the efficiency of a firm the following ratios are calculated:

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1) Inventory / Stock Turnover Ratio
2) Debtors / Receivables Turnover Ratio
3) Average / Debt Collection Period
4) Creditors / Payables Turnover Ratio
5) Average / Credit Payment Period
6) Working Capital Turnover Ratio
7) Fixed Assets Turnover Ratio
8) Capital Turnover Ratio

INVENTORY / STOCK TURNOVER RATIO: This ratio indicates the number of times the
stock has been turned over during the period & evaluates the efficiency with which a firm
is able to manage its inventory. The purpose is to ensure only minimum funds are tied up in
inventory. A high inventory turnover or stock velocity indicates efficient management of
inventory because the stocks are sold frequently & the lesser amount of money is required
to finance the stock & vice versa.

Inventory Turnover Ratio = 𝑪𝒐𝒔𝒕 𝒐𝒇 𝒈𝒐𝒐𝒅𝒔 𝒔𝒐𝒍𝒅

𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚

Cost of Goods Sold = Opening Stock + Purchases + Direct Expenses – Closing Stock

OR

Cost of Goods Sold = Sales – Gross Profit

Average Inventory = Opening Stock + Closing Stock

2
NOTE: (i) In the absence of cost of goods sold, cost of sales or sales can be used to calculate
this ratio. (ii) When only closing stock is given it is taken to be average stock.

DEBTORS / RECEIVABLES TURNOVER RATIO: A concern sells goods on credit which

results in tying up substantial funds of a firm in the form of debtors and bills receivables.
Trade debtors are expected to be converted into cash in a short period of time and hence
affect the liquidity position of a firm. Debtors’ turnover ratio indicates the velocity of debt
collection i.e. the number of times debtors are turned over during a year. The higher the
debtors’ turnover ratio the more efficient is the management of debtors in the firm and vice
versa.

Debtors Turnover Ratio = Net Credit Sales

Average Receivables

Net Credit Sales = Total Sales – (Cash sales + return inwards)

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Receivables = Sundry Debtors + Bills Receivables

Average Receivables = Opening receivables + Closing receivables

2

AVERAGE / DEBT COLLECTION PERIOD: This ratio represents the average number of
days for which a firm has to wait before its receivables are converted into cash. The shorter
collection period the better is the collection performance and lesser are the chances of bad
debts and vice versa.

Average Collection Period = No of days / months in a year

Debtors Turnover Ratio

CREDITORS / PAYABLES TURNOVER RATIO: In course of business, a firm will have to

make credit purchases which have to be paid the firm after a short period. Hence, creditors
would like to know if the firm has a good liquidity position. This ratio indicates the velocity
of debt payment i.e. the number of times creditors are turned over during a year in relation
to purchases. Higher the ratio better is the firm’s position in paying debts, maintaining
liquidity & procuring credit from the market and vice versa.

Creditors Turnover Ratio = Net Credit Purchases

Average Payables

Net Credit Purchases = Total Purchases – (cash purchases + returns outwards)

Trade Payables = Sundry Creditors + Bills Payable

Average Payables = Opening Payables + Closing Payables

2
AVERAGE / CREDIT PAYMENT PERIOD: This ratio represents the average number of
days it takes a firm to meet its short-term liabilities i.e. pay off its creditors. Lower the
ratio the better is the liquidity position of the firm & discount earned will also be high and
vice versa.

Average Payment Period = No of days / months in a year

Creditors Turnover Ratio

WORKING CAPITAL TURNOVER RATIO: This ratio indicates the velocity of utilization
of net working capital i.e the number of times the working capital is turned over during a
year. This ratio measures the efficiency with which the working capital is being used by a
firm. A higher ratio indicates efficient utilization of working capital and vice versa.

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Working Capital Turnover Ratio = Net Sales
Net Working Capital

Working Capital = Current Assets – Current Liabilities

FIXED ASSETS TURNOVER RATIO: This ratio studies the velocity of utilization of net fixed
assets i.e the number of times the fixed assets are turned over during the year.

Fixed Assets Turnover Ratio = Net Sales

Net Fixed Assets

OR

Fixed Assets Turnover Ratio = Cost of Sales

Net Fixed Assets

Net Fixed Assets = Fixed Assets –Depreciation

NOTE: In the absence of cost of sales, sales or cost of goods sold can be utilized to calculate
this ratio.
CAPITAL TURNOVER RATIO: This ratio indicates the velocity of utilization capital i .e the
number of times the capital is turned over during a year.

Capital Turnover Ratio = Net Sales

Capital Employed
OR
Capital Turnover Ratio = Cost of Sales
Capital Employed

FINANCIAL RATIOS

SHORT – TERM FINANCIAL / LIQUIDITY RATIOS: Liquidity refers to the ability of a

concern to meet its current obligations as & when they become due. If the current assets can
pay off current liabilities, then the liquidity position will be satisfactory. On the hand, if the
current liabilities are not met by current assets, then the liquidity position is not good. The
bankers, suppliers & short-term creditors are interested in the liquidity position of a firm, as
they will extend credit only if the firm’s working capital position is good. To measure the
liquidity of a firm the following ratios are calculated:

CURRENT / WORKING CAPITAL RATIO: It is the relationship between current assets &
current liabilities. It is also as working capital ratio. This ratio is widely used as a measure
short term financial or liquidity position of a firm. An increase in current ratio indicates an

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improvement in the firm’s liquidity position & vice versa. Rule of thumb for current ratio is
2:1.
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑨𝒔𝒔𝒆𝒕𝒔
Current Ratio =
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔

Current assets include cash & bank balance, marketable securities, bills receivables, sundry
debtors, temporary investments, inventories, work – in – progress & prepaid expenses.
Current liabilities include bills payable, sundry creditors, outstanding expenses, short term
advances, dividend payable, income tax payable, bank overdraft.

LIQUID / ACID TEST / QUICK RATIO: This ratio is the relationship between quick or
liquid assets & current liabilities. This ratio is a more rigorous test of a firm’s liquidity
position. An asset is said to be liquid if it can be converted into cash within a short period.
A high acid test ratio indicates that the firm has sufficient liquidity to meet its current
obligations. Rule of thumb for liquid ratio is 1:1.

Liquid/Acid Test/Quick Ratio = Liquid or Quick Assets

Current Liabilities

Liquid Assets = current assets – (inventories + prepaid expenses)

OR
Liquid Assets include cash & bank balance, marketable securities, temporary investments,
bills receivables & sundry debtors.

ABSOLUTE LIQUID / CASH RATIO: It is the relationship between absolute liquid assets &
current liabilities. It is called as cash ratio as these assets immediately realize cash. Absolute
liquid assets include cash balance, bank balance & marketable securities. Rule of thumb of
absolute liquid ratio is 0.5: 1 or 1: 2.

Absolute-Liquid/Cash Ratio = Absolute - Liquid Assets

Current Liabilities

LONG – TERM FINANCIAL / SOLVENCY RATIOS: Solvency refers to the ability of a

concern to meet its long-term obligations. The long-term creditors of a firm are primarily
interested in knowing the firm’s ability to pay regular interest on borrowings, repayment of
the principal amount and security of their loans. To measure the solvency of a firm the
following ratios are calculated:

o Debt Equity Ratio

o Capital Gearing Ratio
o Proprietory / Equity / Net Worth To Total Assets Ratio
o Solvency Ratio / Ratio Of Total Liabilities To Total Assets
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o Fixed Assets To Net Worth/Proprietor’s Funds Ratio
o Fixed Assets To Total Long Term Funds / Fixed Assets Ratio

DEBT EQUITY RATIO: This ratio, also known as External – Internal Equity ratio indicates the
relationship between outsiders’ funds and shareholders’ funds. This ratio measures the relative
claims of outsiders and the owners against the firm’s assets. Long term debt includes debentures,
mortgages and long-term borrowings. Shareholders’ funds consist of equity share capital,
preference share capital, capital reserves, revenue reserves, accumulated profits, reserves for
contingencies, sinking funds, etc. The accumulated losses and deferred expenses should be
deducted from shareholders’ funds. The Debt – Equity ratio of a firm should be 2: 1.
(Company is aggressive in financing if it is 2:1 and conservative in financing if it is 1: 2).

Debt – Equity Ratio = Total Long-Term Debt

Shareholders’ Funds

CAPITAL GEARING RATIO: This ratio is used to describe the relationship between equity
shareholder’s funds and other fixed interest & dividend bearing funds. The firm is said to be
in low gear if preference share capital & other fixed interest-bearing loans are less than
equity shareholders’ funds. Low geared means less than 1; evenly geared means equal to 1
and highly geared means more than 1.

Capital Gearing Ratio = Fixed Interest & Dividend bearing Funds

Equity Shareholders’ Funds

Fixed Interest Bearing Funds = Debentures + Long Term Loans

Fixed Dividend Bearing Fund = Preference Share Capital

PROPRIETORY / EQUITY / NET WORTH TO TOTAL ASSETS RATIO: This ratio

establishes the relationship between a firm’s shareholders’ funds and its total assets. The total
assets denote total resources of the concern. Higher the ratio better is the long-term solvency
position of the company.

Proprietary / Equity Ratio = Shareholders’ Funds

Total Assets (excluding goodwill)

Total Assets = Net Fixed Assets + Current Assets + Investments.

SOLVENCY RATIO / RATIO OF TOTAL LIABILITIES TO TOTAL ASSETS:

This ratio indicates the relationship between the total liabilities to outsiders to total assets
of a firm. Lower the ratio, more stable is the long-term solvency position of a firm.

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BBA (WOW) MANAGEMENT ACCOUNTING
Solvency Ratio = Total Liabilities to Outsiders X 100
Total Assets

Total Liabilities to outsiders = Long Term Debt + Current Liabilities

FIXED ASSETS TO NET WORTH/PROPRIETOR’S FUNDS RATIO: This ratio establishes

the relationship between fixed assets and shareholder’s funds. Fixed Assets include all
intangible assets like goodwill, patents, copyrights, trademarks, etc unless they are worthless.
This ratio indicates the extent to which shareholders’ funds are sunk into the fixed assets. If
the ratio is less than 100%, it implies that owners’ funds are more than total fixed assets and
a part of the working capital is provided by the shareholders; and vice versa.

𝑭𝒊𝒙𝒆𝒅 𝑨𝒔𝒔𝒆𝒕𝒔 (𝒂𝒇𝒕𝒆𝒓

Fixed Assets to Net Worth Ratio =
𝒅𝒆𝒑𝒓𝒆𝒄𝒊𝒂𝒕𝒊𝒐𝒏)
𝑺𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓𝘍𝒔𝑭𝒖𝒏𝒅𝒔

FIXED ASSETS TO TOTAL LONG TERM FUNDS / FIXED ASSETS RATIO:

Fixed Assets Ratio = Fixed Assets (after depreciation)

Total Long-Term Funds

Fixed Assets include all intangible assets like goodwill, patents, copyrights, trademarks, etc unless
they are worthless.

Total Long Term Funds = Equity Share Capital + Preference Share Capital + Reserves & Surplus

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+ Debentures + Long-Term Borrowings – Fictitious -Assets

This ratio indicates the extent to which the total fixed assets are financed by long term
funds of the firm. In case the fixed assets exceed the total of the long term funds it implies
that the firm has financed a part of fixed assets out of working capital which is not a
good financial policy and vice versa. If 75 – 80% of the long term funds are used to
finance the fixed assets the ratio is good. The remaining funds will be used to finance the
permanent working capital.

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