Key Points

An accounting ratio is a mathematical expression showing the relationship between two related accounting figures from financial statements. It is used to analyze the financial performance and position of a business.

The main objectives of ratio analysis are to assess a firm's liquidity, solvency, efficiency, and profitability. It also helps in identifying strengths and weaknesses and making intra-firm and inter-firm comparisons.

Ratios are functionally classified into four main types: Liquidity Ratios, Solvency Ratios, Activity (or Turnover) Ratios, and Profitability Ratios. Each category assesses a different aspect of the business's performance.

The Current Ratio measures a firm's ability to meet its short-term obligations within a year. It is calculated as Current Assets divided by Current Liabilities, with an ideal ratio often considered to be 2:1.

The Quick Ratio is a stricter measure of liquidity, excluding less liquid assets. It is calculated as Quick Assets (Current Assets minus Inventories) divided by Current Liabilities, with an ideal ratio of 1:1.

The Debt-Equity Ratio measures the relationship between long-term debt and shareholders' funds. It is calculated as Long-Term Debt divided by Equity, and a ratio of 2:1 is generally considered safe.

This ratio measures the extent to which a company's assets cover its long-term debt. It is calculated by dividing Total Assets by Long-Term Debt, where a higher ratio indicates greater financial security for lenders.

The Interest Coverage Ratio assesses a firm's ability to service its interest payments on debt. It is calculated as Profit before Interest and Tax divided by Interest on Long-term Debts.

This ratio measures how many times a company's inventory is sold and replaced over a period. It is calculated as Cost of Revenue from Operations divided by Average Inventory.

This ratio indicates the efficiency with which a firm collects its credit sales. It is calculated as Net Credit Revenue from Operations divided by Average Trade Receivables.

This ratio shows how quickly a company pays its suppliers for credit purchases. It is calculated as Net Credit Purchases divided by Average Trade Payables.

This ratio measures how efficiently a company is using its working capital to generate sales. It is calculated as Revenue from Operations divided by Working Capital (Current Assets minus Current Liabilities).

The Gross Profit Ratio shows the margin of profit on sales before deducting operating expenses. It is calculated as Gross Profit divided by Revenue from Operations, multiplied by 100.

The Operating Ratio measures the cost of operations in relation to revenue. It is calculated as (Cost of Revenue from Operations + Operating Expenses) divided by Revenue from Operations, with a lower ratio being better.

The Net Profit Ratio measures the overall profitability of the business after all expenses, including tax. It is calculated as Net Profit after Tax divided by Revenue from Operations, multiplied by 100.

ROI, or Return on Capital Employed, measures the overall profitability of the firm relative to the total funds invested. It is calculated as Profit before Interest and Tax divided by Capital Employed.

EPS measures the profit available to each equity share. It is calculated as Profit available for Equity Shareholders divided by the Number of Equity Shares.

Ratio analysis is limited by its reliance on historical data, differing accounting practices, and ignorance of price-level changes and qualitative factors. Ratios are indicators and not solutions in themselves.