Chapter Notes

Meaning of Accounting Ratios

An accounting ratio is a tool used in financial statement analysis. It's a mathematical calculation that shows the relationship between two accounting numbers taken from financial statements. This relationship can be expressed in several ways:

• As a fraction or proportion (e.g., 2:1)
• As a percentage (e.g., 10%)
• As a number of times (e.g., 6 times)

Objectives of Ratio Analysis

Ratio analysis is a key technique for interpreting the financial results of a business. It helps users of financial information to:

• Identify areas needing more attention: Ratios can highlight specific parts of the business, like inventory management or debt levels, that may have problems.
• Find potential for improvement: By analyzing ratios, management can see which areas are performing well and which could be improved with focused effort.
• Analyze performance deeply: Ratios provide a detailed look into the company's profitability (earning capacity), liquidity (ability to meet short-term bills), solvency (ability to meet long-term debt), and efficiency (how well it uses its assets).
• Enable comparison: Ratios allow for cross-sectional analysis, which means comparing the company's performance against industry standards or competitors.
• Aid in future planning: Information from ratio analysis is useful for making projections and estimating future performance.

Advantages of Ratio Analysis

When done correctly, ratio analysis helps stakeholders understand how efficiently a business is being run. Its main advantages are:

• Helps to understand the effectiveness of decisions: Ratios show whether the company's operating, investing, and financing decisions have improved its performance.
• Simplifies complex data: Ratios turn large, complex accounting figures into simpler, more understandable numbers and establish clear relationships between them.
• Helpful in comparative analysis: By comparing ratios over several years (intra-firm comparison or time series analysis), one can identify trends. Comparing with other firms (inter-firm comparison) helps gauge relative performance.
• Identifies problem areas: Ratios act like a "whistle blower," pointing out areas of weakness that need attention and areas of strength that can be further improved.
• Enables SWOT analysis: Ratios help explain changes in the business, allowing management to understand its Strengths, Weaknesses, Opportunities, and Threats (SWOT).
• Allows for various comparisons: Performance can be benchmarked against the company's own past performance, other companies, or industry standards.

Limitations of Ratio Analysis

Because ratios are calculated from financial statements, they inherit all the limitations of that accounting data. Key limitations include:

Limitations arising from Accounting Data:

• Limitations of Accounting Data: Accounting figures are not always precise. They are a mix of recorded facts, accounting conventions, and personal judgments (like estimating the useful life of an asset). This means the ratios are also based on estimates, not absolute truths.
• Ignores Price-Level Changes: Accounting assumes the value of money is stable. In reality, inflation erodes the purchasing power of money, making it meaningless to compare financial data from different years without adjusting for price changes.
• Ignores Qualitative Aspects: Ratios are purely quantitative. They ignore non-monetary factors like the quality of management, employee morale, or customer satisfaction, which are crucial for a business's success.
• Variations in Accounting Practices: Different companies may use different accounting policies (e.g., for valuing inventory or calculating depreciation). This makes it difficult to make a valid comparison between two firms.
• Forecasting: Ratios are based on historical data. Using them alone to forecast the future is not reliable, as future success also depends on many non-financial factors.

Limitations of Ratios Themselves:

• Means, not the End: Ratios are tools for analysis; they don't provide answers on their own. They indicate a problem but do not solve it.
• Lack of Standardised Definitions: There is no universal agreement on the exact formula for some ratios. For example, "liquid liabilities" might sometimes exclude a bank overdraft, which can change the result.
• No Universally Accepted Standards: There is no single "ideal" value for a ratio that applies to all industries or companies. What is good for one industry might be poor for another.
• Based on Unrelated Figures: As mentioned earlier, a ratio calculated from two unrelated numbers is meaningless.

Types of Ratios

Ratios can be classified in two main ways: traditional and functional.

Traditional Classification (based on where the numbers come from in the financial statements):

• Statement of Profit and Loss Ratios: Both numbers are taken from the Statement of Profit and Loss (e.g., Gross Profit Ratio).
• Balance Sheet Ratios: Both numbers are from the Balance Sheet (e.g., Current Ratio).
• Composite Ratios: One number is from the Statement of Profit and Loss and the other is from the Balance Sheet (e.g., Trade Receivables Turnover Ratio).

Functional Classification (based on the purpose of the ratio): This is the most commonly used classification.

1. Liquidity Ratios: These measure the firm's ability to meet its short-term obligations (debts due within a year).
2. Solvency Ratios: These measure the firm's ability to meet its long-term obligations.
3. Activity (or Turnover) Ratios: Also called Efficiency Ratios, these measure how efficiently the company is using its resources to generate revenue.
4. Profitability Ratios: These measure the earning capacity and overall operational efficiency of the business.

Liquidity Ratios

Liquidity ratios are used to assess the short-term solvency of a business—its ability to pay its current bills and expenses on time. The two main liquidity ratios are the Current Ratio and the Quick Ratio.

Current Ratio

The Current Ratio shows the relationship between a company's current assets and its current liabilities.

Formula: Current Ratio = Current Assets / Current Liabilities

• Current Assets are assets that are expected to be converted into cash or used up within one year. They include items like cash, inventories, trade receivables (debtors), prepaid expenses, and short-term investments.
• Current Liabilities are obligations that are due for payment within one year. They include trade payables (creditors), short-term borrowings, and other current liabilities.

• Inventories: ₹50,000
• Trade receivables: ₹50,000
• Advance tax: ₹4,000
• Cash and cash equivalents: ₹30,000
• Trade payables: ₹1,00,000
• Short-term borrowings (bank overdraft): ₹4,000

Solution:

• Current Assets = ₹50,000 + ₹50,000 + ₹4,000 + ₹30,000 = ₹1,34,000
• Current Liabilities = ₹1,00,000 + ₹4,000 = ₹1,04,000
• Current Ratio = ₹1,34,000 / ₹1,04,000 = 1.29 : 1

Significance: The Current Ratio measures the margin of safety a company has to cover its short-term debts.

• A generally accepted safe range for this ratio is 2:1. This means having twice the amount of current assets as current liabilities.
• A very high ratio is not necessarily good. It might mean that the company's resources are being underutilized, with too much money tied up in non-productive assets like excess inventory.
• A low ratio is risky. It suggests that the company might struggle to pay its short-term debts on time, which could damage its creditworthiness.

Quick or Liquid Ratio

The Quick Ratio, also known as the Acid-Test Ratio, is a stricter measure of liquidity than the Current Ratio. It excludes assets that are not easily converted into cash.

Formula: Quick Ratio = Quick Assets / Current Liabilities

• Quick Assets (or Liquid Assets) are current assets that can be converted into cash very quickly. To calculate them, we start with total current assets and subtract inventories and other less liquid assets like prepaid expenses and advance tax.

• Current Assets = ₹1,34,000
• Current Liabilities = ₹1,04,000
• Inventories = ₹50,000
• Advance tax = ₹4,000

Solution:

• Quick Assets = Current Assets - (Inventories + Advance Tax) = ₹1,34,000 - (₹50,000 + ₹4,000) = ₹80,000
• Quick Ratio = ₹80,000 / ₹1,04,000 = 0.77 : 1

Significance: This ratio shows a company's ability to meet its short-term obligations without having to sell its inventory.

• A safe or ideal ratio is generally considered to be 1:1. This indicates that the company has enough quick assets to cover its current liabilities completely.
• A ratio much lower than 1:1 can be risky, while a very high ratio might suggest that the company is not investing its liquid funds effectively.

• Payment of a current liability (e.g., paying a creditor ₹10,000): Current Assets decrease to ₹40,000 and Current Liabilities decrease to ₹15,000. The new ratio is 2.67:1. The ratio improves.
• Purchasing goods on credit (e.g., ₹10,000): Current Assets (inventory) increase to ₹60,000 and Current Liabilities (creditors) increase to ₹35,000. The new ratio is 1.7:1. The ratio reduces.
• Sale of a fixed asset for cash (e.g., a computer for ₹3,000): Current Assets (cash) increase to ₹53,000, but Current Liabilities remain unchanged. The new ratio is 2.12:1. The ratio improves.

Solvency Ratios

Solvency Ratios are used to assess a business's ability to meet its long-term financial obligations. Lenders and investors use these ratios to judge the long-term health and risk profile of a company.

Debt-Equity Ratio

The Debt-Equity Ratio measures the relationship between long-term debt and shareholders' funds (equity). It shows how much of the company's long-term financing comes from debt versus equity.

Formula: Debt-Equity Ratio = Long-term Debts / Shareholders' Funds (Equity)

• Long-term Debts include long-term borrowings, debentures, and other long-term liabilities.
• Shareholders' Funds (Equity) consist of share capital, reserves and surplus, and money received against share warrants.

Significance: This ratio indicates the company's level of indebtedness.

• From a lender's perspective, a low Debt-Equity Ratio is safer, as it means the business is financed more by its owners than by outsiders, providing a larger safety cushion. A ratio of 2:1 is often considered a safe upper limit.
• From an owner's perspective, a high ratio can sometimes be beneficial. If the company earns a higher return on its investments than the interest it pays on debt, the excess earnings go to the shareholders. This is known as "trading on equity." However, it is also much riskier.

• Long-term borrowings: ₹4,00,000
• Other long-term liabilities & provisions: ₹1,00,000
• Share capital: ₹12,00,000
• Reserves and surplus: ₹2,00,000
• Money received against share warrants: ₹1,00,000

Solution:

• Long-term Debts = ₹4,00,000 + ₹1,00,000 = ₹5,00,000
• Equity = ₹12,00,000 + ₹2,00,000 + ₹1,00,000 = ₹15,00,000
• Debt-Equity Ratio = ₹5,00,000 / ₹15,00,000 = 0.33 : 1

Debt to Capital Employed Ratio

This ratio shows the proportion of long-term debt in the total long-term funds used in the business.

Formula: Debt to Capital Employed Ratio = Long-term Debt / Capital Employed

• Capital Employed = Long-term Debt + Shareholders' Funds. It represents the total long-term funds invested in the business.

Significance: Similar to the Debt-Equity Ratio, it measures the extent of debt financing. A low ratio indicates greater security for lenders.

Proprietary Ratio

The Proprietary Ratio shows the proportion of total assets financed by the owners (shareholders).

Formula: Proprietary Ratio = Shareholders' Funds / Capital Employed (or Net Assets)

Significance: A higher ratio is a positive sign, as it indicates a strong financial structure and provides a greater safety margin for creditors.

Total Assets to Debt Ratio

This ratio measures how much of the company's assets are financed by long-term debt. It shows the extent to which assets cover the debt.

Formula: Total Assets to Debt Ratio = Total Assets / Long-term Debts

Significance: A higher ratio indicates a safer position for lenders, as it means that a larger portion of assets has been financed by owners' funds and that the debt is well-covered by assets.

Interest Coverage Ratio

This ratio measures a company's ability to make its interest payments on outstanding debt.

Formula: Interest Coverage Ratio = Net Profit before Interest and Tax / Interest on Long-term Debts

Significance: It shows how many times the company's profits can cover its interest obligations. A higher ratio is better, as it indicates a strong capacity to service debt, providing a high degree of safety for lenders.

• Net Profit after tax: ₹60,000
• 15% Long-term debt: ₹10,00,000
• Tax rate: 40%

Solution:

1. Calculate Net Profit before tax: Net Profit before tax = Net Profit after tax / (1 - Tax rate) = ₹60,000 / (1 - 0.40) = ₹60,000 / 0.60 = ₹1,00,000
2. Calculate Interest on Long-term Debt: Interest = 15% of ₹10,00,000 = ₹1,50,000
3. Calculate Net Profit before Interest and Tax: = Net Profit before tax + Interest = ₹1,00,000 + ₹1,50,000 = ₹2,50,000
4. Calculate Interest Coverage Ratio: = ₹2,50,000 / ₹1,50,000 = 1.67 times

Activity (or Turnover) Ratios

Activity Ratios, also known as Turnover Ratios or Efficiency Ratios, measure how effectively a firm is using its assets to generate sales. A higher turnover ratio generally indicates better asset utilization and improved efficiency.

Inventory Turnover Ratio

This ratio shows how many times a company's inventory is sold and replaced over a period.

Formula: Inventory Turnover Ratio = Cost of Revenue from Operations / Average Inventory

• Cost of Revenue from Operations = Revenue from Operations - Gross Profit.
• Average Inventory = (Opening Inventory + Closing Inventory) / 2.

Significance:

• A high turnover is generally good, as it suggests strong sales and efficient inventory management. However, a very high ratio could also mean the company is buying in small lots or losing sales due to stockouts.
• A low turnover is a warning sign. It may indicate overstocking, obsolete inventory, or poor sales performance.

Trade Receivables Turnover Ratio

This ratio measures how efficiently a firm collects its credit sales from customers (debtors).

Formula: Trade Receivables Turnover Ratio = Net Credit Revenue from Operations / Average Trade Receivables

• Average Trade Receivables = (Opening Debtors & Bills Receivable + Closing Debtors & Bills Receivable) / 2.

Significance: A higher ratio indicates that the company is collecting its debts quickly. This ratio can be used to calculate the Average Collection Period, which shows the average number of days it takes to collect money from customers.

Average Collection Period = Number of days in a year / Trade Receivables Turnover Ratio

Trade Payable Turnover Ratio

This ratio indicates how quickly a company pays its suppliers (creditors).

Formula: Trade Payables Turnover Ratio = Net Credit Purchases / Average Trade Payables

• Average Trade Payables = (Opening Creditors & Bills Payable + Closing Creditors & Bills Payable) / 2.

Significance: This ratio reveals the company's payment pattern.

• A high ratio suggests prompt payments to suppliers.
• A low ratio might mean the company gets generous credit terms from its suppliers, or it could indicate delayed payments, which can harm the company's reputation.
• This can also be used to find the Average Payment Period.

Average Payment Period = Number of days in a year / Trade Payables Turnover Ratio

Net Assets or Capital Employed Turnover Ratio

This ratio shows the relationship between revenue and the total long-term funds invested in the business.

Formula: Net Assets Turnover Ratio = Revenue from Operations / Capital Employed

Significance: A high turnover indicates efficient utilization of the company's capital to generate sales. This ratio can be broken down further:

• Fixed Assets Turnover Ratio = Net Revenue from Operations / Net Fixed Assets
• Working Capital Turnover Ratio = Net Revenue from Operations / Working Capital

Higher turnover in all these categories reflects efficiency, leading to better liquidity and profitability.

Profitability Ratios

Profitability Ratios are used to measure a business's ability to generate earnings relative to its sales, assets, and equity. They show how efficiently the company is being managed.

Gross Profit Ratio

This ratio measures the profit margin on the products sold.

Formula: Gross Profit Ratio = (Gross Profit / Net Revenue from Operations) x 100

Significance: It shows the margin available to cover operating and other expenses. A higher ratio is desirable and indicates either a higher selling price, a lower cost of goods sold, or both.

Operating Ratio

This ratio measures the proportion of a company's revenue that is used to cover its operational costs.

Formula: Operating Ratio = ((Cost of Revenue from Operations + Operating Expenses) / Net Revenue from Operations) x 100

• Operating Expenses include administrative, selling, and distribution expenses.

Significance: This ratio is a measure of operational efficiency. A lower operating ratio is better, as it means a smaller percentage of revenue is being spent on operations, leaving more for interest, taxes, and profits.

Operating Profit Ratio

This is the complement of the Operating Ratio and reveals the operating profit margin.

Formula: Operating Profit Ratio = (Operating Profit / Revenue from Operations) x 100 OR Operating Profit Ratio = 100 - Operating Ratio

Significance: It measures the profitability from the core business operations. A higher ratio indicates better operational efficiency.

Net Profit Ratio

This ratio measures the overall profitability of the company after all expenses, including interest and taxes, have been deducted.

Formula: Net Profit Ratio = (Net Profit / Revenue from Operations) x 100

Significance: It reflects the overall efficiency of the business and is a key indicator for investors.

Return on Capital Employed or Investment (ROI)

ROI is a comprehensive measure of profitability that shows how efficiently the long-term funds (from both owners and lenders) have been used to generate profit.

Formula: ROI = (Profit before Interest and Tax / Capital Employed) x 100

Significance: It is considered one of the best measures of a company's overall profitability. It helps assess whether the firm is earning a higher return on its capital than the cost of that capital (e.g., the interest rate on its loans).

Return on Shareholders' Funds (RONW)

This ratio, also called Return on Net Worth, is crucial for shareholders as it measures the return generated on their investment.

Formula: RONW = (Profit after Tax / Shareholders' Funds) x 100

Significance: Shareholders want this ratio to be high. It should ideally be higher than the company's overall ROI, which would indicate that the use of debt is benefiting the shareholders.

Earnings per Share (EPS)

EPS shows the portion of a company's profit allocated to each outstanding share of common stock.

Formula: EPS = Profit available for equity shareholders / Number of Equity Shares

• Profit available for equity shareholders = Net Profit after Tax - Dividend on Preference Shares.

Significance: EPS is a very important metric for shareholders and heavily influences the market price of a share.

Book Value per Share

This ratio gives an idea of the net asset value of a single equity share.

Formula: Book Value per Share = Equity Shareholders' Funds / Number of Equity Shares

Significance: It represents the amount each shareholder would receive if the company were liquidated. It is often compared to the market price of the share.

Dividend Payout Ratio

This ratio shows the proportion of earnings that are distributed to shareholders in the form of dividends.

Formula: Dividend Payout Ratio = Dividend per Share / Earnings per Share

Significance: It reflects the company's dividend policy. A high payout ratio means the company is returning more of its earnings to shareholders, while a low ratio might suggest the company is retaining earnings for growth and reinvestment.

Price / Earning Ratio (P/E Ratio)

The P/E Ratio compares the company's share price to its earnings per share.

Formula: P/E Ratio = Market Price of a Share / Earnings per Share

Significance: It indicates how much investors are willing to pay for each rupee of earnings. A high P/E ratio often suggests that investors expect high future growth in earnings. It is a key metric for valuing a company's stock.