Accountancy Chapter 2.5 – Accounting Ratios

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Chapter 2.5 – Accounting Ratios

Accountancy Chapter 2.5 – Accounting Ratios

1. Introduction to Accounting Ratios

  • Definition: Mathematical expressions comparing two or more financial figures from financial statements (Balance Sheet, Profit & Loss Account).
  • Purpose: Simplify complex financial data to assess liquidity, solvency, efficiency, and profitability.
  • Forms: Expressed as fractions, proportions, percentages, or multiples.
    • Example:
    • Gross Profit Ratio = Gross Profit / Revenue from Operations × 100

2. Objectives of Ratio Analysis

  1. Identify Problem Areas: Highlight inefficiencies in operations or resource allocation.
  2. Evaluate Profitability: Assess returns on investments and operational efficiency.
  3. Facilitate Comparisons:
    • Intra-firm: Track performance across periods.
    • Inter-firm: Compare with industry benchmarks.
  4. Forecast Trends: Predict future performance using historical data.
  5. Support Decision-Making: Aid stakeholders (investors, creditors, management) in strategic planning.

3. Advantages of Ratio Analysis

  1. Simplification: Converts complex data into understandable metrics.
  2. Performance Tracking: Monitors efficiency in resource utilization.
  3. SWOT Analysis: Identifies strengths, weaknesses, opportunities, and threats.
  4. Creditworthiness Assessment: Helps creditors evaluate repayment capacity.
  5. Operational Insights: Reveals inventory management efficiency, debt repayment capability, etc.

4. Limitations of Ratio Analysis

  1. Dependence on Historical Data: Ignores inflation or market changes.
  2. Accounting Policies: Variations in depreciation methods or inventory valuation distort comparisons.
  3. Qualitative Ignorance: Excludes non-monetary factors (e.g., employee morale).
  4. Manipulation Risk: Financial statements can be window-dressed.
  5. Lack of Standards: No universal ideal ratios; industry-specific benchmarks vary.

5. Types of Ratios

I. Liquidity Ratios

Assess short-term debt-paying capacity.

  1. Current Ratio:

Current Ratio = Current Assets / Current Liabilities​

Current Assets: Cash, inventory, receivables, prepaid expenses.
Current Liabilities: Creditors, short-term loans, overdrafts.

  • Ideal Range: 2:1.
  • Example: Current Assets=Rs. 1,34,000, Current Liabilities=Rs. 1,04,000⇒ Ratio=1.29:1
  • Significance: Measures safety margin for creditors.
  1. Quick (Liquid) Ratio:

Quick Ratio = Quick Assets / Current Liabilities

(Quick Assets = Current Assets − Inventory − Prepaid Expenses)

  •  Ideal Range: 1:1.
  • Example: Quick Assets=Rs. 80,000, Current Liabilities=Rs. 1,04,000⇒ Ratio=0.77:1
  • Significance: Tests immediate liquidity without inventory liquidation.

II. Solvency Ratios

Evaluate long-term debt repayment capacity.

  1. Debt-Equity Ratio:

Debt-Equity Ratio = Long-term Debt / Shareholders’ Funds

Shareholders’ Funds: Equity capital + Reserves + Surplus.

  • Example: Debt=Rs. 5,00,000, Equity=Rs. 15,00,000⇒ Ratio=0.33:
  • Significance: Indicates financial leverage; higher ratio = higher risk.

2. Debt to Capital Employed Ratio:

    Debt to Capital Employed = Long-term Debt / Capital Employed

    (Capital Employed = Debt + Equity)

    • Example: Debt=Rs. 5,00,000, Capital Employed=Rs. 20,00,000⇒ Ratio=0.25:1
      1. Proprietary Ratio:

      Proprietary Ratio = Shareholders’ Funds / Total Assets​

      • Significance: Shows proportion of assets funded by owners.

        4. Interest Coverage Ratio:

          Interest Coverage=EBIT / Interest Expense

          • Example: EBIT=Rs. 2,50,000, Interest=Rs. 1,50,000⇒ Ratio=1.67 times

            III. Activity (Turnover) Ratios

            Measure operational efficiency.

            1. Inventory Turnover Ratio:

            Inventory Turnover = Cost of Revenue from Operations / Average Inventory

            • Example: Cost of Revenue=Rs. 60,000, Average Inventory=Rs. 20,000⇒ Ratio=3 
            • Significance: Higher ratio = efficient inventory management.

            2. Trade Receivables Turnover Ratio:

              Receivables Turnover = Net Credit Sales / Average Receivables

              Average Collection Period: 365 / Receivables Turnover​

                3. Trade Payables Turnover Ratio:

                  Payables Turnover = Net Credit Purchases / Average Payables

                  Average Payment Period: 365 / Payables Turnover​

                  4. Fixed Assets Turnover:

                    Fixed Assets Turnover = Revenue from Operations / Net Fixed Assets

                    IV. Profitability Ratios

                    Assess earnings relative to sales, assets, or equity.

                    1. Gross Profit Ratio:

                    Gross Profit Ratio = Gross Profit / Revenue from Operations × 100

                    Example: Gross Profit=Rs. 10,000, Revenue=Rs. 1,00,000⇒ Ratio=10%

                      1. Operating Ratio:

                      Operating Ratio = (Cost of Revenue + Operating Expenses) / Revenue ×100

                      1. Net Profit Ratio:

                      Net Profit Ratio = Net Profit After Tax / Revenue × 100

                      1. Return on Investment (ROI):

                      ROI = EBIT / Capital Employed × 100

                      1. Earnings Per Share (EPS):

                      EPS = (Net Profit – Preference Dividend) / Number of Equity Shares​

                      6. Practical Applications & Analysis

                      • Interpreting Ratios:
                        • A high Debt-Equity Ratio (>2:1) signals over-leverage.
                        • A low Inventory Turnover indicates obsolete stock or poor sales.
                      • Cross-Validation: Use multiple ratios (e.g., Current Ratio + Quick Ratio) for robust analysis.
                      • Trend Analysis: Compare ratios over time to identify improving/declining performance.

                      7. Summary of Key Formulas

                      RatioFormula
                      Current RatioCurrent Assets / Current Liabilities
                      Debt-Equity RatioLong-term Debt / Shareholders’ Funds
                      Inventory TurnoverCost of Revenue / Average Inventory
                      ROIEBIT / Capital Employed × 100
                      Gross Profit RatioGross Profit / Revenue × 100

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