Chapter 5

Accounting Ratios

Financial statements aim at providing financial information about a business enterprise to meet the information needs of the decision-makers. Financial statements prepared by a business enterprise in the corporate sector are published and are available to the decision-makers. These statements provide financial data which require analysis, comparison and interpretation for taking decision by the external as well as internal users of accounting information. This act is termed as financial statement analysis. It is regarded as an integral and important part of accounting. As indicated in the previous chapter, the most commonly used techniques of financial statements analysis are comparative statements, common size statements, trend analysis, accounting ratios and cash flow analysis. The first three have been discussed in detail in the previous chapter. This chapter covers the technique of accounting ratios for analysing the information contained in financial statements for assessing the solvency, efficiency and profitability of the enterprises.

5.1 Meaning of Accounting Ratios

As stated earlier, accounting ratios are an important tool of financial statement analysis. A ratio is a mathematical number calculated as a reference to relationship of two or more numbers and can be expressed as a fraction, proportion, percentage, and a number of times. When the number is calculated by referring to two accounting numbers derived from the financial statements, it is termed as accounting ratio. For example if the gross profit of the business is Rs. 10,000 and the sales are Rs. 1,00,000, it can be said that the gross profit is 10% (10,000/1,00,000) x 100 of the ‘Revenue from Operations. This ratio is termed as gross profit ratio. Similarly, inventory turnover ratio may be 6 which implies that inventory turns into ‘Revenue from Operations’ six times in a year.

It needs to be observed that accounting ratios exhibit relationship, if any between accounting numbers extracted from financial statements, they are essentially derived numbers and their efficacy depends a great deal upon the basic numbers from which they are calculated. Hence, if the financial statements contain some errors, the derived numbers in terms of ratio analysis would also present an erroneous scenerio. Further, a ratio must be calculated using numbers which are meaningfully correlated. A ratio calculated by using two unrelated numbers would hardly serve any purpose. For example, the furniture of the business is Rs. 1,00,000 and Purchases are Rs. 3,00,000. The ratio of purchases to furniture is 3 (3,00,000/1,00,000) but it hardly has any relevance. The reason is that there is no relationship between these two aspects.

5.2 Objectives of Ratio Analysis

Ratio analysis is indispensable part of interpretation of results revealed by the financial statements. It provides users with crucial financial information and points out the areas which require investigation. Ratio analysis is a technique. Which involves regrouping of data by application of arithmetical relationships, though its interpretation is a complex matter. It requires a fine understanding of the way and the rules used for preparing financial statements. Once done effectively, it provides a wealth of information which helps the analyst:

1. To know the areas of the business which need more attention;

2. To know about the potential areas which can be improved with the effort in the desired direction;

3. To provide a deeper analysis of the profitability, liquidity, solvency and efficiency levels in the business;

4. To provide information for making cross sectional analysis by comparing the performance with the best industry standards;

5. To provide information derived from financial statements useful for making projections and estimates for the future.

5.3 Advantages of Ratio Analysis

The ratio analysis if properly done improves the user’s understanding of the efficiency with which the business is being conducted. The numerical relationships throw light on many latent aspects of the business. If properly analysed, the ratios make us understand various problem areas as well as the bright spots of the business. The knowledge of problem areas help management take care of them in future. The knowledge of areas which are working better helps you improve the situation further. It must be emphasised that ratios are means to an end rather than the end in themselves. Their role is essentially indicative and that of a whistle blower. There are many advantages derived from the ratio analysis. These are summarised as follows:

1. Helps understand efficacy of decisions: The ratio analysis helps you understand whether the business firm has taken the right kind of operating, investing and financing decisions. It indicates how far they have helped in improving the performance.

2. Simplify complex figures and establish relationships: Ratios help in simplifying the complex accounting figures and bring out their relationships. They help summarise the financial information effectively and assess the managerial efficiency, firm’s credit worthiness, earning capacity, etc.

3. Helpful in comparative analysis: The ratios are not be calculated for one year only. When many year figures are kept side by side, they help a great deal in exploring the trends visible in the business. The knowledge of trend helps in making projections about the business which is a very useful feature.

4. Identification of problem areas: Ratios help business in identifying the problem areas as well as the bright areas of the business. Problem areas would need more attention and bright areas will need polishing to have still better results.

5. Enables SWOT analysis: Ratios help a great deal in explaining the changes occurring in the business. The information of change helps the management a great deal in understanding the current threats and opportunities and allows business to do its own SWOT (Strength-Weakness-Opportunity-Threat) analysis.

6. Various comparisons: Ratios help comparisons with certain bench marks to assess as to whether firm, performance is better or otherwise. For this purpose, the profitability, liquidity, solvency, etc. of a business may be compared: (i) over a number of accounting periods with itself (Intra-firm Comparison/Time Series Analysis), (ii) with other business enterprises (Inter-firm Comparison/Cross-sectional Analysis), and (iii) with standards set for that firm/industry (comparison with standard (or industry) expectations).

5.4 Limitations of Ratio Analysis

Since the ratios are derived from the financial statements, any weakness in the original financial statements will also creep in the derived analysis in the form of ratio analysis. Thus, the limitations of financial statements also form the limitations of the ratio analysis. Hence, to interpret the ratios, the user should be aware of the rules followed in the preparation of financial statements and also their nature and limitations. The limitations of ratio analysis which arise primarily from the nature of financial statements are as under:

1. Limitations of Accounting Data: Accounting data give an unwar-ranted impression of precision and finality. In fact, accounting data “reflect a combination of recorded facts, accounting conventions and personal judgements and the judgements and conventions applied affect them materially. For example, profit of the business is not a precise and final figure. It is merely an opinion of the accountant based on application of accounting policies. The soundness of the judgement necessarily depends on the competence and integrity of those who make them and on their adherence to Generally Accepted Accounting Principles and Conventions”. Thus, the financial statements may not reveal the true state of affairs and so the ratios will also not give the true picture.

2. Ignores Price-level Changes: The financial accounting is based on stable money measurement principle. It implicitly assumes that price level changes are either non-existent or minimal. But the truth is otherwise. We are normally living in inflationary economies where the power of money declines constantly. A change in the price level makes analysis of financial statement of different accounting years meaningless because accounting records ignore changes in value of money.

3. Ignore Qualitative or Non-monetary Aspects: Accounting provides information about quantitative (or monetary) aspects of business. Hence, the ratios also reflect only the monetary aspects, ignoring completely the non-monetary (qualitative) factors.

4. Variations in Accounting Practices: There are differing accounting policies for valuation of stock, calculation of depreciation, treatment of intangibles, definition of certain financial variables, etc. available for various aspects of business transactions. These variations leave a big question mark on the cross sectional analysis. As there are variations in accounting practices followed by different business enterprises, a valid comparison of their financial statements is not possible.

5. Forecasting: Forecasting of future trends based only on historical analysis is not feasible. Proper forecasting requires consideration of non-financial factors as well.

Now let us talk about the limitations of the ratios. The various limitations are:

1. Means and not the End: Ratios are means to an end rather than the end by itself.

2. Lack of ability to resolve problems: Their role is essentially indicative and of whistle blowing and not providing a solution to the problem.

3. Lack of standardised definitions: There is a lack of standardised definitions of various concepts used in ratio analysis. For example, there is no standard definition of liquid liabilities. Normally, it includes all current liabilities, but sometimes it refers to current liabilities less bank overdraft.

4. Lack of universally accepted standard levels: There is no universal yardstick which specifies the level of ideal ratios. There is no standard list of the levels universally acceptable, and, in India, the industry averages are also not available.

5. Ratios based on unrelated figures: A ratio calculated for unrelated figures would essentially be a meaningless exercise. For example, creditors of Rs. 1,00,000 and furniture of Rs. 1,00,000 represent a ratio of 1:1. But it has no relevance to assess efficiency or solvency.

Hence, ratios should be used with due consciousness of their limitations while evaluatory the performance of an organisation and planning the future strategies for its improvement.

5.5 Types of Ratios

There is a two way classification of ratios: (1) traditional classification, and (2) functional classification. The traditional classification has been on the basis of financial statements to which the determinants of ratios belong. On this basis the ratios are classified as follows:

1. ‘Statement of Profit and Loss Ratios: A ratio of two variables from the statement of profit and loss is known as statement of profit and loss ratio. For example, ratio of gross profit to revenue from operations is known as gross profit ratio. It is calculated using both figures from the statement of profit and loss.

2. Balance Sheet Ratios: In case both variables are from balance sheet, it is classified as Balance Sheet Ratios. For example, ratio of current assets to current liabilities known as current ratio is calculated using both figures from balance sheet.

3. Composite Ratios: If a ratio is computed with one variable from the statement of profit and loss and another variable from the balance sheet, it is called composite ratio. For example, ratio of credit revenue from operations to trade receivables (known as trade receivables turnover ratio) is calculated using one figure from the statement of profit and loss (credit revenue from operations) and another figure (trade receivables) from the balance sheet.

Although accounting ratios are calculated by taking data from financial statements but classification of ratios on the basis of financial statements is rarely used in practice. It must be recalled that basic purpose of accounting is to throw useful light on the financial performance (profitability) and financial position (its capacity to raise money and invest them wisely) as well as changes occurring in financial position (possible explanation of changes in the activity level). As such, the alternative classification (functional classification) based on the purpose for which a ratio is computed, is the most commonly used classification which reach as follows:

1. Liquidity Ratios: To meet its commitments, business needs liquid funds. The ability of the business to pay the amount due to stakeholders as and when it is due is known as liquidity, and the ratios calculated to measure it are known as ‘Liquidity Ratios’. They are essentially short-term in nature.

2. Solvency Ratios: Solvency of business is determined by its ability to meet its contractual obligations towards stakeholders, particularly towards external stakeholders, and the ratios calculated to measure solvency position are known as ‘Solvency Ratios’. They are essentially long-term in nature.

3. Activity (or Turnover) Ratios: This refers to the ratios that are calculated for measuring the efficiency of operation of business based on effective utilisation of resources. Hence, these are also known as ‘Efficiency Ratios’.

4. Profitability Ratios: It refers to the analysis of profits in relation to sales or funds (or assets) employed in the business and the ratios calculated to meet this objective are known as ‘Profitability Ratios’.

5.6 Liquidity Ratios

Liquidity ratios are calculated to have indications about the short term solvency of the business, i.e. the firm’s ability to meet its current obligations. These are analysed by looking at the amounts of current assets and current liabilities in the balance sheet. The two ratios included in this category are Current Ratio and Liquid Ratio.

5.6.1 Current Ratio

Current ratio is the proportion of current assets to current liabilities. It is expressed as follows:

Current Ratio = Current Assets : Current Liabilities or 

Current assets include current investments, inventories, trade receivables (debtors and bills receivables), cash and cash equivalents, short-term loans and advances and other current assets such as prepaid expenses, advance tax and accrued income, etc.

Current liabilities include short-term borrowings, trade payables (creditors and bills payables), other current liabilities and short-term provisions.

Illustration 1

Calculate Current ratio from the following information:

5.6.2 Quick Ratio

It is the ratio of quick (or liquid) asset to current liabilities. It is expressed as

Quick ratio = Quick Assets : Current Liabilities or 

The quick assets are defined as those assets which are quickly convertible into cash. While calculating quick assets we exclude the closing stock and prepaid expenses from the current assets. Because of exclusion of non-liquid current asset, it is considered better than current ratio as a measure of liquidity position of the business. It is calculated to serve as a supplementary check on liquidity position of the business and is therefore, also known as ‘Acid-Test Ratio’.

Illustration 2

Calculate quick ratio from the information given in illustration 1.

Solution

Significance: The ratio provides a measure of the capacity of the business to meet its short-term obligations without any flaw. Normally it is advocated to be safe to have a ratio of 1:1 as unnecessarily low ratio will be very risky and a high ratio suggests unnecessarily deployment of resources in otherwise less profitable short-term investments.

Illustration 3

Calculate ‘Liquidity Ratio’ from the following information:

Current liabilities = Rs. 50,000

Current assets = Rs. 80,000

Inventories = Rs. 20,000

Advance tax = Rs. 5,000

Prepaid expenses = Rs. 5,000

Solution

Illustration 4

X Ltd. has a current ratio of 3.5:1 and quick ratio of 2:1. If excess of current assets over quick assets represented by stock is Rs. 24,000, calculate current assets and current liabilities.

Solution

Current Ratio = 3.5:1

Quick Ratio = 2:1

Let Current Liabilities = x

Current Assets = 3.5x

And Quick Assets = 2x

Stock = Current Assets – Quick Assets

24,000 = 3.5x – 2x

24,000 = 1.5x

x = Rs.16,000

Current Assets = 3.5x = 3.5 × Rs. 16,000 = Rs. 56,000.

Verification : Current Ratio = Current Assets : Current Liabilities

= Rs. 56,000 : Rs. 16,000 = 3.5 : 1

Quick Ratio = Quick Assets – Current Liabilities = Rs. 32,000 : Rs. 16,000 = 2:1

Illustration 5

Calculate the current ratio from the following information :

Total assets = Rs. 3,00,000

Solution

Total assets = Non-current assets + Current assets

Rs. 3,00,000 = Rs. 2,60,000 + Current assets

Current assets = Rs. 3,00,000 – Rs. 2,60,000 = Rs. 40,000

Total assets = Equity and Liabilities

= Shareholders’ Funds + Non-current liabilities +

Current liabilities

Rs. 3,00,000 = Rs. 2,00,000 + Rs. 80,000 + Current Liabilities

Current liabilities = Rs. 3,00,000 – Rs. 2,80,000

= Rs. 20,000

Current Ratio =

Current Assets/Current Liabilities

=Rs. 40,000/Rs. 20,000 = 2 :1

Illustration 6

The current ratio is 2:1. State giving reasons which of the following transactions would improve, reduce and not change the current ratio:

(a) Repayment of current liability;

(b) Purchased goods on credit;

(c) Sale of an office typewriter (Book value – Rs. 4,000) for Rs. 3,000 only;

(d) Sale of merchandise (goods) costing Rs. 10,000 for Rs. 11,000;

(e) Payment of dividend.

Solution

The given current ratio is 2 : 1. Let us assume that current assets are Rs. 50,000 and current liabilities are Rs. 25,000; and so the current ratio is 2:1. Now we will analyse the effect of given transactions on current ratio.

(a) Assume that Rs. 10,000 of creditors is paid by cheque. This will reduce the current assets to Rs. 40,000 and current liabilities to Rs. 15,000. The new ratio will be 2.67 : 1(Rs. 40,000/Rs.15,000). Hence, it has improved.

(b) Assume that Rs. 10,000 goods are purchased on credit. This will increase the current assets to Rs. 60,000 and current liabilities to Rs. 35,000. The new ratio will be 1.7:1(Rs. 60,000/Rs. 35,000). Hence, it has reduced.

(c) Due to sale of a typewriter (a fixed asset) the current assets will increase upto Rs. 53,000 without any change in the current liability. The new ratio will be 2.12:1(Rs. 53,000/Rs. 25,000). Hence, it has improved.

(d) This transaction will decrease the stock by Rs. 10,000 and increase the cash by Rs. 11,000 thereby increasing the current assets by Rs. 1,000 without and change in the current liability. The new ratio will be 2.04:1 (Rs. 51,000/Rs. 25,000). Hence, it has improved.

(e) Assume that  Rs 5,000 is given by way of dividend. It will reduce the current assets to ₹45,000 and short-term provisions (current liabilities) by Rs 5,000. The new ratio will be 2:25:1 (Rs 45,000/Rs 20,000). Hence, it has improved.

5.7 Solvency Ratios

The persons who have advanced money to the business on long-term basis are interested in safety of their payment of interest periodically as well as the repayment of principal amount at the end of the loan period. Solvency ratios are calculated to determine the ability of the business to service its debt in the long run. The following ratios are normally computed for evaluating solvency of the business.

1. Debt equity ratio;

2. Debt ratio;

3. Proprietary ratio;

4. Total Assets to Debt Ratio;

5. Interest Coverage Ratio.

5.7.1 Debt-Equity Ratio

Debt Equity Ratio measures the relationship between long-term debt and equity. If debt component of the total long-term funds employed is small, outsiders feel more secure. From security point of view, capital structure with less debt and more equity is considered favourable as it reduces the chances of bankruptcy. Normally, it is considered to be safe if debt equity ratio is 2:1. It is computed as follows:

Debt-Equity ratio = Long-term Debts/Shareholders' Funds

where:

Shareholders’ Funds (Equity) = Share capital + Reserves and Surplus +

Money received against share warrants

Share Capital = Equity share capital + Preference share capital

or

Shareholders’ Funds (Equity) = Non-current sssets + Working capital –

Non-current liabilities

Working Capital = Current Assets – Current Liabilities

Significance: This ratio measures the degree of indebtedness of an enterprise and gives an idea to the long-term lender regarding extent of security of the debt. As indicated earlier, a low debt equity ratio reflects more security. A high ratio, on the other hand, is considered risky as it may put the firm into difficulty in meeting its obligations to outsiders. However, from the perspective of the owners, greater use of debt trading on equity may help in ensuring higher. returns for them if the rate of earnings on capital employed is higher than the rate of interest payable.

Illustration 7

From the following balance sheet of ABC Co. Ltd. as on March 31, 2015. Calculate debt equity ratio:

5.7.2 Debt to Capital Employed Ratio

The Debt Ratio refers to the ratio of long-term debt to the total of external and internal funds (capital employed or net assets). It is computed as follows:

Debt to Capital Employed Ratio = Long-term Debt/Capital Employed (or Net Assets)

Capital employed is equal to the long-term debt + shareholders’ funds. Alternatively, it may be taken as net assets which are equal to the total assets – current liabilities taking the data of Illustration 7, capital employed shall work out to Rs. 5,00,000 + Rs. 15,00,000 = Rs. 20,00,000. Similarly, Net Assets as Rs. 25,00,000 – Rs. 5,00,000 = Rs. 20,00,000 and the Debt to capital employed ratio as Rs. 5,00,000/Rs. 20,00,000 = 0.25:1.

Significance : Like debt equity ratio, it shows proportion of long-term debt in capital employed. Low ratio provides security to creditors and high ratio helps management in trading on equity. In the above case, the debt ratio is less than half which indicates reasonable funding by debt and adequate security of debt.

It may be noted that Debt Ratio can also be computed in relation to total assets. In that case, it usually refers to the ratio of total debt (long-term debt + current liabilities) to total assets, i.e. total of fixed and current assets (or shareholders funds + long-term debt + current liabilities), and is expressed as

5.7.3 Proprietary Ratio

Proprietary ratio expresses relationship of proprietor’s (shareholders) funds to net assets and is calculated as follows :

Proprietary Ratio = Shareholders' Funds/Capital employed (or net assets)

Based on data of Illustration 7, it shall be worked out as follows:

Rs. 15,00,000/Rs. 20,00,000 = 0.75 : 1

Significance: Higher proportion of shareholders funds in financing the assets is a positive feature as it provides security to creditors. This ratio can also be computed in relation to total assets instead of net assets (capital employed). It may be noted that the total of debt to capital employed ratio and proprietory ratio is equal to 1. Take these ratios worked out on the basis of data of Illustration 7, the debt to Capital Employed ratio is 0.25 : 1 and the Proprietory Ratio 0.75 : 1 the total is 0.25 + 0.75 = 1. In terms of percentage it can be stated that the 25% of the capital employed is funded by debts and 75% by owners’ funds.

5.7.4 Total Assets to Debt Ratio

This ratio measures the extent of the coverage of long-term debts by assets. It is calculated as

Total assets to Debt Ratio = Total assets/Long-term debts

Taking the data of Illustration 8, this ratio will be worked out as follows:

Rs. 14,00,000/Rs. 1,50,000 = 9.33 : 1

The higher ratio indicates that assets have been mainly financed by owners funds and the long-term loans is adequately covered by assets.

It is better to take the net assets (capital employed) instead of total assets for computing this ratio also. It is observed that in that case, the ratio is the reciprocal of the debt to capital employed ratio.

Significance: This ratio primarily indicates the rate of external funds in financing the assets and the extent of coverage of their debts are covered by assets.

Illustration 9

From the following information, calculate Debt Equity Ratio, Total Assets to Debt Ratio, Proprietory Ratio, and Debt to Capital Employed Ratio:

Illustration 10

The debt equity ratio of X Ltd. is 0.5 : 1. Which of the following would increase/ decrease or not change the debt equity ratio?

(i) Further issue of equity shares

(ii) Cash received from debtors

(iii) Sale of goods on cash basis

(iv) Redemption of debentures

(v) Purchase of goods on credit.

Solution

The change in the ratio depends upon the original ratio. Let us assume that external funds are Rs. 5,00,000 and internal funds are Rs. 10,00,000. Now we will analyse the effect of given transactions on debt equity ratio.

(i) Assume that Rs. 1,00,000 worth of equity shares are issued. This will increase the internal funds to Rs. 11,00,000. The new ratio will be 0.45 : 1 (5,00,000/11,00,000). Thus, it is clear that further issue of equity shares decreases the debt-equity ratio.

(ii) Cash received from debtors will leave the internal and external funds unchanged as this will only affect the composition of current assets. Hence, the debt-equity ratio will remain unchanged.

(iii) This will also leave the ratio unchanged as sale of goods on cash basis neither affect Debt nor equity.

(iv) Assume that Rs. 1,00,000 debentures are redeemed. This will decrease the long-term debt to Rs. 4,00,000. The new ratio will be 0.4 : 1 (4,00,000/10,00,000). Redemption of debentures will decrease the debit-equity ratio.

(v) This will also leave the ratio unchanged as purchase of goods on credit neither affect Debt nor equity.

5.7.5 Interest Coverage Ratio

It is a ratio which deals with the servicing of interest on loan. It is a measure of security of interest payable on long-term debt. It expresses the relationship between profits available for payment of interest and the amount of interest payable. It is calculated as follows:

Interest Coverage Ratio = Net Profit before Interest and Tax / Interest on long term debt

Significance:It reveals the number of times interest on long-term debts is covered by the profits available for interest. A higher ratio ensures safety of interest on debts.

Illustration 11

From the following details, calculate interest coverage ratio:

Net Profit after tax Rs. 60,000; 15% Long-term Debt 10,00,000; and Tax Rate 40%.

Solution

Net Profit after Tax = Rs. 60,000

Tax Rate = 40%

Net Profit before tax = Net profit after tax*100/(100 – Tax rate) = Rs. 60,000 x 100/(100 – 40) = Rs. 1,00,000

Interest on Long Term Debt = 15% of Rs. 10,00,000 = Rs. 1,50,000

Net profit before interest and tax = Net profit before tax + Interest = Rs. 1,00,000 + Rs. 1,50,000 = Rs. 2,50,000

Interest Coverage Ratio = Net Profit before Interest and Tax/Interest on long term debt = Rs. 2,50,000/Rs. 1,50,000 = 1.67 times.

5.8 Activity (or Turnover) Ratios

These ratios indicate the speed at which, activities of the business are being performed. The activity ratios express the number of times assets employed, or, for that matter, any constituent of assets, is turned into sales during an accounting period. Higher turnover ratio means better utilisation of assets and signifies improved efficiency and profitability, and as such are known as efficiency ratios. The important activity ratios calculated under this category are

1. Inventory Turnover;

2. Trade receivable Turnover;

3. Trade payable Turnover;

4. Investment (Net assets) Turnover

5. Fixed assets Turnover; and

6. Working capital Turnover.

5.8.1 Inventory Turnover Ratio

It determines the number of times inventory is converted into revenue from operations during the accounting period under consideration. It expresses the relationship between the cost of revenue from operations and average inventory. The formula for its calculation is as follows:

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

Where average inventory refers to arithmetic average of opening and closing inventory, and the cost of revenue from operations means revenue from operations less gross profit.

Significance : It studies the frequency of conversion of inventory of finished goods into revenue from operations. It is also a measure of liquidity. It determines how many times inventory is purchased or replaced during a year. Low turnover of inventory may be due to bad buying, obsolete inventory, etc., and is a danger signal. High turnover is good but it must be carefully interpreted as it may be due to buying in small lots or selling quickly at low margin to realise cash. Thus, it throws light on utilisation of inventory of goods.

Illustration 13

From the following information, calculate inventory turnover ratio:

                                                 Rs.

Revenue from operations = 4,00,000

Average Inventory = 55,000

Gross Profit Ratio = 10%

Solution

Revenue from operations = Rs. 4,00,000

Gross Profit = 10% of Rs. 4,00,000 = Rs. 40,000

Cost of Revenue from operations = Revenue from operations – Gross Profit

= Rs. 4,00,000 – Rs. 40,000 = Rs. 3,60,000

Inventory Turnover Ratio =

Cost of Revenue from Operations/Average Inventory

= Rs. 3,60,000/Rs. 55,000

= 6.55 times

Illustration 14

A trader carries an average stock of Rs. 40,000. His stock turnover is 8 times. If he sells goods at profit of 20% on sales. Find out the profit.

Solution

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

8 =Cost of Revenue from Operations/Rs. 40,000

 Cost of Revenue from operations = 8 × Rs. 40,000

= Rs. 3,20,000

Revenue from operations = Cost of Revenue from operations ×100/80

= Rs. 3,20,000 ×100/80

= Rs. 4,00,000

Gross Profit = Revenue from operations – Cost of Revenue from operations

= Rs. 4,00,000 – Rs. 3,20,000 = Rs. 80,000

5.8.2 Trade Receivables Turnover Ratio

It expresses the relationship between credit revenue from operations and trade receivable. It is calculated as follows :

Trade Receivable Turnover ratio = Net Credit Revenue from Operations/Average Trade Receivable

Where Average Trade Receivable = (Opening Debtors and Bills Receivable + Closing

Debtors and Bills Receivable)/2

It needs to be noted that debtors should be taken before making any provision for doubtful debts.

Significance: The liquidity position of the firm depends upon the speed with which trade receivables are realised. This ratio indicates the number of times the receivables are turned over and converted into cash in an accounting period. Higher turnover means speedy collection from trade receivable. This ratio also helps in working out the average collection period. The ratio is calculated by dividing the days or months in a year by trade receivables turnover ratio.

Illustration 15

Calculate the Trade receivables turnover ratio from the following information:

                                                                            Rs.

Total Revenue from operations               4,00,000

Cash Revenue from operations            20% of Total Revenue from operations

Trade receivables as at 1.4.2016        40,000

Trade receivables as at 31.3.2017     1,20,000

Solution

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

Credit Revenue from operations = Total revenue from operations – Cash revenue from operations

Cash Revenue from operations = 20% of Rs. 4,00,000

= Rs. 4,00,000 ×20/100 = Rs. 80,000

Credit Revenue from operations = Rs. 4,00,000 – Rs. 80,000 = Rs. 3,20,000

* This figure has not been divided by 2, in order to calculate average Trade Receivables as the figures of debtors and bills receivables in the beginning of the year are not available. So when only year-end figures are available use the same as it is.

5.8.4 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.

It is calculated as follows :

Significance : High turnover of capital employed, working capital and fixed assets is a good sign and implies efficient utilisation of resources. Utilisation of capital employed or, for that matter, any of its components is revealed by the turnover ratios. Higher turnover reflects efficient utilisation resulting in higher liquidity and profitability in the business.

Illustration 18

From the following information, calculate (i) Net assets turnover, (ii) Fixed assets turnover, and (iii) Working capital turnover ratios :

Revenue from operations for the year 2016-17 were Rs. 30,00,000

Solution:

Revenue from Operations = Rs. 30,00,000

Capital Employed = Share Capital + Reserves and

Surplus + Long-term Debts

(or Net Assets)

= (Rs.4,00,000 + Rs.6,00,000)

+ (Rs.1,00,000 + Rs.3,00,000)

+ (Rs.2,00,000 + Rs.2,00,000)

= Rs. 18,00,000

Fixed Assets = Rs.8,00,000 + Rs.5,00,000 + Rs.2,00,000

+ Rs.1,00,000 = Rs. 16,00,000

Working Capital = Current Assets – Current Liabilities

= Rs.4,00,000 – Rs.2,00,000 = Rs. 2,00,000

Net Assets Turnover Ratio = Rs.30,00,000/Rs.18,00,000 = 1.67 times

Fixed Assets Turnover Ratio = Rs.30,00,000/Rs.16,00,000 = 1.88 times

Working Capital Turnover Ratio = Rs.30,00,000/Rs.2,00,000 = 15 times

5.9.1 Gross Profit Ratio

Gross profit ratio as a percentage of sales is computed to have an idea about gross margin. It is computed as follows:

Gross Profit Ratio = Gross Profit/Net Sales × 100

Significance: It indicates gross margin or mark-up on products sold. There is no standard norm for its comparison. It also indicates the margin available to cover operating expenses, non-operating expenses, etc. Change in gross profit ratio may result from change in selling price or cost of sales or a combination of both. A low ratio may indicate unfavourable purchase and sales policy. It must be interpreted carefully as valuation of stock also affects its computation. Higher gross profit ratio is always a good sign.

Illustration 19

Following information is available for the year 2016-17, calculate gross profit ratio:

                                                    Rs

Revenue from Operations:Cash 25,000

                                             :Credit  75,000

Purchases : Cash                     15,000

Credit                                        60,000

Carriage Inwards                        2,000

Salaries 25,000

Decrease in Stock 10,000

Return Outwards 2,000

Wages 5,000

Solution

Revenue from Operations = Cash Revenue from Operations + Credit Revenue from

Opration

= Rs.25,000 + Rs.75,000 = Rs. 1,00,000

Net Purchases = Cash Purchases + Credit Purchases – Return Outwards

= Rs.15,000 + Rs.60,000 – Rs.2,000 = Rs. 73,000

Cost of Revenue from = Purchases + (Opening Inventory – Closing Inventory) +

operations Direct Expenses

= Purchases + Decrease in inventory + Direct Expenses

= Rs.73,000 + Rs.10,000 + (Rs.2,000 + Rs.5,000)

= Rs.90,000

Gross Profit = Revenue from Operations – Cost of Revenue from

Operation

= Rs.1,00,000 – Rs.90,000

= Rs. 10,000

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

= Rs.10,000/Rs.1,00,000 × 100

= 10%.

5.9.2 Operating Ratio

It is computed to analyse cost of operation in relation to sales. It is calculated as follows:

Operating Ratio = (Cost of Sales + Operating Expenses)/ Net Revenue from Operations × 100

Operating expenses include office expenses, administrative expenses, selling expenses and distribution expenses etc.

Cost of operation is determined by excluding non-operating incomes and expenses such as loss on sale of assets, interest paid, dividend received, loss by fire, speculation gain and so on.

5.9.3 Operating Profit Ratio

It is calculated to reveal operating margin. It may be computed directly or as a residual of operating ratio.

Operating Profit Ratio = 100 – Operating Ratio

Alternatively, it is calculated as under:

Operating Profit Ratio = Revenue from Operations × 100

Where Operating Profit = Revenue from Operations – Operating Cost

Significance: Operating Ratio is computed to express cost of operations excluding financial charges in relation to sales. A corollary of it is ‘Operating Profit Ratio’. 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.

Illustration 20

Given the following information:

Revenue from Operations 3,40,000

Cost of Revenue from Operations 1,20,000

Selling expenses 80,000

Administrative Expenses 40,000

Calculate Gross Profit Ratio and Operation Ratio.

Solution

5.9.4 Net Profit Ratio

Net Profit Ratio is based on all inclusive concept of profit. It relates sales to net profit after operational as well as non-operational expenses and incomes. It is calculated as under:

Net Profit Ratio = Net profit / Revenue from Operations × 100

Generally, net profit refers to Profit after Tax (PAT).

Significance: It is a measure of net profit margin in relation to sales. Besides revealing profitability, 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.

Illustration 21

Gross profit ratio of a company was 25%. Its credit sales was Rs. 20,00,000 and its cash sales was 10% of the total sales. If the indirect expenses of the company were Rs. 50,000, calculate its net profit ratio.

Solution

Cash Revenue from Operations = Rs.20,00,000 × 10/90

= Rs.2,22,222

Hence, total Revenue from Operations are = Rs.22,22,222

Gross profit = 0.25 × 22,22,222 = Rs. 5,55,555

Net profit = Rs.5,55,555 – 50,000

= Rs.5,05,555

Net profit ratio = Net profit/Revenue from Operations

× 100

= Rs.5,05,555/Rs.22,22,222 × 100

= 22.75%.

5.9.5 Return on Capital Employed or Investment

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 fund, debentures and long-term loans. Alternatively, capital employed may be taken as the total of non-factious assets current liabilities. Profit refers to the Profit before Interest and Tax (PBIT) for computation of this ratio. Thus, it is computed as follows:

Return on Investment (or Capital Employed) = Profit before Interest and Tax/ Capital Employed × 100

Significance: It measures return on capital employed in the business. It reveals the efficiency of the business in utilisation of funds entrusted to it by shareholders, debenture-holders and long-term liabilities. For inter-firm comparison, return on capital employed which reveals overall utilisation of fund is considered 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.

5.9.6 Return on Shareholders’ 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.

A better measure of profitability from shareholders point of view is obtained by determining return on total shareholders fund, it is also termed as Return on Net Worth (RONW) and is calculated as under :

5.9.7 Earnings Per Share

The ratio is defined as – EPS = Profit available for equity shareholders/ No. of Equity Shares

In this context, earnings refer to profit available for equity shareholders which is worked out as

This ratio is very important from equity shareholders point of view and so also for the share price in the stock market. This also helps comparison with other firm’s to ascertain its reasonableness and capacity to pay dividend.

5.9.8 Book Value Per Share

This ratio is calculated as :

 Book Value per share = Equity shareholders’ funds/Number of Equity Shares

Equity shareholder funds refer to Shareholders Funds – 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.

5.9.9 Dividend Payout Ratio

This refers to the proportion of earning that are distributed against the shareholders. It is calculated as –

Dividend Payout Ratio =

This reflects company’s dividend policy and growth in owner’s equity.

5.9.10 Price Earning Ratio

The ratio is defined as –P/E Ratio = Market price of a Share/Earnings per Share

For example, if the EPS of company X is Rs. 10 and market price is Rs. 100, the price earning ratio will be 10 (100/10). It reflects investors expectation about the growth in the firm’s earnings and reasonableness of the market price of its shares. P/E ratios vary from industy to industry and company to company in the same industry depending upon investors perception of their future.

Illustration 22

From the following details, calculate Return on Investment:

Also calculate Return on Shareholders’ Funds, EPS, Book value per share and P/E ratio if the market price of the share is Rs. 34 and the net profit after tax was Rs. 1,50,000, and the tax had amounted to Rs. 50,000.

Solution

Profit before interest and tax = Rs. 1,50,000 + Debenture interest + Tax

= Rs. 1,50,000 + Rs. 40,000 + Rs. 50,000

= Rs.2,40,000

Capital Employed = Equity Share Capital + Preference Share

Capital + Reserves + Debentures

= Rs. 4,00,000 + Rs. 1,00,000 + Rs. 1,84,000

+ Rs. 4,00,000 = Rs. 10,84,000

Return on Investment = Profit before Interest and Tax/

Capital Employed × 100

= Rs. 2,40,000/Rs. 10,84,000 × 100

= 22.14%

Shareholders’ Fund = Equity Share Capital + Preference Share Capital

+ General Reserve

= Rs. 4,00,000 + Rs. 1,00,000 + Rs. 1,84,000

= Rs. 6,84,000

Return on Shareholders’ Funds = Profit after tax/shareholders’ Funds × 100

= Rs. 1,50,000/Rs. 6,84,000 × 100

= 21.93%

EPS = Profit available for Equity Shareholders/

Number of Equity Shares

= Rs. 1,38,000/ 40,000 = Rs. 3.45

Preference Share Dividend = Rate of Dividend × Prefence Share Capital

= 12% of Rs. 1,00,000

= Rs. 12,000

where, Dividend on Prefrence = Rate of Dividend × Preference Share Capital

shares = 12% of Rs. 1,00,000

= Rs.12,000

= Rs. 1,50,000 – Rs. 12,000 = Rs. 1,38,000

P/E Ratio = Market price of a share/ Earnings per share

= 34/3.45

= 9.86 Times

Book Value per share = Equity Shareholders’ fund/No. of

equity shares

where, Number of Equity Shares =

Equity share capital / Face value per share

=

Rs. 4,00,000 / Rs.10

= 40,000 shares

Hence, Book value per share = Rs. 5,84,000/40,000 shares = Rs. 14.60

Illustration 23

Calculate current assets of a company from the following information:

Stock turnover ratio = 4 times

Stock at the end is Rs. 20,000 more than the stock in the beginning.

Sales Rs. 3,00,000 and gross profit ratio is 20% of sales.

Current liabilities = Rs. 40,000

Quick ratio = 0.75: 1

Solution

Cost of Revenue from Operations = Revenue from Operations – Gross Profit

= Rs. 3,00,000 – (Rs. 3,00,000 × 20%)

= Rs. 3,00,000 – Rs. 60,000

= Rs. 2,40,000

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

Average Inventory = Cost of Revenue from Operations/4

= Rs. 2,40,000/4 = Rs. 60,000

Average Inventory = (Opening inventory + Closing inventory)/2

Rs. 60,000 = Opening inventory + (Opening inventory

+Rs.20,000)/2

Rs. 60,000 = Opening inventory + Rs. 10,000

Opening Inventory = Rs. 50,000

Closing Inventory = Rs. 70,000

Liquid Ratio = Liquid assets/current liabilities

0.75 = Liquid assets/Rs. 40,000

Liquid Assets = Rs. 40,000 × 0.75 = Rs. 30,000

Current Assets = Liquid assets + Closing inventory

= Rs. 30,000 + Rs. 70,000 = Rs. 1,00,000

Illustration 24

The current ratio is 2.5:1. Current assets are Rs. 50,000 and current liabilities are Rs. 20,000. How much must be the decline in the current assets to bring the ratio to 2:1.

Solution

Current liabilities = Rs. 20,000

For a ratio of 2:1, the current assets must be 2 × 20,000 = Rs. 40,000

Present level of current assets = Rs. 50,000

Necessary decline = Rs. 50,000 – Rs. 40,000 = Rs. 10,000.

Illustration 25

Following information is given by a company from its books of accounts as on March 31, 2017:

Calculate:

i) Current Ratio

ii) Liquid Ratio

iii) Debt Equity Ratio

iv) Interest Coverage Ratio

v) Inventory Turnover Ratio

Solution

Terms Introduced in the Chapter

1. Ratio Analysis

2. Liquidity Ratios

3. Solvency Ratios

4. Activity Ratios

5. Profitability Ratios

6. Return on Investment (ROI)

7. Quick Assets

8. Equity (Shareholders Funds)

9. Return on Net Worth

10. Average Collection Period

11. Receivables

12. Turnover Ratios

13. Efficiency Ratios

14. Dividend Payout