Accounting Ratios

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Ratio Analysis is a technique which involves regrouping of data by application of arithmetical relationships. Ratio Analysis is one of the financial statement analysis techniques and refers to the analysis of the information in the financial statements for assessing

of the enterprise.

In the ratio analysis the relation among different items of financial statements is expressed either as

However, the interpretation of these numbers is a complex task and requireds a good understanding of the way in which the rules are used for preparing the financial statements.

A properly done Ratio Analysis helps in

Primarily the various types of ratios are classified into the following two ways:

The following is the list of relationship established to study the given turnovers.

a. Inventory Turnover: It is expressed as a relationship between the cost of revenue from operations and the average inventory. It depicts the number of times the inventory is converted into revenue from operations during a given accounting period. It is calculated as follows:

It studies the frequency of conversion of inventory of finished goods into revenue from operations. It also measures the liquidity. It gives us an idea about how many times inventory is purchased or replaced during an accounting period. A lower value of turnover implies that there is something wrong with the purchase planning. For instance, there could be over purchasing, obsolete inventory etc. This is a problem that need to be addressed. On the other hand, a higher value of turnover is usually good for the business. However, if the higher value is due to purchases done in small lots or the sale is done at a lower margin to realise cash, this should also need to be addressed. To summarise, the inventory turnover ratio gives us an idea about the utilisation of inventory of goods.

b. Trade Receivables Turnover: It is expressed as a relationship between credit revenue from the operations and trade receivables. It is calculated as:

Here, the debtors are considered before making any provision for doubtful debts.

The liquidity position of the firm depends on the frequency at which the trade receivables are realised. This ratio is an indication of the number of times the receivables are turned over and converted into cash in an accounting period. Higher turnover indicates speedy collection from trade receivables. This ratio also helps in calculating the average collection period. The average collection period is calculated by dividing the days or months in a year by trade receivables turnover ratio as

c. Trade payables turnover: It is expressed as a relationship between trade payables that arise on account of credit purchases and average trade payable. It is calculated as

It reveals average payment period. A lower ratio means that credit allowed by the supplier is for a long period. A lower ratio also means that there are delayed payments to suppliers. This is not a very good policy as it may affect the reputation of the business. From this ratio, the average perod of payment can be worked out by days/months in a year by the Trade Payable Turnover Ratio.

d. Working capital turnover It is expressed as a relationship between net revenue from operations and the working capital. It is calculated as

Higher utilization of capital employed or any of its components is revealed by the turnover ratio. High turnover of capital employed, working capial and fixed assets is good for the business as it implies that the resources are utilized more efficiently. This in-turn implies that there is higher liquidity and profitability in the business.

The liquidity of a business firm is measured by its ability to satisfy its long-term obligations as they become due. For any business that has long-term liabilties, the principal amount owed and the payment of interest on the principal are the long term obligations. To measure the liquidity of the business, the following ratios are used.

1. Debt-Equity Ratio: It is expressed as the ratio of Long term Debt and the Shareholders’ Funds. A lower value of this ratio implies that the business is capable of meeting its long-term obligations/borrowings and a higher value is a risk for the external lenders. It is calculated as

2. Debt to Capital Employed Ratio: It is the ratio of long-term debt to the total of external and internal funds (capital employed or net assets). It is calculated as

It shows proportion of long-term debts in capital employed. A lower ratio indicates security to the lenders and a higher ratio helps the management in trading on equity.

This ratio can also be calculated as

3. Proprietary Ratio: It is expressed as the ratio of proprietor’s or shareholders’ funds to net assets and is calculated as

A higher value of this ratio indicates that a higher portion of the shareholders’ funds are used in financing the asssets and it implies more security to the creditors. This ratio can also be calculated using total assets instead of net assets.

4. Total Assets to Debt Ratio: It is expressed as the ratio of the Total Assets to the long-term debts. It measures the extent of long-term debts by assets. It is expressed as

5. Interest Coverage Ratio: It is expressed as the ratio of the net profit before interest and tax and the interest on long-term debts. It indicates the security of interest payable on long-term debts. In otherwords, it indiacates the number of times the interest on long-term debts is covered by the profits available for interest.

The inventory turnover ratio is the number of times inventory is converted into revenue from the operations during the accounting period under consideration. It is expressed as

It studies the frequency of conversion of inventory of finished goods into revenue from operations. It is also a measure of liquidity and determines how many times inventory is purchased or replaced during a year. The average age of inventory is given as

Clearly it gives the number of days or months for which the inventory is held by the business before it is replinished. Hence, we can say that it represents the average length of time the inventory is held by the firm.

Definition of Liquidity Ratios: To meet its commitments, the 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. Essentially, these are short-term in nature.

Liquidity Ratios are calculated to measure the short-term solvency of the business. In otherwords, they measure the firm’s ability to meet its current obligations. These are analyzed by looking at the amount of current assets and current liabilities in the balance sheets. The two ratios included in this category are

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

Current Assets include

Current liabilities include

The current ratio provides a measure of the degree to which extent the current assets cover current liabilities. The excess of current assets over curernt liabilities provide a measure of safety margin available against uncertainty in realisation of current assets and flow of funds. The ratio should be reasonable. It should neither be very high nor very low. If it is very high, it implies that the there is heavy investment in current assets which is not a good sign as it is an indication of under utilisation or improper utilisation of available resources. On the other hand, a lower ratio puts the business in danger and at the risk of being not able to pay the short-term debts on time. If this situation continues, it will adversely affect the creditworthiness of the business. Normally, a value of 2:1 for the current assets is considered to be in the safe range.

2. Quick or Liquid Ratio: It is the ratio of quick (or liquid) assets to current liabilities. It is expressed as

The quick assets are those assets which can be quickly converted into cash. We can get the quick assets by subtracting the inventories and other current assets such as prepaid expenses, advance tax etc from the current assets. As quick or liquid ratio doesn’t include the non-liquid assets, it is condered to be better than the current ratio to measure the liquidity position of the business. It is calculated to serve as a supplementary check on liquidity position of the business and hence is also known as Acid-Test Ratio

Solvency of a business is determined by its ability to meet its contractual obligations towards takeholders, especially towards external stakeholders and the ratios calcualated to measure the solvency position are known as Solvency Ratios. These are essentially long-term in nature.

The solvency ratios are of interest for the persons who have given the money in advance to the business on long-term basis. They are interested in safety of the periodic payment of interest 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 are the solvency ratios that are normally computed for determining the solvency of the business.

1. Debt-Equity Ratio: It measures relationship between long-term debt and equity. The outsiders feel more secured when the debt component of the total long-term funds employed is small. Capital structure with less debt and more equity is considered to be more favourable from the perspective of security as it reduces the possibility of any bankruptcy. Normally, a debt-equity ratio of 2:1 is considered to be safe. However, it may vary among different industries. It is calculated as

This ratio measures the degree of indebtedness of an enterprise. The long-term lenders get an idea about the extent of security of the debt. A lower value of this ratio is considered to be an indication of more security. A higher value is considered to be risky as it may put the firm into difficulty in meeting its obligations to outsiders. However, from the point of vies of owners, greater use of debt (trading on equity) might help in bringing higher returns for them if the rate of earnings on capital employed is more than the rate of interest payable.

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

It shows the proportion of long-term debts in capital employed. A lower value of this ratio provides security to the lenders and a higher value helps the management to trade on equity.

The Debt to Capital employed Ratio can also be computed in relation to total assets. When it is computed thus, it usually refers to the ratio of total debts (long-term debts + current liabilities) to total assets ie., tottal of non-current and current assets (shareholders’ funds + long-term debts + current liabilities), and can be expressed as

3. Proprietary Ratio: The proprietary ratio is expressed as a relationship of prorietor’s (shareholders’) funds to net assets. It is calculated as follows:

A higher value of shareholders’ funds in financing the assets is good as it provides security to creditors. Instead of net assets, the total assets are also used to calculated this ratio. The total of debt to capital employed ratio and proprietary ratio is equal to 1.

4. Total Assets to Debt Ratio: This is used to measure the extend of the coverage of long-term debts by assets. It is calculated as

A higher value of this ratio indicates that the assets have been majorly financed by owners’ funds and the long-term loans is adequeately covered by the assets.

It makes much better sense to consider the net assets (capital employed) instead of total assets for calculating this ratio too. When we consider the net assets, the ratio is equal to the reciprocal of the debt to capital employed ratio.

5. Interest Coverage Ratio: This ratio deals with the servicing of interest on loan. It is a measure of the security of interest payable on long-term debts. It is expressed as follows:

This ratio gives us the number of times the interest on long-term debts is covered by the profits available for interest. A higher value of this ratio provides safety of interest on debts.

Profitability Ratios: The ratios calculated to meet the objective of the analysis of profits in relation to revenue from operations or funds (or assets) employed in the business are known as Profitability Ratios.

The profitability or financial performance is mainly summarised in the stasement of profit and loss. The profitability ratios are calculated to analyse the earning capacity of the business which is the outcome of utilisation of resources employed in the business. There is a close relationship between the profit and the efficiency with which the resources employed in the business are utilised. For analysing the profitability of the business, the following ratios are most commonly used.

1. Gros Profit Ratio: Gross profit ratio is a percentage of revenue from operation. It is computed to get an idea about the gross margin. It is computed as follows:

It indicates gross margin on products sold. It also indicates the margin available to cover operating expenses, non-operating expenses etc. Gross profit ratio changes when the selling price or cost of revenue from operations or both of them changes. A lower value of this ratio is an indication of unfavrouable purchase and sales policy. A higher value is considered to be good.

2. Operating Ratio: It is computed to analyse the cost of peration in relation to revenue from operations. It is calculated as follows:

Operating expenses include

Cost of operation is determined by excluding non-operating incomes and expenses such as

3. Operating Profit Ratio: It is calculated to get the operating margin. It may be computed directly or as a residual of operating ratio.

Operating ratio is calculated to express cost of operations excluding financial charges with respect to revenue from operations. A corrollary of it is Operating Profit Ratio. It helps to analyse the performance of the business and gives an idea about the operational efficiency of the business. It is very useful for inter-firm as well as intra-firm comparisons. A lower value of operating profit ratio is considered to be good.

4. Net Profit Ratio: Net Profit ratio is based on all inclusive concept of profit. It expresses the relation between the net proft after operations as well as non-operational expenses to the revenue from operations. It is computed as follows:

Generally, net profit refers to profit after tax (PAT).

It is a measure of net profit margin with respect to revenue from operations. It not only gives an idea about profitability, but it is also a main variable in computing Return on Investment. It reflects the overall efficiency of the business and is considered with great importance from the perspective of investors.

5. Return on Capital Employed or Ivestment: It explains the overal utilisation of the funds by a business. Capital employed refers to the long-term funds employed in the business. It includes

On the other hand, the capital employed can also be considered as the total of non-current assets and working capital. When calculating this ratio, the profit considered is the Profit Before Interest and Tax (PBIT). It is computed as:

It measures the return on capital employed in the business. It gives us an idea about the efficiency of the business in utilisation of funds provided by

When performing inter-firm comparisons, return on capital employed funds is considered a good measure of profitability. It also helps in determining whether the firm is earning a higher return on capital employed as compared to the interest rate paid.

6. Return on Shareholders’ Funds: This ratio is very important from the shareholders’ point of given. It gives an idea about the whether the shareholders’ funds in the business are generating a good return or not. It should be higher than the return on investment. If it is lower than the return on investment then it implies that the company’s funds have not been employed profitably.

The return on shareholders’ funds gives a better measure of profitability from the perspective of the shareholders as it gives the return on total shareholders’ funds. It is also called as Return on Net Worth (RONW). It is calculated as follows:

7. Earnings per Share: This ratio is calculated as

The earnings refer to the profit available for equity shareholders which is calculated as.

This ratio is very important from the perspective of equity share holders and is important for the share price in the stock market. This also helps comparison with other business with respect to reasonableness and capacity to pay dividend.

8. Book Value per share: This ratio is calculated as:

This ratio is important from the perpespective of shareholders as it

9. Dividend Payout Ratio: This ratio refers to the proportion of earnings that are distributed to the shareholders. It is calculated as

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

10. Price/Earnings Ratio: This ratio is calculated as

It reflects the investors’ expectation about the growth in the firm’s earnings and reasonableness of the market price of its shares. Depending on the investor’s perception of the company’s future, P/E Ratio vary from

Both the current ratio and quick ratio provides a measure of the short-term solvency or liquidity of the business. It otherwords, they measure the firm’s ability to meet its current or short-term obligations.

The current ratio gives the relationship of the current assets with the current liabilities. This works well in case of business which have an inventory that can be easily converted into cash. For instance, majority of the items in a supermarket are fast moving consumer goods and have high liquidity. So, it makes better sense to consider the inventory into account when calculating the liquidity of the firm as the inventory can be easily converted into cash. In this case, the current ratio depicts the liquidity of the firm much better.

However, in case of a business, for instance heavy industrial equipment manufacturing business, automotive, seasonal products, it is not possible to convert the inventory (heavy machinery etc) into cash easily. It takes comparatively longer time to sell the finsished product and convert into cash. So, the liquidity of the inentory is very low and hence it can not be easily converted to cash to pay to the short-term creditors. So, we can not take into account the inventory when considering the liquidity of the firm. So, using the quick ratio which does not consider the inventory to calculate the liquidity of the firm is a much better choince here.

One thing to be noted is that, in scenarios where-in the inventory contributes a major portion of the current assets, it can not be ignored. However, in scenarios where-in the the inventory is insignificant compared to other current assets we can safely ignore it and rely on the quick ratio to calculate the liquidity of the firm.