## Chapter:10

# What are Accounting Ratios ?

## Meaning Of Accounting Ratios

Accounting ratios are indicators of a commercial entity’s performance and financial situation. Accounting ratios are used to predict whether a company is likely to go bankrupt soon. Overall, the aim when studying these ratios is to analyse trends.

## Objectives Of Accounting Ratios

- Locate weak spots of business which needs more attention.
- Provide information for making cross-sectional analysis.
- Provide information for making time-series analysis.
- Provide deeper analysis of the liquidity, solvency, activity and profitability of the business.
- Provide information useful for making estimates and preparing the plans for the future.

## Advantages of Accounting Ratios

- Helpful in Analysis of financial statements
- Simplification of accounting data
- Helpful in comparative study
- Helpful in locating the weak spots of the business
- Helpful in forecasting
- Estimate about the trend of the business
- Fination of Ideal Standards
- Effective control
- Study of financial Soundness

## Classification Of Accounting Ratios

## Accounting Ratios

- Liquidity Ratios
- Solvency Ratios
- Activity Ratios
- Profitability Ratios

## Liquidity Ratios

Liquidity ratios analyse the ability of a company to pay off both its current liabilities as they become due as well as their long-term liabilities as they become current.

**Current Ratio :** Calculating the current ratio of a company or individual is the simplest and most common way of measuring liquidity. The current ratio looks at a company's total current assets—cash assets and otherwise—against their total current liabilities like debt obligations. The ideal current ratio is 2:1.

**Current Ratio = Current Assets / Current Liabilities**

**Quick Ratio :** The quick ratio takes higher liquidity assets into account than the current ratio does. The quick ratio considers a company's cash and cash equivalents, short-term investments, and accounts payable against its current liabilities. The ideal current ratio is 1:1.

**Quick Ratio = Quick Assets / Current Liabilities**

Quick Assets includes all current assets except inventory and prepaid expenses.

## Agents Of Pollination

A solvency ratio is a key metric used to measure an enterprise's ability to meet its long-term debt obligations and is used often by prospective business lenders.

**Debt Equity Ratio :**This ratio is a measure of total debt, compared to shareholder equity. Debt Equity Ratio = Debt/Equity or Long-term Debts / Shareholder’s Funds

## Shareholder’s Funds include Share Capital and Reserves & Surplus.

**Total Assets to Debt Ratio :**In this ratio total assets are expressed is relation to long-term debts.

Total Assets to Debt ratio = Total Assets / Debt or Total Assets / Long-term Debts**Interest Coverage Ratio :**This ratio measures a company’s ability to keep up with interest payments, which rise along with outstanding debt. This ratio is also termed as ‘Debt Service Ratio’.

Interest Coverage Ratio = EBIT / Fixed Interest Charges

EBIT = Earnings before Interest and Taxes

Fixed Interest Charges = Interest payable on long-term borrowings**Proprietary Ratio :**Proprietary ratio is a type of solvency ratio that is useful for determining the amount or contribution of shareholders or proprietors towards the total assets of the business.

Proprietary Ratio = Shareholder’s Fund / Total Assets**Debt to Capital Employed Ratio :**The debt to capital employed ratio is calculated by dividing a company’s total debt by its total capital, which is total debt plus total shareholder’s equity. It measures the financial leverage of a company by comparing its total liabilities to total capital.- Debt to Capital Employed Ratio = Total Debt/Total Debt + Shareholder’s Equity

## Activity Ratios Or Turnover Ratios

Turnover ratios or activity ratios represent the amount of assets or liabilities that a company replaces in relations to its sales.

**Inventory Turnover Ratio :**It is a ratio which shows the number of times a company has sold and replaced the stock or inventory in a given time period.

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

Where, Cost of Revenue from Operations = Opening Inventory + Purchases Direct Charges – Closing Inventory

Average Inventory = (Opening Inventory + Closing Inventory) / 2**Trade Receivables Turnover Ratio :**It is used to determine the efficiency by which the business is managing the credit that is being extended to its customers and evaluate how long does it take for the business to collect the outstanding debt in the accounting period.

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

Trade Receivables include Debtors and Bills Receivables**Trade Payables Turnover Ratio :**It is a relationship between the net credit purchases and average trade payables.

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

Trade Payables include Creditors and Bills Payables**Working Capital Turnover Ratio :**It is a relationship between working capital and revenue from operations. Working Capital Turnover Ratio = Net Revenue from Operations / Working Capital

Where, Working Capital = Current Assets - Current Liabilities**Fixed Asset Turnover Ratio :**The fixed assets turnover ratio is an efficiency ratio that measures a companies return on their investment in property, plant and equipment by comparing net sales with fixed assets. Fixed Asset Turnover Ratio = Revenue from operations/Average fixed assets**Net Asset Turnover Ratio :**The net assets turnover ratio measures the efficiency of a company’s assets in generating revenue or sales. Net Asset Turnover Ratio =Revenue from operations/Average total assets

## Profitability Ratios Or Income Ratios

Profitability Ratios assess a company’s ability to earn profits from its sales or operations, balance sheet assets, or shareholder’s equity.

**Gross Profit Ratio :**It shows the relationship between the Gross Profit and Revenue from Operations (i.e., Net Sales).

Gross Profit Ratio = Gross Profit / Revenue from Operations × 100**Operating Ratio :**It shows the relationship between Operating Cost and Revenue from Operations.

Operating Ratio = [Cost of Revenue from Operations + Operating Expenses] / Revenue from Operations × 100**Operating Profit Ratio :**It shows the relationship between Operating Profit and Revenue from Operations i.e., Net Sales.

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

Operating Profit = Net Profit + Non-Operating Expenses – Non-Operating Incomes**Net Profit Ratio :**It shows the relationship between Net Profit and Revenue from Operations, i.e., Net Sales.

Net Profit Ratio = Net Profit / Revenue from Operations × 100**Return on Investment :**It shows the relationship between Net Profit/Earnings before interest and tax with capital employed. This ratio is also known as ‘Rate of Return’ or ‘Return on Capital Employed’ or Yield on Capital’.

Return on Investment = Net Profit before Interest, Tax and Dividends / Capital Employed × 100