Financial statements aim at providing financial


 Gerard Welch
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1 Accounting Ratios 5 LEARNING OBJECTIVES After studying this chapter, you will be able to : explain the meaning, objectives and limitations of accounting ratios; identify the various types of ratios commonly used ; calculate various ratios to assess solvency, liquidity, efficiency and profitability of the firm; interpret the various ratios calculated for intrafirm and interfirm comparisons. Financial statements aim at providing financial information about a business enterprise to meet the information needs of the decisionmakers. Financial statements prepared by a business enterprise in the corporate sector are published and are available to the decisionmakers. 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 statements 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
2 Accounting Ratios 203 the financial statements, it is termed as accounting ratio. For example, if the gross profit of the business is Rs. 10,000 and the Revenue from Operations are 10, 000 Rs. 1,00,000, it can be said that the gross profit is 10% 100 1, 00, 000 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. Ratios 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 scenario. 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 lot 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 crosssectional analysis by comparing the performance with the best industry standards; and 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
3 204 Accountancy : Company Accounts and Analysis of Financial Statements 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 ratio analysis. These are summarised as follows: 1. Helps to understand efficacy of decisions: The ratio analysis helps you to 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 WeaknessOpportunityThreat) analysis. 6. Various comparisons: Ratios help comparisons with certain bench marks to assess as to whether firm s 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 (Intrafirm Comparison/Time Series Analysis), (ii) with other business enterprises (Interfirm Comparison/Crosssectional 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
4 Accounting Ratios 205 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 unwarranted impression of precision and finality. In fact, accounting data reflect a combination of recorded facts, accounting conventions and personal judgements which 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 of the enterprises and so the ratios will also not give the true picture. 2. Ignores Pricelevel Changes: The financial accounting is based on stable money measurement principle. It implicitly assumes that price level changes are either nonexistent 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 pricelevel makes analysis of financial statement of different accounting years meaningless because accounting records ignore changes in value of money. 3. Ignore Qualitative or Nonmonetary Aspects: Accounting provides information about quantitative (or monetary) aspects of business. Hence, the ratios also reflect only the monetary aspects, ignoring completely the nonmonetary (qualitative) factors. 4. Variations in Accounting Practices: There are differing accounting policies for valuation of inventory, calculation of depreciation, treatment of intangibles Assets definition of certain financial variables etc., available for various aspects of business transactions. These variations leave a big question mark on the crosssectional 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 nonfinancial 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.
5 206 Accountancy : Company Accounts and Analysis of Financial Statements 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 evaluating the performance of an organisation and planning the future strategies for its improvement. Test your Understanding I 1. State which of the following statements are True or False. (a) (b) (c) (d) (e) (f) The only purpose of financial reporting is to keep the managers informed about the progress of operations. Analysis of data provided in the financial statements is termed as financial analysis. Longterm borrowings are concerned about the ability of a firm to discharge its obligations to pay interest and repay the principal amount. A ratio is always expressed as a quotient of one number divided by another. Ratios help in comparisons of a firm s results over a number of accounting periods as well as with other business enterprises. A ratio reflects quantitative and qualitative aspects of results. 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.
6 Accounting Ratios Balance Sheet Ratios: In case both variables are from the balance sheet, it is classified as balance sheet ratios. For example, ratio of current assets to current liabilities known as current ratio. It 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 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 is 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. These are essentially shortterm 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. These are essentially longterm in nature. 3. Activity (or Turnover) Ratios: This refers to the ratios that are calculated for measuring the efficiency of operations 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 revenue from operations or funds (or assets) employed in the business and the ratios calculated to meet this objective are known as Profitability Ratios.
7 208 Accountancy : Company Accounts and Analysis of Financial Statements Exhibit  1 ABC PHARMACEUTICALS LTD. Profitability Ratios PBDIT/total income Net profit/total income Cash flow/total income Return on Net Worth (PAT/Net Worth) Return on Capital Employed (PBDIT/Average capital employed) Activity Ratios Trade Receivables turnover (days) Inventory turnover (days) Working capital/total capital employed (%) Interest/total income (%) Leverage and Financial Ratios Debtequity ratio Current ratio Quick ratio Cash and Cash equivalents/total assets (%) Interest cover/age Valuation Ratios Earnings per share Cash earnings per share Dividend per share Book value per share Price/Earning Liquidity Ratios Liquidity ratios are calculated to measure the shortterm 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 liquidity ratio 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 Current Liabilities
8 Accounting Ratios 209 Current assets include current investments, inventories, trade receivables (debtors and bills receivables), cash and cash equivalents, shortterm loans and advances and other current assets such as prepaid expenses, advance tax and accrued income, etc. Current liabilities include shortterm borrowings, trade payables (creditors and bills payables), other current liabilities and shortterm provisions. Illustration 1 Calulate Current Ratio from the following information: Particulars Rs. Inventories 50,000 Trade receivables 50,000 Advance tax 4,000 Cash and cash equivalents 30,000 Trade payables 1,00,000 Shortterm borrowings (bank overdraft) 4,000 Current Ratio Current Assets Current Liabilities Current Assets Inventories + Trade receivables + Advance tax + Cash and cash equivalents Rs. 50,000 + Rs. 50,000 + Rs. 4,000 + Rs. 30,000 Rs. 1,34,000 Current Liabilities Trade payables + Shortterm borrowings Rs. 1,00,000 + Rs. 4,000 Rs. 1,04,000 Current Ratio Rs.1,34, :1 Rs.1, 04, 000 Significance: It provides a measure of degree to which current assets cover current liabilities. The excess of current assets over current liabilities provides 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 or very low. Both the situations have their inherent disadvantages. A very high current ratio implies heavy investment in current assets which is not a good sign as it reflects under utilisation or improper utilisation of resources. A low ratio endangers the business and puts it at risk of facing a situation where it will not be able to pay its shortterm debt on time. If this problem persists, it may affect firms credit worthiness adversely. Normally, it is safe to have this ratio within the range of 2:1.
9 210 Accountancy : Company Accounts and Analysis of Financial Statements 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 Quick Assets Current Liabilities The quick assets are defined as those assets which are quickly convertible into cash. While calculating quick assets we exclude the inventories at the end and other current assets such as prepaid expenses, advance tax, etc., from the current assets. Because of exclusion of nonliquid current assets 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 AcidTest Ratio. Illustration 2 Calculate quick ratio from the information given in illustration 1. Quick Ratio Quick Assets Current Liabilities Quick Assets Current assets (Inventories + Advance tax) Rs. 1,34,000 (Rs. 50,000 + Rs. 4,000) Rs. 80,000 Current Liabilities Rs. 1,04,000 Quick Ratio Rs. 80, :1 Rs. 1,04,000 Significance: The ratio provides a measure of the capacity of the business to meet its shortterm 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 shortterm 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
10 Accounting Ratios 211 Solution Liquidity Ratio Liquid Assets Current Liabilities Liquidity Assets Current assets (Inventories + Prepaid expenses + Advance tax) Rs. 80,000 (Rs. 20,000 + Rs. 5,000 + Rs. 5,000) Rs. 50,000 Liquidity Ratio Rs. 50,000 1:1 Rs. 50,000 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 inventories is Rs. 24,000, calculate current assets and current liabilities. Current Ratio 3.5:1 Quick Ratio 2:1 Let Current liabilities x Current assets 3.5x and Quick assets 2x Inventories Current assets Quick assets 24, x 2x 24, x x Rs.16,000 Current Liabilities 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, : 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 Noncurrent liabilities Rs. 80,000 Shareholders Funds Rs. 2,00,000 NonCurrent Assets: Fixed assets Rs. 1,60,000 Noncurrent Investments Rs. 1,00,000
11 212 Accountancy : Company Accounts and Analysis of Financial Statements Total assets Noncurrent 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 + Noncurrent 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 2 :1 Rs. 20,000 Do it Yourself 1. Current liabilities of a company are Rs. 5,60,000, current ratio is 2.5:1 and quick ratio is 2:1. Find the value of the Inventories. 2. Current ratio 4.5:1, quick ratio 3:1.Inventory is Rs. 36,000. Calculate the current assets and current liabilities. 3. Current assets of a company are Rs. 5,00,000. Current ratio is 2.5:1 and Liquid ratio is 1:1. Calculate the value of current liabilities, liquid assets and inventories. 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) Payment of current liability; (b) Purchased goods on credit; (c) Sale of a Computer (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. The given current ratio is 2 : 1. Let us assume that current assets are Rs. 50,000 and current liabilities are Rs. 25,000; Thus, 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.
12 Accounting Ratios 213 (b) (c) (d) (e) Assume that goods of Rs. 10,000 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. Due to sale of a computer (a fixed asset) the current assets will increase to Rs. 53,000 without any change in the current liabilities. The new ratio will be 2.12 : 1 (Rs. 53,000/Rs. 25,000). Hence, it has improved. This transaction will decrease the inventories by Rs. 10,000 and increase the cash by Rs. 11,000 thereby increasing the current assets by Rs. 1,000 without any change in the current liabilities. The new ratio will be 2.04 : 1 (Rs. 51,000/Rs. 25,000). Hence, it has improved. Assume that Rs. 5,000 is given by way of dividend. It will reduce the current assets to Rs. 45,000 without any change in the current liabilities. The new ratio will be 1.8 : 1 (Rs. 45,000/Rs. 25,000). Hence, it has reduced. 5.7 Solvency Ratios The persons who have advanced money to the business on longterm basis are interested in safety of their 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 ratios are normally computed for evaluating solvency of the business. 1. DebtEquity Ratio; 2. Debt to Capital Employed Ratio; 3. Proprietary Ratio; 4. Total Assets to Debt Ratio; 5. Interest Coverage Ratio DebtEquity Ratio DebtEquity Ratio measures the relationship between longterm debt and equity. If debt component of the total longterm 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. However, it may vary from industry to industry. It is computed as follows: DebtEquity Ratio Long term Debts Shareholders' Funds
13 214 Accountancy : Company Accounts and Analysis of Financial Statements 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) Noncurrent sssets + Working capital Noncurrent liabilities Working Capital Current Assets Current Liabilities Significance: This ratio measures the degree of indebtedness of an enterprise and gives an idea to the longterm 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, Calculate debt equity ratio: ABC Co. Ltd. Balance Sheet as at 31 March, 2015 Particulars Note Amount No. (Rs.) I. Equity and Liabilities 1. Shareholders funds a) Share capital 12,00,000 b) Reserves and surplus 2,00,000 c) Money received against share warrants 1,00, Noncurrent Liabilities a) Longterm borrowings 4,00,000 b) Other longterm liabilities 40,000 c) Longterm provisions 60, Current Liabilities a) Shortterm borrowings 2,00,000 b) Trade payables 1,00,000 c) Other current liabilities 50,000 d) Shortterm provisions 1,50,000 25,00,000 II. Assets 1. NonCurrent Assets a) Fixed assets 15,00,000 b) Noncurrent investments 2,00,000 c) Longterm loans and advances 1,00,000
14 Accounting Ratios Current Assets a) Current investments 1,50,000 b) Inventories 1,50,000 c) Trade receivables 1,00,000 d) Cash and cash equivalents 2,50,000 e) Shortterm loans and advances 50,000 25,00,000 DebtEquity Ratio Debts Equity Debt Longterm borrowings + Other longterm liabilities + Longterm provisions Rs. 4,00,000 + Rs. 40,000 + Rs. 60,000 Rs. 5,00,000 Equity Share capital + Reserves and surplus + Money received against share warrants Rs. 12,00,000 + Rs. 2,00,000 + Rs. 1,00,000 Rs. 15,00,000 Alternatively, Equity Noncurrent assets + Working capital Noncurrent liabilities Rs. 18,00,000 + Rs. 2,00,000 Rs. 5,00,000 Rs. 15,00,000 Working Capital Current assets Current liabilities Rs. 7,00,000 Rs. 5,00,000 Rs. 2,00,000 Debt Equity Ratio 50, :1 1,50,0000 Illustration 8 From the following balance sheet of a company, calculate DebtEquity Ratio: Balance Sheet Particulars Note Rs. No. I. Equity and Liabilities 1. Shareholders funds a) Share capital 10,00,000 b) Reserves and surplus 1 1,00, NonCurrent Liabilities Longterm borrowings 1,50, Current Liabilities 1,50,000 14,00,000
15 216 Accountancy : Company Accounts and Analysis of Financial Statements II. Assets 1. NonCurrent Assets a) Fixed assets  Tangible assets 2 11,00, Current Assets a) Inventories 1,00,000 b) Trade receivables 90,000 c) Cash and cash equivalents 1,10,000 14,00,000 Notes to Accounts Rs. 1. Share Capital Equity Share Capital 8,00,000 Preference Share Capital 2,00,000 10,00,000 Fixed Assets Rs. 2. Tangible Assets: Plant and Machinery 5,00,000 Land and Building 4,00,000 Motor Car 1,50,000 Furniture 50,000 11,00,000 DebtEquity Ratio Long  term Debts Equity (Shareholders'Funds) Longterm Debts Longterm Borrowings Rs. 1,50,000 Equity Share capital + Reserves and surplus Rs. 10,00,000 + Rs. 1,00,000 Rs. 11,00,000 Debt Equity Ratio 1,50,000 11,00, : Debt to Capital Employed Ratio The Debt to capital employed ratio refers to the ratio of longterm debt to the total of external and internal funds (capital employed or net assets). It is computed as follows: Debt to Capital Employed Ratio Longterm Debt/Capital Employed (or Net Assets)
16 Accounting Ratios 217 Capital employed is equal to the longterm 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, :1. Significance: Like debtequity ratio, it shows proportion of longterm debts in capital employed. Low ratio provides security to lenders and high ratio helps management in trading on equity. In the above case, the debt to Capital Employed ratio is less than half which indicates reasonable funding by debt and adequate security of debt. It may be noted that Debt to Capital Employed Ratio can also be computed in relation to total assets. In that case, it usually refers to the ratio of total debts (longterm debts + current liabilities) to total assets, i.e., total of noncurrent and current assets (or shareholders, funds + longterm debts + current liabilities), and is expressed as Proprietary Ratio Total Debts Debt to Capital Employed Ratio Total Assets 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, : 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 In terms of percentage it can be stated that the 25% of the capital employed is funded by debts and 75% by owners funds Total Assets to Debt Ratio This ratio measures the extent of the coverage of longterm debts by assets. It is calculated as Total assets to Debt Ratio Total assets/longterm debts Taking the data of Illustration 8, this ratio will be worked out as follows: Rs. 14,00,000/Rs. 1,50, : 1
17 218 Accountancy : Company Accounts and Analysis of Financial Statements The higher ratio indicates that assets have been mainly financed by owners funds and the longterm 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: Balance Sheet as at March 31, 2015 Particulars Note Rs. No. I. Equity and Liabilities: 1. Shareholders funds a) Share capital 4,00,000 b) Reserves and surplus 1,00, Noncurrent Liabilities Longterm borrowings 1,50, Current Liabilities 50,000 7,00,000 II. Assets 1. Noncurrent Assets a) Fixed assets 4,00,000 b) Noncurrent investments 1,00, Current Assets 2,00,000 7,00,000 i) DebtEquity Ratio Debts Equity Debt Longterm borrowings Rs. 1,50,000 Equity Share capital + Reserves and surplus Rs. 4,00,000 + Rs. 1,00,000 Rs. 5,00,000 DebtEquity Ratio Rs. 1,50,000 Rs. 5,00, : 1
18 Accounting Ratios 219 ii) Total Assets to Debt Ratio Total assets Long  term debts Total Assets Fixed assets + Noncurrent investments + Current assets Rs. 4,00,000 + Rs. 1,00,000 + Rs. 2,00,000 Rs. 7,00,000 Longterm Debt Rs. 1,50,000 Total Asset to Debt Ratio Rs. 7,00,000 Rs. 1,50, : 1 iii) Proprietary Ratio or Shareholders' Funds Total Assets Rs. 5,00,000 Rs. 7,00, : 1 iv) Debt to Capital Employed Ratio Long  term debts Capital Employed Capital Employed Shareholders Funds + Longterm borrowings Rs. 5,00,000 + Rs. 1,50,000 Rs. 6,50,000 Debt to Capital Employed Ratio Long  term debts Capital Employed Rs. 1,50, 000 Rs. 6,50, : 1 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. 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.
19 220 Accountancy : Company Accounts and Analysis of Financial Statements 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 debtequity 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 debtequity 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 longterm 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 debitequity ratio. (v) This will also leave the ratio unchanged as purchase of goods on credit neither affect Debt nor equity 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 longterm debts. 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 longterm debts Significance: It reveals the number of times interest on longterm 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% Longterm debt 10,00,000; and Tax rate 40%. Net Profit after Tax Rs. 60,000 Tax Rate 40% Net Profit before tax Net profit after tax 100/(100 Tax rate) Rs. 60, /(100 40)
20 Accounting Ratios 221 Rs. 1,00,000 Interest on Longterm Debt 15% of Rs. 10,00,000 Rs. 1,50,000 Net profit before interest and tax Net profit before tax + Interest Interest Coverage Ratio 5.8 Activity (or Turnover) Ratio Rs. 1,00,000 + Rs. 1,50,000 Rs. 2,50,000 Net Profit before Interest and Tax/Interest on longterm debt Rs. 2,50,000/Rs. 1,50, times. 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 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.
21 222 Accountancy : Company Accounts and Analysis of Financial Statements Test your Understanding II (i) (ii) (iii) (iv) (v) (vi) The following groups of ratios are primarily measure risk: A. liquidity, activity, and profitability B. liquidity, activity, and inventory C. liquidity, activity, and debt D. liquidity, debt and profitability The ratios are primarily measures of return: A. liquidity B. activity C. debt D. profitability The of business firm is measured by its ability to satisfy its shortterm obligations as they become due: A. activity B. liquidity C. debt D. profitability ratios are a measure of the speed with which various accounts are converted into revenue from operations or cash: A. activity B. liquidity C. debt D. profitability The two basic measures of liquidity are: A. inventory turnover and current ratio B. current ratio and liquid ratio C. gross profit margin and operating ratio D. current ratio and average collection period The is a measure of liquidity which excludes, generally the least liquid asset: A. current ratio, trade receivable B. liquid ratio, trade receivable C. current ratio, inventory D. liquid ratio, inventory Illustration 12 From the following information, calculate inventory turnover ratio :
22 Accounting Ratios 223 Rs. Inventory in the beginning 18,000 Inventory at the end 22,000 Net purchases 46,000 Wages 14,000 Revenue from operations 80,000 Carriage inwards 4,000 Inventory Turnover Ratio Cost of Revenue from Operations Average Inventory Cost of Revenue from Operations Inventory in the beginning + Net Purchases + Wages + Carriage inwards Inventory at the end Rs. 18,000 + Rs. 46,000 + Rs. 14,000 + Rs. 4,000 Rs. 22,000 Rs. 60,000 Average Inventory Inventory in the beginning + Inventory at the end 2 Rs. 18,000 + Rs. 22,000 2 Rs. 20,000 Inventory Turnover Ratio Rs. 60,000 Rs. 20,000 3 Times 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% 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
23 224 Accountancy : Company Accounts and Analysis of Financial Statements Inventory Turnover Ratio Cost of Revenue from Operations Average Inventory Rs. 3,60,000 Rs. 55, times Illustration 14 A trader carries an average inventory of Rs. 40,000. His inventory turnover ratio is 8 times. If he sells goods at a profit of 20% on Revenue from operations, find out the gross profit. 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, Revenue from operations Cost of Revenue from operations 80 Gross Profit 100 Rs. 3,20,000 Rs. 4,00, Revenue from operations Cost of Revenue from operations Rs. 4,00,000 Rs. 3,20,000 Rs. 80,000 Do it Yourself 1. Calculate the amount of gross profit: Average inventory Rs. 80,000 Inventory turnover ratio 6 times Selling price 25% above cost 2. Calculate Inventory Turnover Ratio: Annual Revenue from operations Rs. 2,00,000 Gross Profit 20% on cost of Revenue from operations Inventory in the beginning Rs. 38,500 Inventory at the end Rs. 41,500
24 Accounting Ratios 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 Where Average Trade Receivable Net Credit Revenue from Operations/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. i.e., Number of days or Months 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 ,000 Trade receivables as at ,20,000 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, Rs. 80,000 Credit Revenue from operations Rs. 4,00,000 Rs. 80,000 Rs. 3,20,000
25 226 Accountancy : Company Accounts and Analysis of Financial Statements Opening Trade Receivables + Closing Average Trade Receivables Trade Receivables 2 Rs. 40,000 + Rs. 1,20,000 2 Rs. 80,000 Trade Receivables Turnover Rations Net Credit Revenue Form Operations Average Inventoary Trade Receivables Turnover Ratio Rs. 3,20,000 Rs. 80,000 4 times Trade Payable Turnover Ratio Trade payables turnover ratio indicates the pattern of payment of trade payable. As trade payable arise on account of credit purchases, it expresses relationship between credit purchases and trade payable. It is calculated as follows: Trade Payables Turnover ratio Net Credit purchases/ Average trade payable Where Average Trade Payable (Opening Creditors and Bills Payable + Closing Creditors and Bills Payable)/2 Average Payment Period No. of days/month in a year Trade Payables Turnover Ratio Significance : It reveals average payment period. Lower ratio means credit allowed by the supplier is for a long period or it may reflect delayed payment to suppliers which is not a very good policy as it may affect the reputation of the business. The average period of payment can be worked out by days/months in a year by the Trade Payable Turnover Ratio. Illustration 16 Calculate the Trade payables turnover ratio from the following figures: Rs. Credit purchases during ,00,000 Creditors on ,00,000 Bills Payables on ,00,000 Creditors on ,30,000 Bills Payables on ,000 Trade Payables Turnover Ratio Net Credit Purchases Average Trade Payables
26 Accounting Ratios 227 Average Trade Payables Creditors in the beginning + Bills payables in the beginning + Creditors at the end + Bills payables at the end Rs. 3,00,000 + Rs. 1,00,000 + Rs. 1,30,000 + Rs. 70,000 Rs. 3,00,000 Trade Payables Turnover Ratio Illustration 17 From the following information, calculate 2 2 Rs. 12, 00, 000 Rs. 3,00,000 4 times (i) (ii) (iii) (iv) Given : Trade receivables turnover ratio Average collection period Trade rayable turnover ratio Average payment period (Rs.) Revenue from Operations 8,75,000 Creditors 90,000 Bills receivable 48,000 Bills payable 52,000 Purchases 4,20,000 Trade debtors 59,000 (i) Trade Receivables Turnover Ratio Net Credit Revenue from operation Average Trade Receivable Rs. 8,75,000 (Rs. 59,000 + Rs. 48,000) * 8.18 times * 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 yearend figures are available use the same as it is.
27 228 Accountancy : Company Accounts and Analysis of Financial Statements (ii) Average Collection Period 365 Trade Receivables Turnover Ratio days (iii) Trade Payable Turnover Ratio Purchases * Average Trade Payables Purchases Creditors + Bills payable 4,20,000 90, ,000 4,20,000 1,42, times (iv) Average Payment Period 365 Trade Payables Turnover Ratio days *Since no information regarding credit purchase is given, hence it will be related as net purchases 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 : Net Assets or Capital Employed Turnover ratio Revenue from Operation Capital Employed Capital employed turnover ratio which studies turnover of capital employed (or Net Assets) is analysed further by following two turnover ratios : (a) Fixed Assets Turnover Ratio : It is computed as follows: Fixed asset turnover Ratio Net Revenue from Operation Net Fixed Assets
28 Accounting Ratios 229 (b) Working Capital Turnover Ratio : It is calculated as follows : Net Revenue from Operation Working Capital Turnover Ratio Working Capital 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 : Amount Amount (Rs.) (Rs.) Preference shares capital 4,00,000 Plant and Machinery 8,00,000 Equity share capital 6,00,000 Land and Building 5,00,000 General reserve 1,00,000 Motor Car 2,00,000 Balance in Statement of Profit and 3,00,000 Furniture 1,00,000 Loss 15% debentures 2,00,000 Inventory 1,80,000 14% Loan 2,00,000 Debtors 1,10,000 Creditors 1,40,000 Bank 80,000 Bills payable 50,000 Cash 30,000 Outstanding expenses 10,000 Revenue from operations for the year were Rs. 30,00,000 Revenue from Operations Rs. 30,00,000 Capital Employed Fixed Assets Working Capital Share Capital + Reserves and Surplus + Longterm 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 Rs.8,00,000 + Rs.5,00,000 + Rs.2,00,000 + Rs.1,00,000 Rs. 16,00,000 Current Assets Current Liabilities Rs.4,00,000 Rs.2,00,000 Rs. 2,00,000
29 230 Accountancy : Company Accounts and Analysis of Financial Statements Net Assets Turnover Ratio Rs.30,00,000/Rs.18,00, times Fixed Assets Turnover Ratio Rs.30,00,000/Rs.16,00, times Working Capital Turnover Ratio Rs.30,00,000/Rs.2,00, times. Test your Understanding III (i) (ii) (iii) (iv) (v) (vi) The is useful in evaluating credit and collection policies. A. average payment period B. current ratio C. average collection period D. current asset turnover The measures the activity of a firm s inventory. A. average collection period B. inventory turnover C. liquid ratio D. current ratio The may indicate that the firm is experiencing stock outs and lost sales. A. average payment period B. inventory turnover ratio C. average collection period D. quick ratio ABC Co. extends credit terms of 45 days to its customers. Its credit collection would be considered poor if its average collection period was. A. 30 days B. 36 days C. 47 days D. 37 days are especially interested in the average payment period, since it provides them with a sense of the billpaying patterns of the firm. A. Customers B. Stockholders C. Lenders and suppliers D. Borrowers and buyers The ratios provide the information critical to the long run operation of the firm A. liquidity B. activity C. solvency D. profitability
30 Accounting Ratios Profitability Ratios The profitability or financial performance is mainly summarised in the statement of profit and loss. 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. The various ratios which are commonly used to analyse the profitability of the business are: 1. Gross profit ratio 2. Operating ratio 3. Operating profit ratio 4. Net profit ratio 5. Return on Investment (ROI) or Return on Capital Employed (ROCE) 6. Return on Net Worth (RONW) 7. Earnings per share 8. Book value per share 9. Dividend payout ratio 10. Price earning ratio Gross Profit Ratio Gross profit ratio as a percentage of revenue from operations is computed to have an idea about gross margin. It is computed as follows: Gross Profit Ratio Gross Profit/Net Revenue of Operations 100 Significance: It indicates gross margin on products sold. It also indicates the margin available to cover operating expenses, nonoperating expenses, etc. Change in gross profit ratio may be due to change in selling price or cost of revenue from operations or a combination of both. A low ratio may indicate unfavourable purchase and sales policy. Higher gross profit ratio is always a good sign. Illustration 19 Following information is available for the year , 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
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