ACCOUNTING RATIOS XII ACCOUNTS TERM 1 ALL IMPORTANT THEORY & FORMULAE SUNIL PANDA COMMERCE CLASSES SUNIL PANDA SIR Ratio :- Ratio is an arithmetical expression of relationship between two interdependent or related item. Ratio when calculated on the basis of accounting information are called Accounting Ratio. SUNIL PANDA SIR Accounting ratio can be expressed by any of the following manner: 1. 2. 3. 4. Pure ratio Percentage Time Fraction SUNIL PANDA SIR Objective of Ratio Analysis :- Ratio Analysis serves the purpose of various users who are interested in the financial statements. It simplifies, Summarises and systematics the figures in the financial statements 1) To simplify the accounting information 2) To determine liquidity, i.e. short term solvency ( ability of the enterprise to meet its short term financial obligation) and long term solvency (ability of the enterprise to pay its long term liabilities) of the business 3) To asses the operating efficiency of the business 4) To Analyse the profitability of the business 5) To help in comparative analysis, i.e. inter-firm and intra-firm comparisons SUNIL PANDA SIR Advantage of Ratio Analysis a) b) c) d) e) f) Useful tool for analysis of financial statements Simplifies accounting data Useful in assessing the operating efficiency of business Useful for forecasting Useful in locating the weak areas Useful in inter-firm and intra firm comparison SUNIL PANDA SIR Classification or Types of accounting ratio a) Liquidity ratio :- These ratio show the ability of the enterprise to meet it short term financial obligations. Important liability ratio are (i) current ratio (ii) quick ratio b) Solvency ratio :- These ratio are calculated to assess long term financial position of the enterprise solvency means ability of the enterprise to meet its long term financial obligation i.e. liabilities. Important solvency ratio are (i) debt to equity ratio, (ii) total assets to debt ratio, (iii) proprietary ratio, and (iv) interest coverage ratio SUNIL PANDA SIR c) Activity Ratio or Turnover ratios:- These ratio show how efficiently a company is using its resources. Important activity ratio are (i) inventory turnover ratio, (ii) trade receivables turnover ratio, (iii) trade payables turnover ratio, and (iv) working capital turnover ratio d) Profitability Ratio :- Profitability of a firm can be measured by its profitability ratio. Important profitability ratio are (i) gross profit ratio, (ii) operating ratio, (iii) operating profit ratio, (iv) net profit ratio and (v) return on investment SUNIL PANDA SIR Liquidity (Short term solvency) ratio “Current ratio” Liquidity of business refers to the firm ability to meet its current obligation i.e. short term financial liabilities Inventories ( excluding loose tools and stores and spare) FOR CALCULATION OF CURRENT RATIO Current ratio Ideal ratio is 2:1 If the current ratio is 2 or more than 2, it means the firm is adequately liquid and shall be able to meet its current financial obligation but if the current ratio is less than 2 it means the firm may face difficulty in meeting its current financial obligation. High current ratio means better liquidity position. But a very high current ratio means poor management of funds. SUNIL PANDA SIR Liquid ratio or quick ratio or acid test ratio :Ideal ratio :- Quick ratio of 1:1 is an accepted standard, since for every rupee of current liabilities, there is a rupee of quick assets In case of liquid ratio is less than 1 it means that current liabilities are more than its quick assets. As a result the enterprise may not be able to meet its short term financial obligation i.e. current liabilities, if they fall due for payment on that date SUNIL PANDA SIR Debt to equity ratio Ideal ratio 2:1 A high debt to equity ratio means that the enterprise is depending more on borrowings or external debts in comparison to shareholders to shareholders fund. In effect lenders are at higher risks and have lower safety cover. On the other hand low debt to equity ratio means that the enterprise is depending more on share holders funds than external equities. In effect lenders are at a lower risk and have higher safety cover SUNIL PANDA SIR Total assets to debt ratio A high ratio means higher safety cover for lenders to the business. On the other hand a low ratio means lower safety for lenders as the business depends largely on outside loans for existence. In other words investment by the proprietor is low SUNIL PANDA SIR Proprietary ratio:The objective of computing this ratio is to measure the proportion of total assets financed by proprietors funds. A high proprietary ratio means adequate safety for unsecured lenders and creditors. But a very high ratio means improper mix of proprietors funds and loan funds, which results in lower return on investment A lower proprietary ratio indicates greater risk to unsecured lenders and creditors SUNIL PANDA SIR Interest coverage ratio Objective and significance The ratio is important and meaningful to debenture holders and lenders of long term funds. The objective of calculating this ratio is to determine the amount of profit available to cover interest on long term debt. A high ratio is considered better for the lenders as it shows higher profit margin to meet interest cost SUNIL PANDA SIR Activity ratio :Activity ratio also termed as performance or Turnover ratio measures how well the resources have been used by the enterprises. In other words these ratio measure the effectiveness with which the enterprise uses its available resources SUNIL PANDA SIR The objective of computing inventory turnover ratio is to determine whether investment in stock has been judicious or not i.e. only the required amount is invested in stock. It measures the efficiency of inventory management. A high ratio shows that more sales are being produced by a rupee of investment in inventories. A very high inventory turnover ratio shows overtrading and it may result in working capital shortage A low inventory turnover ratio means inefficient use of investment in inventory, over-investment in stocks. SUNIL PANDA SIR Trade receivables turnover ratio This ratio indicates the number of times trade receivables are turned over in a year in relation to credit sales. It show how quickly trade receivables are converted into cash and cash equivalents and thus show the efficiency in collection of amount due against trade receivables. A high ratio is better since it show that debts are collected more promptly A lower ratio shows inefficiency in collection or increased credit period Debt collection period or Average collection period It provide an approximation of the average time that it takes to collect debtors SUNIL PANDA SIR Trade payables turnover ratio:The objective of calculating trade payables turnover ratio is to determine the efficiency with which the trade payables are managed and paid. High turnover ratio or shorter payment period shows less credit period being available or early payments being made. A high ratio also indicates that the enterprise is not availing full credit period. A low ratio or longer payment period indicates that creditors are not paid in time or increased credit period SUNIL PANDA SIR Working capital turnover ratio The objective of computing the ratio is to ascertain whether or not working capital has been effectively used in generating revenue. A high ratio show efficient use of working capital, whereas, low ratio show its inefficient use. Working capital turnover ratio is considered to be a better measure than the inventory turnover ratio since it shows the efficiency or inefficiency in the use of the working capital SUNIL PANDA SIR Gross profit ratio The main objective of computing gross profit ratio is to determine the efficiency with which production and / or purchase operation and selling operation are carried on. Higher gross profit ratio is better as it leaves higher margin to meet operating expense and creation of reserve SUNIL PANDA SIR Operating ratio The objective of computing operating ratio is to assess the operational efficiency of the business It show the percentage of revenue from operation that is absorbed by the cost of revenue from operation (COGS) and operating expense. Lower operating ratio is better because it leaves higher profit margin to meet non-operating expense to pay dividend etc. a rise in the operating ratio indicates decline in efficiency SUNIL PANDA SIR Operating profit ratio The objective of computing the ratio is to determine operational efficiency of the business An increase in the ratio over the previous period shows improvement in the operational efficiency of the business enterprise SUNIL PANDA SIR Net profit ratio Net profit ratio is an indicator of overall efficiency of the business. Higher the net profit ratio better the business. This ratio helps in determining the operational efficiency of the business. An increase in the ratio over the pervious period shows improvement in the operational efficiency and decline means otherwise. A comparison with the industry standards is also an indicator of the efficiency of the business SUNIL PANDA SIR Return on investment (ROI) or Return on capital employed Return on capital employed or return on investment assess overall performance of the enterprise. It measure how efficiently the resources of the business are used. Return on capital employed is a fair measure of the profitability of any concern with the result that the performance of different industries may be compared An enterprise should have a satisfactory ratio. To assess whether the ratio is satisfactory or not it should be compared with its own ratios of the past year or with the ratio of similar enterprises in the industry or with the ratio of industry standards. SUNIL PANDA SIR Thank you KEEP ON SUPPORTING SUNIL PANDA SIR
