<h5 id="51-meaning-of-accounting-ratios">5.1 Meaning of Accounting Ratios</h5> <ul> <li> <p>Accounting ratios are mathematical numbers calculated as a reference to the relationship of two or more accounting numbers derived from financial statements.</p> </li> <li> <p>They can be expressed as a fraction, proportion, percentage, or a number of times and are used to exhibit a relationship, if any, between accounting numbers.</p> </li> <li> <p>The accuracy and relevance of accounting ratios heavily depend on the financial statements from which they are calculated. If the financial statements contain errors, the derived numbers in terms of ratio analysis would also present an erroneous scenario.</p> </li> <li> <p>A ratio must be calculated using numbers that are meaningfully correlated. A ratio calculated by using two unrelated numbers would hardly serve any purpose.</p> </li> <li> <p>Examples of accounting ratios include the gross profit ratio and inventory turnover ratio. For instance, a gross profit ratio of 10% implies that the gross profit is 10% of the ‘Revenue from Operations’. Similarly, an inventory turnover ratio of 6 implies that inventory turns into ‘Revenue from Operations’ six times in a year.</p> </li> </ul> <p>======</p> <h5 id="52-objectives-of-ratio-analysis">5.2 Objectives of Ratio Analysis</h5> <ul> <li>Ratio analysis is a crucial part of interpreting financial statements.</li> <li>It provides vital financial information and highlights areas that require investigation.</li> <li>It helps in identifying business areas that need more attention and potential areas for improvement.</li> <li>It provides a detailed analysis of a company’s profitability, liquidity, solvency, and efficiency levels.</li> <li>It is useful for making cross-sectional analysis by comparing performance with industry standards and for making future projections and estimates.</li> </ul> <p>======</p> <h5 id="53-advantages-of-ratio-analysis">5.3 Advantages of Ratio Analysis</h5> <ul> <li>Ratio analysis helps understand the effectiveness of business decisions regarding operations, investments, and financing.</li> <li>Ratios simplify complex accounting figures, establish relationships, and summarize financial information effectively.</li> <li>They are helpful in comparative analysis, identifying trends over multiple years, and making projections about the business.</li> <li>Ratios assist in identifying problem areas and bright spots in a business, enabling management to address issues and improve performance.</li> <li>Ratios enable SWOT analysis, comparisons with benchmarks, and assessing a firm’s performance in terms of profitability, liquidity, and solvency.</li> </ul> <p>======</p> <h5 id="54-limitations-of-ratio-analysis">5.4 Limitations of Ratio Analysis</h5> <ul> <li>The purpose of financial reporting is not only to inform managers about the progress of operations. It also provides information to investors, creditors, and other stakeholders.</li> <li>Analysis of data provided in financial statements is indeed called financial analysis.</li> <li>Long-term borrowings are concerned about a firm’s ability to pay interest and repay the principal amount over its lifetime.</li> <li>A ratio is always expressed as a quotient of one number divided by another.</li> <li>Ratios help in comparisons of a firm’s results over multiple accounting periods and with other business enterprises.</li> <li>Ratios reflect quantitative aspects of results, not qualitative ones. They are based on monetary data and do not consider non-monetary factors.</li> </ul> <p>======</p> <h5 id="55-types-of-ratios">5.5 Types of Ratios</h5> <ul> <li>The traditional classification of ratios is based on financial statements. This includes:</li> </ul> <ol> <li>Statement of Profit and Loss Ratios, such as the Gross Profit Ratio.</li> <li>Balance Sheet Ratios, such as the Current Ratio.</li> <li>Composite Ratios, which use variables from both the Statement of Profit and Loss and the Balance Sheet, such as the Trade Receivables Turnover Ratio.</li> </ol> <ul> <li>However, a more common classification of ratios is based on their purpose:</li> </ul> <ol> <li>Liquidity Ratios, which measure a business’s ability to pay short-term debts, such as the Current Ratio.</li> <li>Solvency Ratios, which measure a business’s ability to meet long-term debts.</li> <li>Activity (or Turnover) Ratios, which measure the efficiency of a business’s operations.</li> <li>Profitability Ratios, which analyze profits in relation to revenue or funds employed, such as the Gross Profit Ratio.</li> </ol> <p>======</p> <h5 id="56-liquidity-ratios">5.6 Liquidity Ratios</h5> <ul> <li>Liquidity ratios measure the short-term solvency of a business.</li> <li>They are calculated using current assets and current liabilities from the balance sheet.</li> <li>Current ratio is a liquidity ratio that evaluates a firm’s ability to pay short-term debts. It is calculated as current assets divided by current liabilities.</li> <li>Liquidity ratio, also known as the quick ratio, measures a firm’s ability to meet its short-term obligations with its most liquid assets. It is calculated as quick assets divided by current liabilities.</li> <li>Quick assets typically include cash, marketable securities, and accounts receivable.</li> </ul> <p>======</p> <h5 id="561-current-ratio">5.6.1 Current Ratio</h5> <ul> <li>The Current Ratio is calculated by dividing Current Assets by Current Liabilities.</li> <li>Current Assets include Inventories, Trade receivables, Advance tax, and Cash and cash equivalents.</li> <li>Current Liabilities consist of Trade payables and Short-term borrowings.</li> <li>Using the given data, the Current Ratio is calculated to be 1.29:1.</li> <li>An ideal Current Ratio should be within the range of 2:1, providing a balance between safety margin and investment in current assets.</li> </ul> <p>======</p> <h5 id="562-quick-or-liquid-ratio">5.6.2 Quick or Liquid Ratio</h5> <ul> <li>Quick ratio, also known as the acid-test ratio, is the ratio of quick assets to current liabilities. It is calculated as Quick Assets / Current Liabilities.</li> <li>Quick assets are current assets excluding inventories and other non-liquid current assets such as prepaid expenses and advance tax.</li> <li>The quick ratio is considered a better measure of a company’s ability to meet its short-term obligations than the current ratio, as it only considers the most liquid assets.</li> <li>A quick ratio of 1:1 is generally considered ideal, indicating that a company has enough quick assets to cover its current liabilities.</li> <li>Illustration 2 and 3 provide examples of calculating the quick ratio using a given set of financial information.</li> <li>Illustration 4 and 5 demonstrate the use of the quick ratio and current ratio in calculating current assets, current liabilities, and other financial metrics.</li> </ul> <p>(Do it Yourself)</p> <ol> <li>To find the value of inventories, first, find the quick assets by multiplying current liabilities by the quick ratio (2/3 of current liabilities in this case). Then subtract quick assets from current assets to find the value of inventories.</li> <li>Current assets can be found by multiplying current liabilities by the current ratio and then adding the inventory value. Current liabilities can be found by dividing current assets by the current ratio.</li> <li>Current liabilities can be found by dividing current assets by the current ratio. Liquid assets can be found by subtracting inventories from current assets. Inventories can be found by subtracting liquid assets from current assets.</li> </ol> <p>(Illustration 6)</p> <ul> <li>Payment of current liability: Improves current ratio</li> <li>Purchased goods on credit: Reduces current ratio</li> <li>Sale of a Computer for less than book value: Improves current ratio</li> <li>Sale of merchandise for more than cost: Improves current ratio</li> <li>Payment of unclaimed dividend: Improves current ratio.</li> </ul> <p>======</p> <h5 id="57-solvency-ratios">5.7 Solvency Ratios</h5> <ul> <li>Solvency ratios are used to determine a business’s ability to service its long-term debt.</li> <li>Debt-Equity Ratio: Compares the amount of debt to the amount of equity in a company.</li> <li>Debt to Capital Employed Ratio: Measures the proportion of a company’s debt to its total capital (debt + equity).</li> <li>Proprietary Ratio: Shows the relationship between shareholders’ funds and total assets.</li> <li>Total Assets to Debt Ratio: Indicates the proportion of a company’s assets that could be used to pay off its debts.</li> <li>Interest Coverage Ratio: Demonstrates a company’s ability to meet its interest payments on debt.</li> </ul> <p>======</p> <h5 id="571-debt-equity-ratio">5.7.1 Debt-Equity Ratio</h5> <ul> <li>Debt-Equity Ratio is a measure of the relationship between long-term debt and equity.</li> <li>It is computed as: Debt-Equity Ratio = Long-term Debts / Shareholders’ Funds</li> <li>Shareholders’ Funds = Share capital + Reserves and Surplus + Money received against share warrants + Share application money pending allotment</li> <li>It is significant as it indicates the degree of indebtedness of an enterprise and gives an idea to long-term lenders regarding the extent of security of the debt.</li> <li>A low debt equity ratio is considered safe and reflects more security, while a high ratio is considered risky as it may put the firm in difficulty in meeting its obligations to outsiders.</li> </ul> <p>======</p> <h5 id="572-debt-to-capital-employed-ratio">5.7.2 Debt to Capital Employed Ratio</h5> <ul> <li>The Debt to Capital Employed Ratio is the ratio of long-term debt to the total of external and internal funds (capital employed or net assets).</li> <li>It is computed as Long-term Debt/Capital Employed (or Net Assets), where Capital Employed is equal to Long-term Debt + Shareholders’ Funds.</li> <li>Alternatively, Capital Employed can be taken as Net Assets, which are equal to Total Assets - Current Liabilities.</li> <li>The Debt to Capital Employed Ratio indicates the proportion of long-term debts in capital employed and provides security to lenders at a low ratio and helps management in trading on equity at a high ratio.</li> <li>It can also be computed in relation to total assets, where it refers to the ratio of total debts (long-term debts + current liabilities) to total assets.</li> </ul> <p>======</p> <h5 id="573-proprietary-ratio">5.7.3 Proprietary Ratio</h5> <ul> <li>Proprietary ratio, also known as proprietorship ratio, is a financial ratio that expresses the relationship of proprietor’s (shareholders) funds to net assets.</li> <li>It is calculated by dividing shareholders’ funds by capital employed (or net assets). The formula is: Proprietary Ratio = Shareholders’ Funds / Capital employed.</li> <li>Using the data from Illustration 7, the proprietary ratio is calculated as Rs. $15,00,000 /$ Rs. $20,00,000 = 0.75 : 1$.</li> <li>The significance of this ratio is that a higher proportion of shareholders funds in financing the assets is a positive feature as it provides security to creditors.</li> <li>The total of debt to capital employed ratio and proprietory ratio is equal to 1. For instance, if the debt to capital employed ratio is $0.25:1$, the Proprietory Ratio would be $0.75: 1$, and their total would be $0.25 + 0.75 = 1$. This means that 25% of the capital employed is funded by debts and 75% by owners’ funds.</li> </ul> <p>======</p> <h5 id="574-total-assets-to-debt-ratio">5.7.4 Total Assets to Debt Ratio</h5> <ul> <li>The debt-equity ratio is calculated as Debts/Equity, which is 1,50,000/5,00,000 = 0.3:1.</li> <li>The total assets to debt ratio is calculated as Total Assets/Long-term debts, which is 7,00,000/1,50,000 = 4.67:1.</li> <li>The proprietary ratio is calculated as Shareholders’ Funds/Total Assets, which is 5,00,000/7,00,000 = 0.71:1.</li> <li>The debt to capital employed ratio is calculated as Long-term debts/Capital Employed, which is 1,50,000/6,50,000 = 0.23:1.</li> <li>Further issue of equity shares decreases the debt-equity ratio, while redemption of debentures decreases the debit-equity ratio. Cash received from debtors, sale of goods on cash basis, and purchase of goods on credit leave the debt-equity ratio unchanged.</li> </ul> <p>======</p> <h5 id="575-interest-coverage-ratio">5.7.5 Interest Coverage Ratio</h5> <ul> <li>The Interest Coverage Ratio is a measure of the security of interest payable on long-term debts.</li> <li>It is calculated using the formula: Interest Coverage Ratio = Net Profit before Interest and Tax / Interest on long-term debts.</li> <li>The ratio reveals the number of times interest on long-term debts is covered by the profits available for interest.</li> <li>A higher ratio indicates a greater safety of interest on debts.</li> <li>For the given data, the Interest Coverage Ratio is calculated to be 1.67 times.</li> </ul> <p>======</p> <h5 id="58-activity-or-turnover-ratio">5.8 Activity (or Turnover) Ratio</h5> <ul> <li>Activity ratios, also known as efficiency ratios, indicate the speed of business activities.</li> <li>They express the number of times assets or their constituents are turned into sales during an accounting period.</li> <li>Higher turnover ratios signify better utilization of assets, improved efficiency, and profitability.</li> <li>Important activity ratios include: <ol> <li>Inventory Turnover</li> <li>Trade Receivable Turnover</li> <li>Trade Payable Turnover</li> <li>Investment (Net Assets) Turnover</li> <li>Fixed Assets Turnover</li> <li>Working Capital Turnover</li> </ol> </li> </ul> <p>These ratios help measure how efficiently a business is managing its assets and resources.</p> <p>======</p> <h5 id="581-inventory-turnover-ratio">5.8.1 Inventory Turnover Ratio</h5> <ul> <li>Revenue from operations = Rs. 4,00,000</li> <li>Gross Profit = 10% of Rs. 4,00,000 = Rs. 40,000</li> <li>Cost of Revenue from operations = Revenue from operations - Gross Profit = Rs. 3,60,000</li> <li>Inventory Turnover Ratio = Cost of Revenue from Operations / Average Inventory = 6.55 times</li> <li>Gross Profit when Average Inventory = Rs. 40,000 and Inventory Turnover Ratio = 8 times = Rs. 3,20,000 (calculated)</li> </ul> <p>======</p> <h5 id="582-trade-receivables-turnover-ratio">5.8.2 Trade Receivables Turnover Ratio</h5> <ul> <li>Trade Receivables Turnover Ratio is calculated by the formula: Net Credit Revenue from Operations / Average Trade Receivables</li> <li>Average Trade Receivables is calculated as (Opening Debtors and Bills Receivable + Closing Debtors and Bills Receivable) / 2</li> <li>Higher Trade Receivables Turnover Ratio indicates speedy collection from trade receivables</li> <li>This ratio also helps in determining the average collection period</li> <li>Illustration: If Total Revenue from operations is Rs. 4,00,000, Cash Revenue from operations is Rs. 80,000, Opening Trade Receivables is Rs. 40,000 and Closing Trade Receivables is Rs. 1,20,000, then Trade Receivables Turnover Ratio = 4 times.</li> </ul> <p>======</p> <h5 id="583-trade-payable-turnover-ratio">5.8.3 Trade Payable Turnover Ratio</h5> <ul> <li>Trade Payables Turnover Ratio is a financial ratio that indicates a company’s ability to pay off its short-term liabilities related to trade payables.</li> <li>It is calculated as Net Credit Purchases divided by Average Trade Payables.</li> <li>Average Trade Payables is calculated as (Opening Creditors + Bills Payable + Closing Creditors + Bills Payable) divided by 2.</li> <li>The Significance of this ratio is that it reveals the average payment period, and a lower ratio may indicate that credit allowed by the supplier is for a long period or delayed payments to suppliers, which can affect the reputation of the business.</li> <li>The Average Payment Period can be worked out by dividing the number of days in a month by the Trade Payables Turnover Ratio.</li> </ul> <p>======</p> <h5 id="584-net-assets-or-capital-employed-turnover-ratio">5.8.4 Net Assets or Capital Employed Turnover Ratio</h5> <ul> <li>The Fixed Assets Turnover Ratio is 1.88 times, calculated as Rs.30,00,000/Rs. 16,00,000. This ratio is useful in evaluating credit and collection policies.</li> <li>The Working Capital Turnover Ratio is 15 times, calculated as Rs.30,00,000/Rs.2,00,000. This ratio measures the activity of a firm’s inventory.</li> <li>The average collection period indicates the firm’s bill-paying patterns and is especially important for lenders and suppliers (option C).</li> <li>Inventory Turnover Ratio (option B) measures the activity of a firm’s inventory.</li> <li>The average payment period may indicate stockouts and lost sales (option A), which is a concern for customers and stockholders.</li> </ul> <p>Note: I have assumed that the “Test your Understanding - III” is not part of the text to be summarized and have not included it in the bullet points.</p> <p>======</p> <h5 id="59-profitability-ratios">5.9 Profitability Ratios</h5> <ul> <li>Profitability ratios are used to analyze the earning capacity of a business, which is determined by the utilization of resources.</li> <li>Gross profit ratio, operating ratio, operating profit ratio, and net profit ratio are all calculated using data from the statement of profit and loss.</li> <li>Return on Investment (ROI) or Return on Capital Employed (ROCE), and Return on Net Worth (RONW) are used to measure the return on investment and net worth.</li> <li>Earnings per share and book value per share provide information about the company’s earnings and net worth per share.</li> <li>Dividend payout ratio and price earning ratio are used to assess the company’s dividend distribution and stock price valuation.</li> </ul> <p>======</p> <h5 id="591-gross-profit-ratio">5.9.1 Gross Profit Ratio</h5> <ul> <li>Gross Profit Ratio is a percentage of revenue from operations that indicates gross margin on products sold.</li> <li>It is calculated as Gross Profit / Net Revenue of Operations * 100.</li> <li>Gross Profit is calculated as Purchases + (Opening Inventory - Closing Inventory) + Direct Expenses.</li> <li>Net Revenue of Operations is calculated as Cash Revenue from Operations + Credit Revenue from Operations.</li> <li>A low gross profit ratio may indicate unfavorable purchase and sales policy.</li> </ul> <p>======</p> <h5 id="592-operating-ratio">5.9.2 Operating Ratio</h5> <ul> <li>The Operating Ratio is used to analyze the cost of operation in relation to revenue from operations.</li> <li>It is calculated by dividing the sum of Cost of Revenue from Operations and Operating Expenses by Net Revenue from Operations, all expressed as a percentage.</li> <li>Operating Expenses include office expenses, administrative expenses, selling expenses, distribution expenses, depreciation, and employee benefit expenses.</li> <li>Cost of Operation is determined by excluding non-operating incomes and expenses.</li> <li>Non-operating expenses can include loss on sale of assets, interest paid, dividend received, loss by fire, and speculation gain.</li> </ul> <p>======</p> <h5 id="593-operating-profit-ratio">5.9.3 Operating Profit Ratio</h5> <ul> <li>Gross Profit: Rs. 2,20,000, calculated as Revenue from Operations (Rs. 3,40,000) minus Cost of Revenue from Operations (Rs. 1,20,000).</li> <li>Gross Profit Ratio: 64.71%, calculated as (Gross Profit / Revenue from Operations) * 100.</li> <li>Operating Cost: Rs. 2,40,000, calculated as Cost of Revenue from Operations (Rs. 1,20,000) plus Selling expenses (Rs. 80,000) and Administrative Expenses (Rs. 40,000).</li> <li>Operating Ratio: 70.59%, calculated as (Operating Cost / Net Revenue from Operations) * 100.</li> </ul> <p>======</p> <h5 id="594-net-profit-ratio">5.9.4 Net Profit Ratio</h5> <ul> <li>Net profit ratio is a measure of net profit margin in relation to revenue from operations.</li> <li>It is calculated as Net Profit/Revenue from Operations * 100, where net profit generally refers to profit after tax.</li> <li>The main significance of net profit ratio is that it reveals the profitability of a business and reflects the overall efficiency of the business.</li> <li>It is also a main variable in the computation of Return on Investment.</li> <li>In the given illustration, the net profit ratio is calculated as 22.75% for a company with gross profit ratio of 25%, credit revenue from operations of Rs. 20,00,000, cash revenue from operations of 10% of the total revenue from operations, and indirect expenses of Rs. 50,000.</li> </ul> <p>======</p> <h5 id="595-return-on-capital-employed-or-investment">5.9.5 Return on Capital Employed or Investment</h5> <ul> <li>Return on Capital Employed (ROCE) or Return on Investment (ROI) measures the overall utilization of funds by a business enterprise.</li> <li>Capital Employed includes shareholders’ funds, debentures, and long-term loans, or it can be calculated as the total of non-current assets and working capital.</li> <li>The Profit Before Interest and Tax (PBIT) is used to compute the ROCE. The formula is: ROCE = PBIT / Capital Employed * 100</li> <li>ROCE indicates the efficiency of the business in utilizing funds entrusted by shareholders, debenture-holders, and long-term loans.</li> <li>It is considered a good measure for inter-firm comparison of profitability and helps assess if the firm earns a higher return on capital employed compared to the interest rate paid.</li> </ul> <p>======</p> <h5 id="596-return-on-shareholders-funds">5.9.6 Return on Shareholders’ Funds</h5> <ul> <li>The Return on Shareholders’ Funds (ROSF) is a crucial ratio for shareholders to assess the profitability of their investment in a company.</li> <li>It is preferable for the ROSF to be higher than the return on investment, indicating that company funds are being employed profitably.</li> <li>A more comprehensive measure of profitability from a shareholder’s perspective is the Return on Total Shareholders’ Funds (RONW).</li> <li>Also known as Return on Net Worth, RONW is calculated by dividing Profit after Tax by Shareholders’ Funds and multiplying by 100.</li> <li>A higher RONW indicates a more profitable use of shareholders’ funds and a better return on their investment.</li> </ul> <p>======</p> <h5 id="597-earnings-per-share">5.9.7 Earnings per Share</h5> <ul> <li>Earnings per Share (EPS) is calculated as: EPS = Profit available for equity shareholders / Number of Equity Shares</li> <li>Earnings, in this context, refer to the profit available for equity shareholders, which is derived after deducting Preference Share Dividends from Profit After Tax.</li> <li>EPS is a significant ratio for equity shareholders and for determining share price in the stock market.</li> <li>It assists in comparing a company with others to evaluate its reasonableness and capacity to pay dividends.</li> <li>EPS ratio is essential for equity shareholders and stock market price determination.</li> </ul> <p>======</p> <h5 id="598-book-value-per-share">5.9.8 Book Value per Share</h5> <ul> <li>The Book Value per Share is a financial ratio.</li> <li>It is calculated as: Book Value per share = Equity shareholders’ funds / Number of Equity Shares</li> <li>Equity shareholders’ funds is equivalent to Shareholders’ Funds - Preference Share Capital.</li> <li>This ratio is significant for equity shareholders as it indicates the value of their holdings.</li> <li>It can also influence the market price of the shares.</li> </ul> <p>======</p> <h5 id="599-dividend-payout-ratio">5.9.9 Dividend Payout Ratio</h5> <ul> <li>Dividend Payout Ratio is the proportion of earnings that are distributed to shareholders.</li> <li>It is calculated by dividing Dividend per share by Earnings per share.</li> <li>It reflects a company’s dividend policy.</li> <li>High Dividend Payout Ratio indicates a higher proportion of earnings being paid out as dividends.</li> <li>Low Dividend Payout Ratio indicates a lower proportion of earnings being paid out as dividends and higher retention of earnings for growth.</li> </ul> <p>======</p> <h5 id="5910-price--earning-ratio">5.9.10 Price / Earning Ratio</h5> <ul> <li>Earnings per share (EPS) = Profit available for Equity Shareholders / Number of Equity Shares = Rs. 2.50</li> <li>Book value per share = Equity Shareholders’ Funds / Number of Equity Shares = Rs. 12.50</li> <li>Dividend per share = Dividend declared * Earnings per share = Re. 1.50</li> <li>Dividend payout ratio = Dividend per share / Earnings per share = 0.6</li> <li>Price earning ratio = Market price of a share / Earnings per share = 5.20</li> </ul> <p>(Terms introduced in the chapter: Ratio Analysis, Liquidity Ratios, Solvency Ratios, Activity Ratios, Profitability Ratios, Return on Investment (ROI), Quick Assets, Shareholders’ Funds (Equity), Return on Net Worth, Average Collection Period, Trade Receivables, Turnover Ratios, Efficiency Ratios, Dividend Payout)</p> <p>======</p>