Accounting Notes XII

Accounting Ratios 5
F inancial statements aim at providing financial

information about a business enterprise to meet
the information needs of the decision-makers.
Financial statements prepared by a business
enterprise in the corporate sector are published and
are available to the decision-makers. 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
LEARNING OBJECTIVES
statements, trend analysis, accounting ratios and
After studying this chapter,
you will be able to : cash flow analysis. The first three have been
• explain the meaning, discussed in detail in the previous chapter. This
objectives and limitations chapter covers the technique of accounting ratios
of accounting ratios; for analysing the information contained in financial
• identify the various statements for assessing the solvency, efficiency and
types of ratios commonly profitability of the enterprises.
used ;
• calculate various ratios 5.1 Meaning of Accounting Ratios
to assess solvency,
liquidity, efficiency and As stated earlier, accounting ratios are an important
profitability of the firm; tool of financial statements analysis. A ratio is a
• interpret the various mathematical number calculated as a reference to
ratios calculated for relationship of two or more numbers and can be
intra-firm and inter- expressed as a fraction, proportion, percentage and
firm comparisons. a number of times. When the number is calculated
by referring to two accounting numbers derived from
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 of the
1, 00, 000
‘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 cross-sectional 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
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-
Weakness-Opportunity-Threat) 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
(Intra-firm Comparison/Time Series Analysis), (ii) with other business
enterprises (Inter-firm Comparison/Cross-sectional 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
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 Price-level Changes: The financial accounting is based on
stable money measurement principle. It implicitly assumes that price
level changes are either non-existent 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 price-level makes
analysis of financial statement of different accounting years meaningless
because accounting records ignore changes in value of money.
3. Ignore Qualitative or Non-monetary Aspects: Accounting provides
information about quantitative (or monetary) aspects of business.
Hence, the ratios also reflect only the monetary aspects, ignoring
completely the non-monetary (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 cross-sectional 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
non-financial 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.
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) The only purpose of financial reporting is to keep the managers informed
about the progress of operations.
(b) Analysis of data provided in the financial statements is termed as financial
analysis.
(c) Long-term borrowings are concerned about the ability of a firm to discharge
its obligations to pay interest and repay the principal amount.
(d) A ratio is always expressed as a quotient of one number divided by another.
(e) Ratios help in comparisons of a firm’s results over a number of accounting
periods as well as with other business enterprises.
(f) 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.
2. 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 short-term 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
long-term 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’.
Exhibit - 1
ABC PHARMACEUTICALS LTD.
Profitability Ratios
2012-13 2013-14 2014-15
PBDIT/total income 14.09 15.60 17.78
Net profit/total income 6.68 7.19 10.26
Cash flow/total income 7.97 8.64 12.13
Return on Net Worth (PAT/Net Worth) 16.61 10.39 14.68
Return on Capital Employed
(PBDIT/Average capital employed) 15.40 15.33 16.17
Activity Ratios
2012-13 2013-14 2014-15
Trade Receivables turnover (days) 104.00 87.00 80.00
Inventory turnover (days) 98.00 100.00 96.00
Working capital/total capital employed (%) 68.84 60.04 51.11
Interest/total income (%) 4.48 3.67 3.14
Leverage and Financial Ratios

2012-13 2013-14 2014-15
Debt-equity ratio 1.45 0.66 0.77
Current ratio 3.50 3.72 3.58
Quick ratio 2.45 2.40 2.39
Cash and Cash equivalents/total assets (%) 12.76 14.48 7.93
Interest cover/Age 3.15 4.25 4.69
Valuation Ratios
2012-13 2013-14 2014-15
Earnings per share 15.00 12.75 21.16
Cash earnings per share 18.78 15.58 24.85
Dividend per share 3.27 2.73 2.66
Book value per share 94.77 124.86 147.62
Price/Earning 8.64 15.03 13.40
5.6 Liquidity Ratios

Liquidity ratios are calculated to measure the short-term 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.
5.6.1 Current Ratio

Current ratio is the proportion of current assets to current liabilities. It is
expressed as follows:
Current Assets
Current Ratio = Current Assets : Current Liabilities or
Current Liabilities
Current assets include current investments, inventories, trade receivables

(debtors and bills receivables), cash and cash equivalents, short-term loans and
advances and other current assets such as prepaid expenses, advance tax and
accrued income, etc.
Current liabilities include short-term borrowings, trade payables (creditors
and bills payables), other current liabilities and short-term 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
Short-term borrowings (bank overdraft) 4,000
Solution:
Current Assets
Current Ratio =
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 + Short-term borrowings
= Rs. 1,00,000 + Rs. 4,000
= Rs. 1,04,000
Rs.1,34,000
Current Ratio = = 1.29 :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 short-term 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.
5.6.2 Quick Ratio
It is the ratio of quick (or liquid) asset to current liabilities. It is expressed as

Quick Assets
Quick ratio = Quick Assets : Current Liabilities or
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 non-liquid 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 ‘Acid-Test Ratio’.
Illustration 2
Calculate quick ratio from the information given in illustration 1.
Solution:
Quick Assets
Quick Ratio =
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
Rs. 80,000
Quick Ratio = = 0.77 :1
Rs. 1,04,000
Significance: The ratio provides a measure of the capacity of the business to

meet its short-term 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
short-term 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
Solution
Liquid Assets
Liquidity Ratio =
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
Rs. 50,000
Liquidity Ratio = = 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.
Solution:
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
24,000 = 3.5x – 2x
24,000 = 1.5x
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. 16,000
= 3.5 : 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
Non-current liabilities = Rs. 80,000
Shareholders’ Funds = Rs. 2,00,000
Non-Current Assets:
Fixed assets = Rs. 1,60,000
Non-current Investments = Rs. 1,00,000
Solution:
Total assets = Non-current 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 + Non-current 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 Assets
Current Ratio =
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.
Solution:
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.
(b) 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.
(c) 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.
(d) 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.
(e) 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 long-term 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. Debt-Equity Ratio;
2. Debt to Capital Employed Ratio;
3. Proprietary Ratio;
4. Total Assets to Debt Ratio;
5. Interest Coverage Ratio.
5.7.1 Debt-Equity Ratio
Debt-Equity Ratio measures the relationship between long-term debt and equity.
If debt component of the total long-term 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:
Long − term Debts
Debt-Equity Ratio =
Shareholders' Funds
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) = Non-current sssets + Working capital –
Non-current liabilities
Working Capital = Current Assets – Current Liabilities
Significance: This ratio measures the degree of indebtedness of an enterprise

and gives an idea to the long-term 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, 2015. 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 1,00,000
2. Non-current Liabilities
a) Long-term borrowings 4,00,000
b) Other long-term liabilities 40,000
c) Long-term provisions 60,000
3. Current Liabilities
a) Short-term borrowings 2,00,000
b) Trade payables 1,00,000
c) Other current liabilities 50,000
d) Short-term provisions 1,50,000
25,00,000
II. Assets
1. Non-Current Assets
a) Fixed assets 15,00,000
b) Non-current investments 2,00,000
c) Long-term loans and advances 1,00,000
2. 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) Short-term loans and advances 50,000
25,00,000
Solution:
Debts
Debt-Equity Ratio =
Equity
Debt = Long-term borrowings + Other long-term liabilities +
Long-term 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 = Non-current assets + Working capital – Non-current
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
50, 0000
Debt Equity Ratio = = 0.33 : 1
1,50, 0000
Illustration 8
From the following balance sheet of a company, calculate Debt-Equity Ratio:
Balance Sheet
Particulars Note Rs.
No.
b) Reserves and surplus 1 1,00,000
2. Non-Current Liabilities
Long-term borrowings 1,50,000
3. Current Liabilities 1,50,000
14,00,000
II. Assets
1. Non-Current Assets
a) Fixed assets
- Tangible assets 2 11,00,000
2. 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
Solution:
Long - term Debts

Debt-Equity Ratio =
Equity (Shareholders'Funds)
Long-term Debts = Long-term Borrowings
= Rs. 1,50,000
Equity = Share capital + Reserves and surplus

= Rs. 10,00,000 + Rs. 1,00,000 = Rs. 11,00,000
1, 50, 000
Debt Equity Ratio = = 0.136 : 1
11, 00, 000
5.7.2 Debt to Capital Employed Ratio
The Debt to capital employed ratio refers to the ratio of long-term debt to the
total of external and internal funds (capital employed or net assets). It is computed
as follows:
Debt to Capital Employed Ratio = Long-term Debt/Capital Employed (or Net Assets)
Capital employed is equal to the long-term 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. 20,00,000 = 0.25:1.
Significance: Like debt-equity ratio, it shows proportion of long-term 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
(long-term debts + current liabilities) to total assets, i.e., total of non-current
and current assets (or shareholders, funds + long-term debts + current liabilities),
and is expressed as
Total Debts
Debt to Capital Employed Ratio =
Total Assets
5.7.3 Proprietary Ratio

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. 20,00,000 = 0.75 : 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 0.25 + 0.75 = 1. In terms of percentage it can be stated that
the 25% of the capital employed is funded by debts and 75% by owners’ funds.
5.7.4 Total Assets to Debt Ratio

This ratio measures the extent of the coverage of long-term debts by assets. It is
calculated as
Total assets to Debt Ratio = Total assets/Long-term debts
Taking the data of Illustration 8, this ratio will be worked out as follows:
Rs. 14,00,000/Rs. 1,50,000 = 9.33 : 1
The higher ratio indicates that assets have been mainly financed by owners
funds and the long-term 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
No.
I. Equity and Liabilities:
3. Current Liabilities 50,000
7,00,000
II. Assets
1. Non-current Assets
a) Fixed assets 4,00,000
b) Non-current investments 1,00,000
2. Current Assets 2,00,000
7,00,000
Solution:
Debts
i) Debt-Equity Ratio =
Equity
Debt = Long-term borrowings = Rs. 1,50,000
Equity = Share capital + Reserves and surplus
= Rs. 4,00,000 + Rs. 1,00,000 = Rs. 5,00,000
Rs. 1,50,000
Debt-Equity Ratio = = 0.3 : 1
Rs. 5, 00, 000
Total assets
ii) Total Assets to Debt Ratio =
Long - term debts
Total Assets = Fixed assets + Non-current investments + Current assets
= Rs. 4,00,000 + Rs. 1,00,000 + Rs. 2,00,000 = Rs. 7,00,000
Long-term Debt = Rs. 1,50,000
Rs. 7, 00, 000

Total Asset to Debt Ratio = = 4.67 : 1
Rs. 1,50, 000
Shareholders' Funds
iii) Proprietary Ratio = or
Total Assets
Rs. 5, 00, 000

= = 0.71 : 1
Rs. 7, 00, 000
Long - term debts

iv) Debt to Capital Employed Ratio =
Capital Employed
Capital Employed = Shareholders’ Funds + Long-term borrowings
= Rs. 5,00,000 + Rs. 1,50,000
= Rs. 6,50,000
Long - term debts

Debt to Capital Employed Ratio=
Capital Employed
Rs. 1,50, 000

= = 0.23 : 1
Rs. 6,50, 000
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.
Solution:
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.
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 debt-equity 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 debt-equity 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 long-term 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
debit-equity ratio.
(v) This will also leave the ratio unchanged as purchase of goods on credit
neither affect Debt nor equity.
5.7.5 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 long-term 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 long-term debts
Significance: It reveals the number of times interest on long-term 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% Long-term debt 10,00,000; and Tax rate
40%.
Solution:
Net Profit after Tax = Rs. 60,000
Tax Rate = 40%
Net Profit before tax = Net profit after tax × 100/(100 – Tax rate)
= Rs. 60,000 × 100/(100 – 40)
=Rs. 1,00,000
Interest on Long-term Debt =15% of Rs. 10,00,000 = Rs. 1,50,000
Net profit before interest and tax =Net profit before tax + Interest
=Rs. 1,00,000 + Rs. 1,50,000 = Rs. 2,50,000
Interest Coverage Ratio =Net Profit before Interest and
Tax/Interest on long-term debt
= Rs. 2,50,000/Rs. 1,50,000
= 1.67 times.
5.8 Activity (or Turnover) Ratio

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.
5.8.1 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.
Test your Understanding – II
(i) 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
(ii) The _________ ratios are primarily measures of return:
A. liquidity
B. activity
C. debt
D. profitability
(iii) The _________ of business firm is measured by its ability to satisfy its short-
term obligations as they become due:
A. activity
B. liquidity
C. debt
D. profitability
(iv) _________ 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
(v) 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
(vi) 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 :
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
Solution:
Cost of Revenue from Operations

Inventory Turnover Ratio =
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
Inventory in the beginning + Inventory at the end

Average Inventory =
2
Rs. 18, 000 + Rs. 22, 000

= = Rs. 20,000
2
Rs. 60, 000

∴ Inventory Turnover Ratio = = 3 Times
Rs. 20, 000
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%
Solution:
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

Average Inventory
Rs. 3, 60, 000

= = 6.55 times
Rs. 55, 000
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.
Solution:

Average Inventory

8=
Rs. 40, 000
∴ Cost of Revenue from operations = 8 × Rs. 40,000

= Rs. 3,20,000
100
Revenue from operations = Cost of Revenue from operations ×
80
100
= Rs. 3,20,000 × = Rs. 4,00,000
80
Gross Profit = 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
5.8.2 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 = Net Credit Revenue from Operations/Average
Trade Receivable
Where 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.
Number of days or Months

i.e.,
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 1.4.2014 40,000
Trade receivables as at 31.3.2015 1,20,000
Solution:
Net Credit Revenue from Operations

Trade Receivables Turnover Ratio =
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
20
= Rs. 4,00,000 × = Rs. 80,000
100
Credit Revenue from operations = Rs. 4,00,000 – Rs. 80,000 = Rs. 3,20,000
Opening Trade Receivables + Closing
Trade Receivables
Average Trade Receivables =
2
Rs. 40, 000 + Rs. 1, 20, 000

= = Rs. 80,000
2
Net Credit Revenue Form Operations

Trade Receivables Turnover Rations =
Average Inventoary
Rs. 3, 20,000
Trade Receivables Turnover Ratio = = 4 times.
Rs. 80,000
5.8.3 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
No. of days/month in a year

Average Payment Period =
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 2014-15 = 12,00,000
Creditors on 1.4.2014 = 3,00,000
Bills Payables on 1.4.2014 = 1,00,000
Creditors on 31.3.2015 = 1,30,000
Bills Payables on 31.3.2015 = 70,000
Solution:
Net Credit Purchases

Trade Payables Turnover Ratio =
Average Trade Payables
Creditors in the beginning + Bills payables in the

beginning + Creditors at the end + Bills payables
at the end
Average Trade Payables =
2
Rs. 3, 00, 000 + Rs. 1, 00, 000 + Rs. 1, 30, 000 + Rs. 70, 000
=
2
= Rs. 3,00,000
Rs. 12, 00, 000

∴ Trade Payables Turnover Ratio = = 4 times
Rs. 3, 00,000
Illustration 17
From the following information, calculate –
(i) Trade receivables turnover ratio
(ii) Average collection period
(iii) Trade rayable turnover ratio
(iv) Average payment period
Given :
(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
Solution:
Net Credit Revenue from operation

(i) Trade Receivables Turnover Ratio =
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 year-end figures are available use the same as it is.
365
(ii) Average Collection Period =
Trade Receivables Turnover Ratio
365
=
8.18
= 45 days
Purchases *
(iii) Trade Payable Turnover Ratio =
Average Trade Payables
Purchases
= Creditors + Bills payable
4,20,000
=
90,000 + 52,000
4,20,000
= 1,42,000
= 2.96 times
365
(iv) Average Payment Period =
Trade Payables Turnover Ratio
365
=
2.96
= 123 days
*Since no information regarding credit purchase is given, hence it will be related as net
purchases.
5.8.4 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 :
Revenue from Operation

Net Assets or Capital Employed Turnover ratio =
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:
Net Revenue from Operation

Fixed asset turnover Ratio =
Net Fixed Assets
(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 2014-15 were Rs. 30,00,000
Solution:
Revenue from Operations = Rs. 30,00,000
Capital Employed = Share Capital + Reserves and
Surplus + Long-term 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
Fixed Assets = Rs.8,00,000 + Rs.5,00,000 + Rs.2,00,000
+ Rs.1,00,000 = Rs. 16,00,000
Working Capital = Current Assets – Current Liabilities
= Rs.4,00,000 – Rs.2,00,000 = Rs. 2,00,000
Net Assets Turnover Ratio = Rs.30,00,000/Rs.18,00,000 = 1.67 times

Fixed Assets Turnover Ratio = Rs.30,00,000/Rs.16,00,000 = 1.88 times
Working Capital Turnover Ratio = Rs.30,00,000/Rs.2,00,000 = 15 times.
Test your Understanding – III
(i) The _________ is useful in evaluating credit and collection policies.

A. average payment period
B. current ratio
C. average collection period
D. current asset turnover
(ii) The ___________ measures the activity of a firm’s inventory.
A. average collection period
B. inventory turnover
C. liquid ratio
D. current ratio
(iii) 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
(iv) 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
(v) ___________ are especially interested in the average payment period, since it
provides them with a sense of the bill-paying patterns of the firm.
A. Customers
B. Stockholders
C. Lenders and suppliers
D. Borrowers and buyers
(vi) The __________ ratios provide the information critical to the long run operation
of the firm
A. liquidity
B. activity
C. solvency
D. profitability
5.9 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.
5.9.1 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, non-operating 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 2014-15, 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
Salaries 25,000
Decrease in Inventory 10,000
Return Outwards 2,000
Wages 5,000
Solution:
Revenue from Operations = Cash Revenue from Operations + Credit Revenue from
Opration
= Rs.25,000 + Rs.75,000 = Rs. 1,00,000
Net Purchases = Cash Purchases + Credit Purchases – Return Outwards
= Rs.15,000 + Rs.60,000 – Rs.2,000 = Rs. 73,000
Cost of Revenue from = Purchases + (Opening Inventory – Closing Inventory) +
operations Direct Expenses
= Purchases + Decrease in inventory + Direct Expenses
= Rs.73,000 + Rs.10,000 + (Rs.2,000 + Rs.5,000)
= Rs.90,000
Gross Profit = Revenue from Operations – Cost of Revenue from
Operation
= Rs.1,00,000 –Rs.90,000
= Rs. 10,000
Gross Profit Ratio = Gross Profit/Net Revenue from Operations × 100
= Rs.10,000/Rs.1,00,000 × 100
= 10%.
5.9.2 Operating Ratio

It is computed to analyse cost of operation in relation to revenue from operations.
It is calculated as follows:
Operating Ratio = (Cost of Revenue from Operations + Operating Expenses)/
Net Revenue from Operations × 100
Operating expenses include office expenses, administrative expenses, selling
expenses, distribution expenses, depreciation and employee benefit expenses etc.
Cost of operation is determined by excluding non-operating incomes and
expenses such as loss on sale of assets, interest paid, dividend received, loss by
fire, speculation gain and so on.
5.9.3 Operating Profit Ratio

It is calculated to reveal operating margin. It may be computed directly or as a
residual of operating ratio.
Operating Profit Ratio = 100 – Operating Ratio
Alternatively, it is calculated as under:
Operating Profit Ratio = Operating Profit/ Revenue from Operations × 100
Where Operating Profit = Revenue from Operations – Operating Cost
Significance: Operating ratio is computed to express cost of operations excluding

financial charges in relation to revenue from operations. A corollary of it is
‘Operating Profit Ratio’. It helps to analyse the performance of business and
throws light on the operational efficiency of the business. It is very useful for
inter-firm as well as intra-firm comparisons. Lower operating ratio is a very
healthy sign.
Illustration 20
Given the following information:
Rs.
Cost of Revenue from Operations 1,20,000
Selling expenses 80,000
Administrative Expenses 40,000
Calculate Gross profit ratio and Operating ratio.
Solution:
Gross Profit = Revenue from Operations – Cost of Revenue from
Operations
= Rs. 3,40,000 – Rs. 1,20,000
= Rs. 2,20,000
Gross Profit
Gross Profit Ratio = × 100
Revenue from operation
Rs. 2,20,000
= 100
Rs. 3,40,000
= 64.71%
Operating Cost = Cost of Revenue from Operations + Selling Expenses
+ Administrative Expenses
= Rs. 1,20,000 + 80,000 + 40,000
= Rs. 2,40,000
Operating Cost
Operating Ratio = × 100
Net Revenue from Operations
Rs. 2,40,000
= 100
Rs. 3,40,000
= 70.59%
5.9.4 Net Profit Ratio

Net profit ratio is based on all inclusive concept of profit. It relates revenue from
operations to net profit after operational as well as non-operational expenses
and incomes. It is calculated as under:
Net Profit Ratio = Net profit/Revenue from Operations × 100
Generally, net profit refers to profit after tax (PAT).
Significance: It is a measure of net profit margin in relation to revenue from
operations. Besides revealing profitability, it is the main variable in computation
of Return on Investment. It reflects the overall efficiency of the business, assumes
great significance from the point of view of investors.
Illustration 21
Gross profit ratio of a company was 25%. Its credit revenue from operations was
Rs. 20,00,000 and its cash revenue from operations was 10% of the total revenue
from operations. If the indirect expenses of the company were Rs. 50,000,
calculate its net profit ratio.
Solution:
Cash Revenue from Operations = Rs.20,00,000 × 10/90
= Rs.2,22,222
Hence, total Revenue from Operations are = Rs.22,22,222
Gross profit = 0.25 × 22,22,222 = Rs. 5,55,555
Net profit = Rs.5,55,555 – 50,000
= Rs.5,05,555
Net profit ratio = Net profit/Revenue from Operations
× 100
= Rs.5,05,555/Rs.22,22,222 × 100
= 22.75%.
5.9.5 Return on Capital Employed or Investment

It explains the overall utilisation of funds by a business enterprise. Capital
employed means the long-term funds employed in the business and includes
shareholders’ funds, debentures and long-term loans. Alternatively, capital
employed may be taken as the total of non-current assets and working capital.
Profit refers to the Profit Before Interest and Tax (PBIT) for computation of this
ratio. Thus, it is computed as follows:
Return on Investment (or Capital Employed) = Profit before Interest and Tax/
Capital Employed × 100
Significance: It measures return on capital employed in the business. It reveals
the efficiency of the business in utilisation of funds entrusted to it by shareholders,
debenture-holders and long-term loans. For inter-firm comparison, return on

capital employed funds is considered a good measure of profitability. It also
helps in assessing whether the firm is earning a higher return on capital employed
as compared to the interest rate paid.
5.9.6 Return on Shareholders’ Funds

This ratio is very important from shareholders’ point of view in assessing whether
their investment in the firm generates a reasonable return or not. It should be
higher than the return on investment otherwise it would imply that company’s
funds have not been employed profitably.
A better measure of profitability from shareholders point of view is obtained
by determining return on total shareholders’ funds, it is also termed as Return
on Net Worth (RONW) and is calculated as under :
Profit after Tax

Return on Shareholders’ Fund = × 100
Shareholders' Funds
5.9.7 Earnings per Share

The ratio is computed as:
EPS = Profit available for equity shareholders/Number of Equity Shares
In this context, earnings refer to profit available for equity shareholders which
is worked out as
Profit after Tax – Dividend on Preference Shares.
This ratio is very important from equity shareholders point of view and
also for the share price in the stock market. This also helps comparison with
other to ascertain its reasonableness and capacity to pay dividend.
5.9.8 Book Value per Share

This ratio is calculated as :
Book Value per share = Equity shareholders’ funds/Number of Equity Shares
Equity shareholder fund refers to Shareholders’ Funds – Preference Share
Capital. This ratio is again very important from equity shareholders point of
view as it gives an idea about the value of their holding and affects market price
of the shares.
5.9.9 Dividend Payout Ratio

This refers to the proportion of earning that are distributed to the shareholders.
It is calculated as –
Dividend per share
Dividend Payout Ratio =
Earnings per share
This reflects company’s dividend policy and growth in owner’s equity.
5.9.10 Price / Earning Ratio

The ratio is computed as –
P/E Ratio = Market Price of a share/earnings per share
For example, if the EPS of X Ltd. is Rs. 10 and market price is Rs. 100, the
price earning ratio will be 10 (100/10). It reflects investors expectation about
the growth in the firm’s earnings and reasonableness of the market price of its
shares. P/E Ratio vary from industy to industry and company to company in
the same industry depending upon investors perception of their future.
Illustration 22
From the following details, calculate Return on Investment:
Share Capital : Equity (Rs.10) Rs. 4,00,000 Current Liabilities Rs. 1,00,000
12% Preference Rs. 1,00,000 Fixed Assets Rs. 9,50,000
General Reserve Rs. 1,84,000 Current Assets Rs. 2,34,000
10% Debentures Rs. 4,00,000
Also calculate Return on Shareholders’ Funds, EPS, Book value per share
and P/E ratio if the market price of the share is Rs. 34 and the net profit after tax
was Rs. 1,50,000, and the tax had amounted to Rs. 50,000.
Solution:
Profit before interest and tax = Rs. 1,50,000 + Debenture interest + Tax
= Rs. 1,50,000 + Rs. 40,000 + Rs. 50,000
= Rs.2,40,000
Capital Employed = Equity Share Capital + Preference Share
Capital + Reserves + Debentures
= Rs. 4,00,000 + Rs. 1,00,000 + Rs. 1,84,000
+ Rs. 4,00,000 = Rs. 10,84,000
Return on Investment = Profit before Interest and Tax/
Capital Employed × 100
= Rs. 2,40,000/Rs. 10,84,000 × 100
= 22.14%
Shareholders’ Fund = Equity Share Capital + Preference Share Capital
+ General Reserve
= Rs. 4,00,000 + Rs. 1,00,000 + Rs. 1,84,000
= Rs. 6,84,000
Return on Shareholders’ Funds = Profit after tax/shareholders’ Funds × 100
= Rs. 1,50,000/Rs. 6,84,000 × 100
= 21.93%
EPS = Profit available for Equity Shareholders/
Number of Equity Shares
= Rs. 1,38,000/ 40,000 = Rs. 3.45
Preference Share Dividend = Rate of Dividend × Prefence Share Capital
= 12% of Rs. 1,00,000
= Rs. 12,000
Profit available to equity = Profit after Tax – Preference dividend on
Shareholders preference shares
where, Dividend on Prefrence = Rate of Dividend × Preference Share Capital

shares = 12% of Rs. 1,00,000
= Rs.12,000
= Rs. 1,50,000 – Rs. 12,000 = Rs. 1,38,000
P/E Ratio = Market price of a share/ Earnings per share
= 34/3.45
= 9.86 Times
Rs. 4, 00, 000

=
Rs.10
= Rs. 40,000
Book Value per share = Equity Shareholders’ fund/No. of
equity shares
Equity share capital

where, Number of Equity Shares =
Face value per share
Hence, Book value per share = Rs. 5,84,000/40,000 shares = Rs. 14.60
It may be noted that various ratios are related with each other. Sometimes,
the combined information regarding two or more ratios is given and missing
figures may need to be calculated. In such a situation, the formula of the ratio
will help in working out the missing figures (See Illsuatration 23 and 24).
Illustration 23
Calculate current assets of a company from the following information:
Inventory turnover ratio = 4 times
Inventory at the end is Rs. 20,000 more than the inventory in the beginning.
Revenue from Operations Rs. 3,00,000 and gross profit ratio is 20% of revenue from
operations.
Quick ratio = 0.75 : 1
Solution:
Cost of Revenue from Operations = Revenue from Operations – Gross Profit
= Rs. 3,00,000 – (Rs. 3,00,000 × 20%)
= Rs. 3,00,000 – Rs. 60,000
= Rs. 2,40,000
Inventory Turnover Ratio = Cost of Revenue from Operations/ Average Inventory
Average Inventory = Cost of Revenue from Operations/4
= Rs. 2,40,000/4 = Rs. 60,000
Average Inventory = (Opening inventory + Closing inventory)/2
Rs. 60,000 = Opening inventory + (Opening inventory
+Rs.20,000)/2
Rs. 60,000 = Opening inventory + Rs. 10,000
Opening Inventory = Rs. 50,000
Closing Inventory = Rs. 70,000
Liquid Ratio = Liquid assets/current liabilities
0.75 = Liquid assets/Rs. 40,000

Liquid Assets = Rs. 40,000 × 0.75 = Rs. 30,000
Current Assets = Liquid assets + Closing inventory
= Rs. 30,000 + Rs. 70,000 = Rs. 1,00,000
Illustration 24
The current ratio is 2.5 : 1. Current assets are Rs. 50,000 and current liabilities
are Rs. 20,000. How much must be the decline in the current assets to bring the
ratio to 2 : 1
Solution:
For a ratio of 2 : 1, the current assets must be 2 × 20,000 = Rs. 40,000
Present level of current assets = Rs. 50,000
Necessary decline = Rs. 50,000 – Rs. 40,000
= Rs. 10,000
Illustration 25
Following information is given by a company from its books of accounts as on
March 31, 2015:
Particulars Rs.
Inventory 1,00,000
Total Current Assets 1,60,000
Shareholders’ funds 4,00,000
13% Debentures 3,00,000
Current liabilities 1,00,000
Net Profit Before Tax 3,51,000
Cost of revenue from operations 5,00,000
Calculate:
i) Current Ratio
ii) Liquid Ratio
iii) Debt Equity Ratio
iv) Interest Coverage Ratio
v) Inventory Turnover Ratio
Solution:
Current Assets
i) Current Ratio =
Current Liabilities
Rs. 1, 60, 000

= = 1.6 : 1
Rs. 1, 00, 000
ii) Liquid Assets = Current assets – Inventory

= Rs. 1,60,000 – Rs. 1,00,000
= Rs. 60,000
Liquid Assets
Liquid Ratio =
Current Liabilities
Rs. 60, 000

= = 0.6 : 1
Rs. 1, 00, 000
Long-term Debts
iii) Debt-Equity Ratio =
Shareholders' Funds
Rs. 3, 00, 000

= = 0.75 : 1
Rs. 4, 00, 000
iv) Net Profit before Interest = Net Profit before Tax + Interest on Long
& Tax term Debts
= Rs. 3,51,000 + (13% of Rs. 3,00,000)
= Rs. 3,51,000 + Rs. 39,000 = Rs. 3,90,000
Net Profit before Interest & Tax

Interest Coverage Ratio =
Interest on Long Term Debts
Rs. 3, 90, 000

= = 10 times
Rs. 39, 000

v) Inventory Turnover Ratio =
Average Inventory
Rs. 5, 00,000
= = 5 times
Rs. 1, 00, 000
Note: In absence of information regarding ‘Inventory in the beginning’ and ‘Inventory
at the end’, the ‘Inventory’ is treated as Average Inventory.
Illustration 26
From the following information calculate (i) Earning per share (ii) Book value
per share (iii) Dividend payout ratio (iv) Price earning ratio
Particulars Rs.
70,000 equity shares of Rs 10 each 7,00,000
Net Profit after tax but before dividend 1,75,000
Market price of a share 13
Dividend declared @ 15%
Solution:
Profit available for Equity Shareholders

i) Earning per share =
Rs. 1, 75, 000

= = Rs. 2.50
Rs. 70, 000
Equity Shareholders' Funds

ii) Book value per share =
Rs. 8, 75,000
= = Rs. 12.50
Rs. 70, 000
Dividend per share

iii) Dividend payout ratio =
Earnings per share
1.50
= = 0.6
2.50
Market price of a share

iv) Price earning ratio =
Earnings per share
13
= = 5.20
2.50
Terms Introduced in the Chapter
1. Ratio Analysis 8. Shareholders’ Funds (Equity)

2. Liquidity Ratios 9. Return on Net Worth
3. Solvency Ratios 10. Average Collection Period
4. Activity Ratios 11. Trade Receivables
5. Profitability Ratios 12. Turnover Ratios
6. Return on Investment (ROI) 13. Efficiency Ratios
7. Quick Assets 14. Dividend Payout
Summary
Ratio Analysis: An important tool of financial statement analysis is ratio
analysis. Accounting ratios represent relationship between two accounting
numbers.
Objective of Ratio Analysis: The objective of ratio analysis is to provide a
deeper analysis of the profitability, liquidity, solvency and activity levels in
the business. It is also to identify the problem areas as well as the strong
areas of the business.
Advantages of Ratio Analysis: Ratio analysis offers many advantages
including enabling financial statement analysis, helping understand efficacy
of decisions, simplifying complex figures and establish relationships, being
helpful in comparative analysis, identification of problem areas, enables
SWOT analysis, and allows various comparisons.
Limitations of Ratio Analysis: There are many limitations of ratio analysis.
Few are based because of the basic limitations of the accounting data on
which it is based. In the first set are included factors like Historical Analysis,
Ignores Price-level Changes, Ignore Qualitative or Non-monetary Aspects,
Limitations of Accounting Data, Variations in Accounting Practices, and
Forecasting. In the second set are included factor like means and not the
end, lack of ability to resolve problems, lack of standardised definitions,
lack of universally accepted standard levels, and ratios based on unrelated
figures.
Types of Ratios: There are many types of ratios, viz., liquidity, solvency,
activity and profitability ratios. The liquidity ratios include current ratio
and acid test ratio. Solvency ratios are calculated to determine the ability
of the business to service its debt in the long run instead of in the short
run. They include debt equity ratio, total assets to debt ratio, proprietary
ratio and interest coverage ratio. The turnover ratios basically exhibit the
activity levels characterised by the capacity of the business to make more
sales or turnover and include Inventory Tur nover, Trade Receivables
Turnover, Trade Payables Turnover, Working Capital Turnover, Fixed Assets
Turnover and Current assets Turnover. Profitability ratios are calculated
to analyse the earning capacity of the business which is the outcome of
utilisation of resources employed in the business. The ratios include Gross
Profit ratio, Operating ratio, Net Profit Ratio, Return on investment (Capital
employed), Earnings per Share, Book Value per Share, Dividend per Share
and Price/Earning ratio.
Questions for Practice
Short Answer Questions

1. What do you mean by Ratio Analysis?
2. What are various types of ratios?
3. What relationships will be established to study:
a. Inventory turnover
b. Trade receivables turnover
c. Trade payables turnover
d. Working capital turnover
4. The liquidity of a business firm is measured by its ability to satisfy its
long-term obligations as they become due. What are the ratios used for
this purpose?
5. The average age of inventory is viewed as the average length of time
inventory is held by the firm for which explain with reasons.
Long Answer Questions

1. What are liquidity ratios? Discuss the importance of current and liquid
ratio.
2. How would you study the Solvency position of the firm?
3. What are various profitability ratios? How are these worked out?
4. The current ratio provides a better measure of overall liquidity only when
a firm’s inventory cannot easily be converted into cash. If inventory is
liquid, the quick ratio is a preferred measure of overall liquidity. Explain.
Numerical Questions
1. Following is the Balance Sheet of Raj Oil Mills Limited as at March 31, 2015.
Calculate current ratio.
Particulars Rs.
b) Reserves and surplus 35,000
Trade Payables 72,000
Total 8,97,000
II. Assets
Fixed assets
– Tangible assets 7,53,000
2. Current Assets
a) Inventories 55,800
b) Trade Receivables 28,800
c) Cash and cash equivalents 59,400
Total 8,97,000
(Ans: Current Ratio 2:1)
2. Following is the Balance Sheet of Title Machine Ltd. as at March 31, 2015.
Particulars Amount
(Rs.)
2. Non-current liabilities
3. Current liabilities
a) Short-term borrowings 6,00,000
b) Trade payables 23,40,000
c) Short-term provisions 60,000
Total 69,00,000
II. Assets
1. Non-current assets
Fixed assets
- Tangible assets 45,00,000
2. Current Assets
b) Trade receivables 9,00,000
d) Short-term loans and advances 72,000
Total 69,00,000
Calculate Current Ratio and Liquid Ratio.

(Ans: Current Ratio 0.8 : 1, Liquid Ratio 0.41 : 1)
3. Current Ratio is 3.5 : 1. Working Capital is Rs. 90,000. Calculate the amount of
Current Assets and Current Liabilities.
(Ans: Current Assets Rs. 1,26,000 and Current Liabilities Rs. 36,000)
4. Shine Limited has a current ratio 4.5 : 1 and quick ratio 3 : 1; if the inventory
is 36,000, calculate Current Liabilities and Current Assets.
(Ans: Current Assets Rs. 1,08,000, Current Liabilities Rs. 24,000)
5. Current Liabilities of a company are Rs. 75,000. If current ratio is 4:1 and Liquid
Ratio is 1 : 1, calculate value of Current Assets, Liquid Assets and Inventory.
(Ans: Current Assets Rs. 3,00,000, Liquid Assets Rs. 75,000 and Inventory
Rs. 2,25,000)
6. Handa Ltd. has inventory of Rs. 20,000. Total liquid assets are Rs. 1,00,000
and quick ratio is 2 : 1. Calculate current ratio.
(Ans: Current Ratio 2.4 : 1)
7. Calculate debt-equity ratio from the following information:
Total Assets Rs. 15,00,000
Current Liabilities Rs. 6,00,000
Total Debts Rs. 12,00,000
(Ans: Debt-Equity Ratio 2 : 1.)
8. Calculate Current Ratio if:
Inventory is Rs. 6,00,000; Liquid Assets Rs. 24,00,000; Quick Ratio 2 : 1.
(Ans: Current Ratio 2.5 : 1)
9. Compute Inventory Turnover Ratio from the following information:
Net Revenue from Operations Rs. 2,00,000
Gross Profit Rs. 50,000
Inventory at the end Rs. 60,000
Excess of inventory at the end over
inventory in the beginning Rs. 20,000
(Ans: Inventory Turnover Ratio 3 times)
10. Calculate following ratios from the following information:
(i) Current ratio (ii) Liquid ratio (iii) Operating Ratio (iv) Gross profit ratio
Current Assets Rs. 35,000
Current Liabilities Rs. 17,500
Inventory Rs. 15,000
Operating Expenses Rs. 20,000
Revenue from Operations Rs. 60,000
Cost of Revenue from operation Rs. 30,000
(Ans: Current Ratio 2 : 1; Liquid Ratio 1.14 : 1; Operating Ratio 83.3%; Gross
Profit Ratio 50%)
11. From the following information calculate:
(i) Gross Profit Ratio (ii) Inventory Turnover Ratio (iii) Current Ratio (iv) Liquid
Ratio (v) Net Profit Ratio (vi) Working Capital Ratio:
Revenue from Operations Rs. 25,20,000
Net Profit Rs. 3,60,000
Cost of Revenue from Operations Rs. 19,20,000
Long-term Debts Rs. 9,00,000
Trade Payables Rs. 2,00,000
Average Inventory Rs. 8,00,000
Current Assets Rs. 7,60,000
Fixed Assets Rs. 14,40,000

Net Profit before Interest and Tax Rs. 8,00,000
(Ans: Gross Profit Ratio 23.81%; Inventory Turnover Ratio 2.4 times; Current
Ratio 2.6 : 1; Liquid Ratio 1.27 : 1; Net Profit Ratio 14.21%; Working Capital
Ratio 2.625 times)
12. Compute Gross Profit Ratio, Working Capital Turnover Ratio, Debt Equity Ratio
and Proprietary Ratio from the following information:
Paid-up Share Capital Rs. 5,00,000
Current Assets Rs. 4,00,000
13% Debentures Rs. 2,00,000
(Ans: Gross Profit Ratio 40%; Working Capital Ratio 8.33 times; Debt–Equity
Ratio 0.4 : 1; Proprietary Ratio 0.51 : 1)
13. Calculate Inventory Turnover Ratio if:
Inventory in the beginning is Rs. 76,250, Inventory at the end is 98,500, Gross
Revenue from Operations is Rs. 5,20,000, Sales Return is Rs. 20,000, Purchases
is Rs. 3,22,250.
(Ans: Inventory Turnover Ratio 3.43 times)
14. Calculate Inventory Turnover Ratio from the data given below:
Inventory in the beginning of the year Rs. 10,000
Stock at the end of the year Rs. 5,000
Carriage Rs. 2,500
Revenue from Operations Rs. 50,000
Purchases Rs. 25,000
(Ans: Inventory Turnover Ratio 4.33 times)
15. A trading firm’s average inventory is Rs. 20,000 (cost). If the inventory turnover
ratio is 8 times and the firm sells goods at a profit of 20% on sales, ascertain
the profit of the firm.
(Ans: Profit Rs. 40,000)
16. You are able to collect the following information about a company for two years:
2013-14 2014-15
Trade receivables on Apr. 01 Rs. 4,00,000 Rs. 5,00,000
Trade receivables on Mar. 31 Rs. 5,60,000
Stock in trade on Mar. 31 Rs. 6,00,000 Rs. 9,00,000
Revenue from operations Rs. 3,00,000 Rs. 24,00,000
(at gross profit of 25%)
Calculate Inventory Turnover Ratio and Trade Receivables Turnover Ratio

(Ans: Inventory Turnover Ratio 2.4 times, Trade Receivables Turnover Ratio
4.53 times)
17. From the following Balance Sheet and other information, calculate following
ratios:
(i) Debt-Equity Ratio (ii) Working Capital Turnover Ratio (iii) Trade Receivables
Turnover Ratio
Balance Sheet as at March 31, 2015
No.
Trade payables 5,00,000
Total 36,00,000
II. Assets
Fixed assets
– Tangible assets 18,00,000
2. Current Assets
b) Trade Receivables 9,00,000
Total 36,00,000
Additional Information: Revenue from Operations Rs. 18,00,000
(Debt-Equity Ratio 0.63 : 1; Working Capital Turnover Ratio 1.39 times; Trade
Receivables Turnover Ratio 2 times)
(Ans: Debt Equity 12 : 19; Working Capital Turnover 1.4 times; Debtors Turnover
2 times)
18. From the following information, calculate the following ratios:
i) Liquid Ratio
ii) Inventory turnover ratio
iii) Return on investment
Rs.
Inventory in the beginning 50,000
Inventory at the end 60,000
Revenue from operations 4,00,000

Gross Profit 1,94,000
Cash and Cash Equivalents 40,000
Trade Receivables 1,00,000
Trade Payables 1,90,000
Other Current Liabilities 70,000
Share Capital 2,00,000
Reserves and Surplus 1,40,000
(Balance in the Statement of Profit & Loss A/c)
(Ans: Liquid Ratio 0.54 : 1; Inventory Turnover Ratio 3.74 times; Return on
Investment 41.17%)
19. From the following, calculate (a) Debt-Equity Ratio (b) Total Assets to Debt Ratio
(c) Proprietary Ratio.
Equity Share Capital Rs. 75,000
Preference Share Capital Rs. 25,000
General Reserve Rs. 45,000
Balance in the Statement of Profit & Loss Rs. 30,000
Debentures Rs. 75,000
Trade Payables Rs. 40,000
Outstanding Expenses Rs. 10,000
(Ans: Debt-Equity Ratio 0.43 : 1; Total Assets to Debt Ratio 4 : 1; Proprietary
Ratio 0.58 : 1)
20. Cost of Revenue from Operations is Rs. 1,50,000. Operating expenses are
Rs. 60,000. Revenue from Operations is Rs. 2,50,000. Calculate Operating Ratio.
(Ans: Operating Ratio 84%)
21. Calculate the following ratio on the basis of following information:
(i) Gross Profit Ratio (ii) Current Ratio (iii) Acid Test Ratio (iv) Inventory Turnover
Ratio (v) Fixed Assets Turnover Ratio
Rs.
Gross Profit 50,000
Inventory 15,000
Trade Receivables 27,500
Cash and Cash Equivalents 17,500
Current Liablilites 40,000
Land & Building 50,000
Plant & Machinery 30,000
Furniture 20,000
(Ans: (i) Gross Profit Ratio 50%; (ii) Current Ratio 1.5:1; (iii) Liquid Ratio 1.125 : 1,
Inventory Turnover Ratio 3.33 times; (iv) Fixed Assets Turnover Ratio 1 : 1)
22. From the following information calculate Gross Profit Ratio, Inventory Turnover
Ratio and Trade Receivable Turnover Ratio.
Inventory at the end Rs. 62,000
Gross Profit Rs. 60,000
Inventory in the beginning Rs. 58,000
Trade Receivables Rs. 32,000
(Ans: Gross Profit Ratio 20%; Inventory Turnover Ratio 4 times; Trade
Receivables Turnover Ratio 9.4 times)
Answers to Test your Understanding
Test your Understanding – I

(a) F, (b) T, (c) T, (d) F, (e) T, (F) F
Test your Understanding – II

(i) D, (ii) D, (iii) B, (iv) A, (v) B, (vi) D
Test your Understanding – III

(i) C, (ii) B, (iii) A, (iv) C, (v) C, (vi) C

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Accounting Ratios 5

F inancial statements aim at providing financial

the financial statements, it is termed as accounting ratio. For example, if the

5.2 Objectives of Ratio Analysis

5.3 Advantages of Ratio Analysis

5.4 Limitations of Ratio Analysis

2.Lack of ability to resolve problems: Their role is essentially indicative

Test your Understanding – I

5.5 Types of Ratios

Leverage and Financial Ratios

5.6 Liquidity Ratios

5.6.1 Current Ratio

Current assets include current investments, inventories, trade receivables

Significance: It provides a measure of degree to which current assets cover current

5.6.2 Quick Ratio

It is the ratio of quick (or liquid) asset to current liabilities. It is expressed as

Significance: The ratio provides a measure of the capacity of the business to

5.7 Solvency Ratios

Significance: This ratio measures the degree of indebtedness of an enterprise

Long - term Debts

Equity = Share capital + Reserves and surplus

Capital employed is equal to the long-term debt + shareholders’ funds.

5.7.3 Proprietary Ratio

5.7.4 Total Assets to Debt Ratio

Rs. 7, 00, 000

Rs. 5, 00, 000

Long - term debts

Long - term debts

Rs. 1,50, 000

5.7.5 Interest Coverage Ratio

5.8 Activity (or Turnover) Ratio

Test your Understanding – II

(i) The following groups of ratios are primarily measure risk:

Cost of Revenue from Operations

Inventory in the beginning + Inventory at the end

Rs. 18, 000 + Rs. 22, 000

Rs. 60, 000

Cost of Revenue from Operations

Rs. 3, 60, 000

Cost of Revenue from Operations

Cost of Revenue from Operations

∴ Cost of Revenue from operations = 8 × Rs. 40,000

5.8.2 Trade Receivables Turnover Ratio

Number of days or Months

Net Credit Revenue from Operations

Opening Trade Receivables + Closing

Rs. 40, 000 + Rs. 1, 20, 000

Net Credit Revenue Form Operations

5.8.3 Trade Payable Turnover Ratio

No. of days/month in a year

Net Credit Purchases

Creditors in the beginning + Bills payables in the

Rs. 12, 00, 000

Net Credit Revenue from operation

Rs. 8,75, 000

Revenue from Operation

Capital employed turnover ratio which studies turnover of capital employed

Net Revenue from Operation

(b) Working Capital Turnover Ratio : It is calculated as follows :

Net Revenue from Operation