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1-ACCOUNTING RATIOS

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                                                                        Subject: Advance Accounting
                                                                        Class : BCom II
                                                                        Chapter: Accounting Ratios

                                Accounting Ratios
(1) Profitability Ratios/General Profitability Ratios:-
               These ratios measure the result of business operations or overall performance and
       effectiveness of the firm.
  (a) Gross Profit Ratio:
       Gross profit ratio is the ratio of gross profit to net sales;
       Formula: Gross Profit Ratio =               Gross Profit x100
                                                     Net Sales
       * Net Sales                   = Total sales – Sales Return
       * Gross Profit                = Net Sales – Cost of goods sold
       * Cost of goods sold          = Opening Stock+ Purchases – Closing Stock + All direct
                                        expenses related to purchases
       (Note:- This cost of goods sold method will be adopted in case of trading concern.)

       * Cost of goods sold        = Cost of raw material + Wages + Direct expenses
                                     + Manufacturing expenses
       (Note:- This method to find the cost of goods sold will be used in case of manufacturing
              concern.)
  (b) Net Profit Ratio:
       This is the ratio of net profit (after tax) to net sales. It is also expressed as a percentage.
       Formula: Net Profit Ratio             =      Net profit after taxes x100
                                                          Net sales
       * Net Profit are obtained after deducting income tax and generally, non operating incomes
         and expenses, e.g interest on investment outside the business, Profit on sale of fixed asset
         etc. are excluded from the net profit for calculating this ratio.
  (c) Operating Ratio:
       This is the ratio of cost of goods sold plus expenses operating to net sales. It is generally
       expressed in percentage.
       Formula: Operating Ratio            =      Operating Cost x100
                                                     Net Sales
                                           OR
                     Operating Ratio       =        Cost of goods sold + Operating expenses x100
                                                                    Net Sales
       * Operating Expenses = Administrative/Office expenses+Selling/Distribution/Marketing exp.
       Note:- Financial charges such as interest, provision for taxation etc. are generally excluded from
              operating expenses.
  (d) Operating Profit Ratio:
       This ratio can be obtained operating profit dividing by Net Sales.
       Formula: Operating Profit Ratio = Operating Profit x100
                                                    Net sales
       * Operating Profit = Gross Profit – Operating expenses
  (e) Expense Ratio:
       Expense ratio indicates the relationship of various expenses to net sales.
       Formula: Expense Ratio             =      Particular Expense x100
                                                     Net Sales
(2) Overall Profitability Ratios:-
       Profits are the measure of overall efficiency of a business. Thus, overall profitability or
       efficiency of a business can be measured in terms of profits related to investments made in
       the business.
  (a) Return on Shareholder’s Investment or Net Worth:
       This ratio is the relationship between Net Profit (after interest & tax) and Shareholder’s
       funds/Proprietor’s funds.
       Formula: Net Profit (after interest & tax) x100
                            Shareholder’s funds
                                                  ii

        * Shareholder’s fund = Equity share capital + Preference share capital + All reserves and
                                 surplus – accumulated losses/Deferred expenses
  (b) Return on Equity Capital:
        It is the relationship between profits of a company and its equity.
        Formula:                    Net Profit after tax – Preference dividend x100
                                               Equity Share Capital

       * Equity share capital = Total called up value of equity shares
  (c) Earnings Per Share:
        It can be obtained by dividing net profit after tax and preference dividend by total number
        of equity shares.
        Formula:                    Dividend per        share
                                    Market value per share

  (e) Dividend Pay-out Ratio/ Pay out Ratio:
        This is calculated to find out the extent to which earnings per share have been used for
        paying dividend and to know what portion of earnings has been retained in the business.
        Formula: Dividend pay out ratio= Dividend per equity share
                                                      Earnings per share

  (f) Price Earning Ratio (PER):
        It is the ratio between market price per equity share and earnings per share.
        Formula: Price earning ratio         = Market price per equity share
                                                     Earnings per share
(3) Liquidity Ratios/Short-term Solvency or Short-term Financial
    Position Ratios:
        (a) Liquidity Ratios.
        (b) Current Assets movement/ Efficiency Ratios/ Activity Ratios.
  (a) Liquidity Ratios:
        Liquidity refers to the ability of a firm to meet its current obligations as and when they
        become due.
        (i) Current Ratio/ Working Capital Ratio:
             It is the relationship between current assets and current liabilities.
        Formula: Current Assets          :      Current Liabilities
                                           OR
                      Current Ratio   =    Current    Assets
                                           Current Liabilities

        * Current Assets = Cash in hand + Cash at bank + Marketable securities or readity realisable
                             investment + Bill receivable + Sundry debtors(excluding bad debts and
                              provision) + Inventories + Work-in-Progress + Prepaid expenses.
        * Current Liabilities = Outstanding expenses + Bills payable + Sundry creditors + Bank over-
                              draft + Accrued expenses + Short-term advances + Income Tax payable
                              + Dividend payable.
        (ii) Liquid Ratio/ Acid Test Ratio/ Quick Ratio:
              It is the ratio of liquid assets to current liabilities.
        Formula: Liquid Ratio =              Liquid     Assets
                                             Current Liabilities
        * Liquid Assets = Cash + Bank + Sundry debtors + Bills Receivable + Marketable securities
                                                   OR
        * Liquid Assets = Current Assets – Inventories (Stock) – Prepaid expenses.
        (iii) Absolute Liquidity Ratio:
             It is ratio of absolute liquid assets to current liabilities.
        Formula: Absolute Liquidity Ratio = Absolute Liquid Assets
                                                     Current Liabilities
                                            iii
    * Absolute Liquid Assets = Cash +             Bank + Marketable Securities
                                             OR
    * Absolute Liquid Assets = Liquid Assets + Bills receivable – Sundry Debtors (excluding bad
                               debts & Provisions)
(b) Current Assets Movement/ Efficiency Ratios:-
          It is the other dimension of liquidity which determines the rate at which various short
          term assets are converted into cash.
    (i) Stock Turnover Ratio/Inventory Turnover Ratio:
          It is relationship between the cost of goods sold during a particular period of time and
          the cost of average inventory during the period.

    Formula:     Inventory Turnover Ratio =            Cost of goods sold
                                                       Average stock at cost
    * Average Stock     = Opening Stock + Closing Stock
                                      2
    Note:-      If Cost Of Goods Sold is not given, then we can use the Net Sales. But if
          Opening Inventory is not given, then Closing Inventory may be taken as Average
          Inventory.
                 Average Turnover Ratio      =         Net     Sales
                                                       Closing Stock
    Note:-       If Average Inventory at Cost is not given, then we can use the Average inventory
          at Selling Price.
                 Average Turnover Ratio      =                     Net Sales_________
                                                       Average inventory at selling price

    Note:- In case of monthly balances of stock are given, then all the monthly balances are
          added and total is divided by the number of months for which the average is calculated.
    (ii) Debtors or Receivables Turnover Ratio:
               It means the number of times average debtors (receivables) are turned over
         During a year. Thus;
    Formula: Debtors Turnover Ratio      =     _ Net Credit Sales__
                                               Average trade debtors

    * Trade Debtors = Bills Receivable + Debtors
    * Average Trade Debtors = Opening trade debtors + Closing trade debtors
                                                        2
    Note:-      Here provision for bad and doubtful debts should not be deducted.
    Note:-      If opening and closing balances of trade debtors and credit sales is not given,
          then debtors turnover ratio can be calculated by this;
                Debtors Turnover Ratio      =      Total sales
                                                    Debtors
    * Debtors means only debtors not Bills Receivable.
    (iii) Average Collection Period:
                The debtors/receivable turnover ratio, when calculated in terms of days known
         as Average Collection Period or Debtors Collection Period Ratio. This represents the
         average number of days for which a firm has to wait before its debtors are converted
         into cash.
    Formula: Average Collection Period =         _No. of Working days_
                                                  Debtors turnover ratio
    (iv) Creditors/Payable Turnover Ratio:
                It signifies the credit period enjoyed by the firm in paying creditors.
    Formula:    Creditors Turnover Ratio =          ___Credit Purchases___
                                                    Average Trade Creditors
    * Trade Creditors = Creditors + Bills Payable
    (v) Average Payment Period Ratio:
                 This represents the number of days taken by the firm to pay its credits.
    Formula:     Average Payment Period Ratio= __No. of working days__
                                                  Creditors turnover ratio
    Note:-       Total purchases may be used, when credit purchases are not given.
                                             iv

    (vi) Working Capital Turnover Ratio:
                It represents the number of times the working capital is turned over in the
            course of a year.
    Formula: Working Capital Turnover Ratio =               ___Cost of sales___
                                                             Net working capital
    * Net Working Capital = Current Assets – Current Liabilities
    Note:-      If cost of sales is not available, then sales figure can be used.
                Working Capital Turnover Ratio =            _____Sales______
                                                            Net working capital
    (vii) Fixed Assets Turnover Ratio:
                It is also known as Sales to Fixed Assets Ratio. This ratio measures the efficiency
          and profit earning capacity of the firm.
                __Cost of Sales__            OR    _________Sales_________
                 Net Fixed Assets                  Fixed Assets – Depreciation
(4) Long Term Solvency Position Ratios:
                   These ratios are also used to analyze the capital structure of the company.
    (i) Debt Equity Ratio/ External-Internal Equity Ratio:
                  It indicates the relationship between the external equities or outsiders funds
          and internal equities or shareholder’s funds.
    Formula: Debt Equity Ratio =                External equities
                                                Internal equities
                                         OR
                  Debt Equity Ratio =           _Outsider’s funds_
                                                Shareholder’s funds
    * Outsider’s funds       = Current liabilities + Long term liabilities
    * Shareholder’s funds = Equity share capital + Preference share capital + Capital reserve
                                + Accumulated profits – Accumulated losses and Deferred expenses
    (ii) Proprietary Ratio or Equity Ratio:
                It is also known as Equity Ratio or Net Worth to Total Assets Ratio. This ratio
         relates the Shareholder’s Funds to Total Assets.
    Formula: Proprietary Ratio       =      Shareholder’s Funds
                                               Total Assets
    (iii) Fixed Assets to Proprietor’s Fund Ratio:
                   This ratio establishes the relationship between fixed assets and shareholder’s
          funds.
    Formula:                                  _Fixed Assets     (after depreciation)_
                                              Proprietor’s funds / Shareholder’s funds

    (iv) Current Asset to Proprietor’s Fund Ratio:
                   This ratio establishes the relationship between current assets and shareholder’s
          funds.
    Formula:                                  _Current Assets_
                                              Proprietor’s funds
    (v) Debt Service Ratio or Interest Coverage Ratio:
                   This ratio relates the fixed interest charges to the income earned by the business
    Formula:                                     Net Profit before Interest and Tax
                                                     Fixed Interest Charges




                                                                         (M.Com. M.A Eco.)
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posted:10/15/2011
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