CORPORATE ACCOUNTING (BBA)

Module V (Accounting Ratios)

Ratio
Ratio is the simple arithmetic expression of the relationship of one
number to another.
Ratio analysis
It is a technique of analysis and interpretation of financial statements.
Accounting Ratio
Ratio calculated in the basis of accounting information are called
accounting ratio.
Objectives / Purpose of Ratio analysis
1. To study short term solvency of a firm.
2. To study long term solvency of a firm.
3. To determine profitability of a firm.
4. To facilitate comparison.
5. To help in managerial decision making.
6. To measure the performance of a firm.
7. To communicate strength and weakness of a firm.
Advantages/ Importance/ Uses of Ratio Analysis
 Advantages to Management
a) Helps in formulating policies.
b) Helps in planning and forecasting.
c) Helps in decision making
 Advantages to shareholders
a) Helps in investors in selecting best companies for investment.
b) Helps in evaluating performance of companies.
c) Helps in calculating values of shares.
 Advantages to government
a) Helps in tax planning.
b) Helps government to study cost structure of industries.
 Advantages to Creditors
a) Helps in measuring liquidity positions.
b) Helps to know strength and weakness of companies.
 Advantages to employees
a) Demand more wages and benefits.
b) Know the financial health of companies.
Limitations of Ratio Analysis
 Inherent limitations of accounting.
 Non-monetary factors ignored.
 Qualitative factors ignored.
 Window dressing.
 Not a substitute for judgement.
 Price level changes.
 Lack of adequate standard.
 Need for comparative analysis.
Functional classification of ratios
Liquidity Solvency Activity / Profitability
Ratios /Leverage Ratios Turnover ratios ratios
Current Ratio Debt Equity ratio Inventory Gross profit
turnover ratio ratio
Quick Ratio Proprietary ratio Debtors Operating
turnover ratio ratio
Total asset to Creditors Operating
debt ratio turnover ratio profit ratio
Fixed asset Net profit
turnover ratio ratio
Working capital Expense Ratio
turnover ratio
Liquid Ratio
It refers to ability of a concern to meet its current obligations.
Current Ratio
It is the ratio of current asset to current liabilities. It shows the
relationship between total current assets and current liabilities. It is
also known as working capital ratio or banker’s ratio.
Quick Ratio
It is the ratio of quick asset to current liabilities. It is the measure of the
instant debt paying ability of a business. It is also called acid test ratio
or liquid ratio.
Difference between current ratio and quick ratio
Current Ratio Quick Ratio
It indicates whether a firm is It indicates whether a firm is
able to pay its current liabilities able to pay its current liabilities
within a year. quickly or within a month.
It expresses relationship It expresses the relationship
between current assets and between quick assets and
current liabilities. current liabilities.
Ideal standard is 2:1 Ideal standard is 1:1
Inventories are taken into Inventories is ignored in the
account I the calculation of calculation of quick ratio
current ratio.
Window Dressing
It is a practice of improving current ratio through manipulation of
accounts.
Window dressing can be done in the following ways
1. Increase in the inventory values.
2. Postponement of purchase of fixed assets for cash.
3. Selling a fixed asset for cash.
4. Paying of current liabilities.
5. Considering short term liabilities as long term.
Debt Equity Ratio
It is a type of ratio which expresses the relationship between debt and
equity. This ratio is also known as security ratio or external internal
ratio.
Total Asset to Debt Ratio
It is a type of ratio which expresses the relationship between total asset
and total liabilities of a business. It is also called solvency ratio.
Proprietary Ratio
It is a ratio which establishes the relationship between shareholders
fund and total asset. This ratio is also known as equity ratio or net
worth ratio.
Fixed Asset Ratio
It is a ratio of fixed asset to long term funds or capital employed.
Capital Gearing Ratio
It is a ratio which indicates the relationship between fixed interest
bearing securities and equity shareholders fund.
Interest Coverage Ratio
It is a ratio which establishes the relationship between operating profits
and interest charges.
Dividend coverage ratio
It is a ratio which measures the ability of a company to pay dividend or
preference shares carrying a fixed rate of dividend.
Overall coverage ratio
It measures the ability of a company to service all fixed obligations out
of its earnings.
Activity ratios
It shows how effectively a firm uses its available resources or assets.
These ratios indicate efficiency in asset management.
a) Inventory turnover Ratio
It is a type of ratio which shows the relationship between costs of
goods sold and average inventory. It is also known as stock turnover
ratio.
Stock Velocity
Stock turnover ratio expressed in time. It can also be expressed in days
or months. It is called stock velocity or stock turnover period.
b) Debtors turnover ratio
It is a ratio which explains the relationship between net credit sales and
average debtors. It is also known as receivable turnover ratio.
Average collection period
Debtor’s turnover ratio expressed in days or months. It is called average
collection period or debtors velocity.
c) Creditors turnover ratio
It shows relationship between net credit purchases and average
creditors. It is also called payable turnover ratio.
Average payment period
Creditor’s turnover ratio expressed in days or months. It is known as
average payment period or creditors velocity.
d) Working capital turnover ratio
The relation between sales and working capital is called working capital
turnover ratio.
e) Fixed asset turnover ratio
It is a ratio which establishes the relationship between net sales and
fixed assets.
Profitability Ratios
It refers to ability of a firm to earn income.
Gross profit ratio
This is the ratio of gross profit to sales expressed as percentage. It is
also known as gross margin.
Operating ratio
It is a ratio expresses the relationship between operating cost and sales.
It indicates overall efficiency in operating the business.
Operating profit ratio
It is a ratio which explains the relationship between operating profits
and net sales.
Net profit Ratio
It is a ratio of net profit earned by business and its net sales. It
measures overall profitability.
Return on investment (ROI)
ROI measure the overall profitability. It establishes the relationship
between profit and return on investment
Uses / Advantages of ROI
1. It measures overall profitability.
2. It measures success of business.
3. It helps in investment decision.
4. It is useful for planning capital structure.
5. It is a foundation of optimum utilization of assets.
6. It can be used to determine price of a product.
Market Test Ratios
Market test ratios are used for evaluating shares and stock which are
traded in the market. Market test ratios are also known as investor’s
ratios or stock market ratios or market valuation ratios.
Earnings per Share (EPS)
This ratio indicates the profits available for each equity share. It is
calculated by dividing the earnings (profits) available to equity
shareholders by the number of equity shares issued.
Dividend per Share (DPS)
It is the amount of profit distributed to equity shareholders divided by
the number of equity shares outstanding.