1. Liquidity Ratios
1 Current Ratio Formula
Significance This ratio shows short-term financial soundness of the business. Higher ratio means better capacity to meet its current obligation. The ideal current ratio is 2 : 1. In case it is very high it shows the idleness of funds. Contents Current Assets mean those assets which are either in
the form of cash or can be converted into cash within 12 months from the date of Balance Sheet or within the period of operating cycle. It includes:
Current Investments,
Inventories (Other than Loose Tools and Stores and Spares),
Trade Receivables (Sundry Debtors Net of Provision for Doubtful Debts and Bills Receivable),
Cash and Cash Equivalents and
Other Current Assets (Except Fictitious Assets such as Unamortised Discount on Issue of Shares, Unamortised Loss on Issue of Shares etc.)
Current Liabilities are those liabilities which are payable within12 months from the date of Balance Sheet or within the period of operating cycle. It includes
Short-term Borrowings, Trade Payables and Short-terms Provisions. 2. Liquidity Ratio/Acid
Test Ratio/Quick Ratio
Formula
Significance Quick ratio is a fairly stringent measure of liquidity. It is based on those current assets which are highly liquid. Quick ratio of 1 : 1 is considered as ideal. Higher the quick ratio better the short-term financial position. Contents Quick Assets = Current Assets – Inventories – Prepaid
Expenses – Fictitious Assets such as Unamortised Discount on Issue of Shares, Unamortised Loss on Issue of Shares etc.
Current Liabilities – same as in Current Ratio.
Quick Assets or Liquid Assets
Current Liabilities
II. Solvency Ratios
1. Debt-Equity Ratio Formula
Significance This ratio assesses the long-term financial position and soundness of the long-term financial policies of the firm. In general, lower the debt-equity ratio higher the degree of protection enjoyed by the lenders. Contents Long-term Debts include
Long-term Borrowings, i.e., debentures, mortgage, public deposit.
Other Long-term Liabilities and Long-term Provisions.
Shareholders’ Funds =
Equity Share Capital + Preference Share Capital + Reserves and Surplus + Money Received against Share Warrants + Deferred Tax Liabilities (Net) [or –
Deferred Tax
Assets (Net)] – Fictitious Assets. 2. Total Assets to
Debit Ratio
Formula
Significance This ratio measures the safety margin available to the suppliers of long-term debts. It measures the extent to which debt is being covered by assets.
Contents Total Assets = Non-current Assets + Current Assets – Fictitious Assets (Deferred Tax Assets (Net), Unamortised Expenses such as Unamortised Loss on Issue of Debentures).
Long-term Debts = Same as in Debt-Equity Ratio.
Debt (Long-term External Equities)
Equity (Shareholders’ Funds)
3 Proprietary Ratio Formula
Significance This ratio shows the extent to which the total assets have been financed by the proprietor. Higher the ratio, greater the satisfaction of lenders and creditors. Contents Shareholders’ Funds:
Liabilities Approach:
Share Capital + Reserves and Surplus + Money Received against Share Warrants + Share Application Money Pending Allotment + Deferred Tax Liabilities (Net) [or – Deferred Tax Assets (Net)] – Fictitious Assets.
Assets Approach:
Total Assets = All Current Assets + Non-current Assets – Deferred Tax Assets (Net) – Fictitious Assets.
4 Interest Coverage Ratio
Formula
Significance This ratio shows how many times the interest charges are covered by the profits available to pay interest charges. The higher the ratio, more secure the lender is in respect of payment of interest regularly. The ideal interest coverage ratio is 6 to 7 times.
III. Activity Ratios/Turnover Ratios 1 Stock (Inventory)
Turnover Ratio
Formula
Significance This ratio measures how fast the stock is moving through the firm and generating sales. Higher the ratio, the more efficient management of inventories and vice versa.
Contents Average Stock or Inventory =
Shareholders’ Funds or
Proprietary Funds
Total Assets
Profit beforeInterest andTax
Interest
Cost of Goods Sold
Average Stock
2. Debtors’ or Trade Receivables Turnover Ratio
Formula
Significance This ratio indicates economy and efficiency in the collection of amount due from debtors. Higher the ratio, better it is since it indicates that debts are being collected more quickly.
Contents In this ratio meaning of debtors is considered account receivable, i.e., debtors plus bills receivable. Provision for Doubtful Debts is not deducted.
3. Creditors’ or Trade Payables
Turnover Ratio
Formula
Significance It indicates the number of times the creditors are turned over in relation to purchases. A high turnover ratio or shorter payment period shows the availability of less credit or yearly payments.
Contents Average Payables =
4 Working Capital Turnover Ratio
Formula
Significance This ratio shows the number of times the working capital has been employed in the process of carrying on business. Higher the ratio, better the efficiency in the utilisation of working capital.
Contents Working Capital = Current Assets – Current Liabilities.
Net Credit Sales
Average Trade Receivables*
*Average Trade Receivables
(Opening Debtors + Opening Bills Receivables) +
(Closing Debtors + Closing Bills Receivables)
2
Net Credit Purchases
Average Trade Payables
(Opening Creditors +Opening Bills Payables) +
(Closing Creditors +Closing Bills Payables)
2
r
Net Revenue from Operations, , Sales o
Cost of Goods Sold
(Cost of Revenue from Operations) Net Working Capital
IV. Profitability ratios
1. Gross Profit Ratio Formula
Significance This ratio indicates the relationship between gross profit and net sales. Higher the Ratio, lower the cost of goods sold.
Contents Gross Profit = Net Sales – Cost of Goods Sold. 2. Operating Ratio Formula
Or
Significance This ratio is calculated to assess the operational efficiency of the business. A decline in the operating ratio, is better because it means higher margin, and thus, more profit.
Contents Cost of Goods Sold
= Net Sales (Revenue from Operations) – Gross Profit Or
Cost of Goods Sold = Cost of Materials Consumed + Purchases of Stock-in-Trade + Changes in Inventories of Finished Goods, WIP and Stock-in-Trade + Direct Expenses.
Net Revenue from Operations = Sales – Sales Return. Operating Expenses = Employees Benefit Expenses + Other Expenses (Other than Non-operating Expenses). 3. Operating Profit
Ratio
Formula
Significance The objective of computing this ratio is to determine the operational efficiency of management.
Contents Operating Profit
= Net Profit + Non-operating Expenses – Non-operating Income.
Gross Profit
100
Net Sales (Net Revenue from Operations)
Cost of Goods Sold + Operating Expenses
100
Net Sales (Net Revenue from Operations)
Cost of Materials Consumed + Purchases of Stock-in-Trade + Changes in Inventories of
,
Finished Goods WIP and Stock-in-Trade + Employees Benefit Expenses + Other Expenses (Other than Non- perating Expenseo
s)
100 Net (Revenue from Operations)
OperatingProfit
4. Net Profit Ratio Formula
Significance It indicates overall efficiency of the business. Higher the net profit ratio, better the business.
5. Return on Investment or Return on Capital Employed
Formula
Significance It assesses the overall performance of the enterprise. It measures, how efficiently the resources entrusted to the business are used.
Contents Capital Employed:
Liabilities Approach: Shareholders’ Funds + Share Application Money Pending Allotment + Non-current Liabilities (including Deferred Tax Liabilities (Net) – Deferred Tax Assets (Net)) – Fictitious Assets.
Assets Approach: Fixed Assets + Non-current Investments (Trade) + Long-term Loans and Advances + Other Non-current Assets (excluding Unamortised Expenses/Losses) + Working Capital) [i.e., Current Assets (excluding Unamortised Expenses/Losses) – Current Liabilities].
Net Profit
100
Sales (Revenue from Operations)
Interest Profit before
Tax and Dividend ×100
