Accounting Ratios

Ratio Analysis: • A technique of analysing financial statements by computing mathematical relationships (ratios) between two related items • A ratio is a mathematical relationship between two quantities • In accounting, ratios express the relationship between items of Balance Sheet and/or P&L Statement Objectives of Ratio Analysis: 1. Measuring liquidity: Can the firm meet short-term obligations? 2. Measuring solvency: Can the firm meet long-term obligations? 3. Measuring profitability: How efficiently is the firm earning profits? 4. Measuring efficiency: How well is the firm managing its assets? 5. Comparison with past performance (trend analysis) 6. Comparison with other firms and industry standards 7. Helping in financial planning and forecasting Limitations of Ratio Analysis: 1. Based on historical/past data — not predictive 2. Does not account for price level changes (inflation) 3. Ignores qualitative factors (management skill, brand, staff morale) 4. Different accounting policies make comparison difficult 5. Window dressing can distort ratios 6. A single ratio is not sufficient — needs to be seen in context 7. Seasonal variations can affect ratios (computed at one point in time) 8. No standard ratio is applicable to all businesses equally

(a) Current Ratio: • Measures ability to pay current liabilities from current assets • Also called Working Capital Ratio Formula: Current Ratio = Current Assets / Current Liabilities Current Assets include: Cash, Bank, Marketable Securities, Debtors (net), Bills Receivable, Prepaid Expenses, Inventory, Advance Tax, Short-term Loans and Advances Current Liabilities include: Creditors, Bills Payable, Bank Overdraft, Outstanding Expenses, Short-term Loans, Proposed Dividend, Provision for Tax, Calls in Advance Ideal value: 2:1 • Means for every ₹1 of current liability, ₹2 of current assets are available • A very high ratio may indicate idle current assets • A very low ratio may indicate liquidity problems (b) Quick Ratio (Liquid Ratio / Acid Test Ratio): • More stringent measure of liquidity — excludes inventory and prepaid expenses (less liquid current assets) • Shows ability to meet immediate obligations Formula: Quick Ratio = Quick Assets / Current Liabilities Quick Assets = Current Assets − Inventory − Prepaid Expenses = Cash + Bank + Short-term Investments + Debtors + Bills Receivable Ideal value: 1:1 • For every ₹1 of current liability, ₹1 of liquid assets available Note: Inventory excluded because: • May not be quickly converted to cash • May be damaged, obsolete, or hard to sell quickly

(a) Debt-Equity Ratio: • Measures the relative proportion of debt and equity financing • Also called Leverage Ratio or Gearing Ratio Formula: Debt-Equity Ratio = Long-term Debt / Shareholders' Equity or = Long-term Debt / (Share Capital + Reserves and Surplus) Ideal: 2:1 (in some contexts 1:1; depends on industry) • High ratio: high financial risk for lenders; firm is highly leveraged • Low ratio: firm is conservatively financed (b) Proprietary Ratio: • Shows the proportion of total assets financed by shareholders' funds (owners) Formula: Proprietary Ratio = Shareholders' Funds / Total Assets = (Share Capital + Reserves and Surplus) / Total Assets Higher is better — indicates less dependence on external debt Ideal: 0.5:1 or above (at least 50% self-financed) (c) Debt to Total Assets Ratio: • Proportion of assets financed by debt (external borrowings) Formula: Debt to Total Assets Ratio = Total Debt / Total Assets = (Long-term + Short-term Borrowings) / Total Assets Lower is better (less dependence on debt) If = 0.4: 40% of assets financed by debt (d) Interest Coverage Ratio (Times Interest Earned): • Measures firm's ability to pay interest from operating profits Formula: Interest Coverage Ratio = Earnings Before Interest and Tax (EBIT) / Interest on Long-term Debt = Net Profit Before Interest and Tax / Interest Charges Higher is better — shows comfortable ability to service debt Ideal: At least 6-7 times • Ratio < 1 means firm cannot cover its interest from operating profit — financially distressed

(a) Inventory Turnover Ratio: • Measures how many times inventory is converted into sales in a period • Higher ratio = faster selling inventory, efficient stock management Formula: Inventory Turnover Ratio = Cost of Revenue from Operations / Average Inventory or = Net Revenue from Operations / Average Inventory (if COGS not given) Average Inventory = (Opening Inventory + Closing Inventory) / 2 Inventory Holding Period = 365 / Inventory Turnover Ratio (days) High ratio: Less investment in stock; efficient (but may risk stockouts) Low ratio: Slow moving stock; blocked capital; risk of obsolescence (b) Debtors Turnover Ratio: • Measures how efficiently the firm collects receivables from credit customers Formula: Debtors Turnover Ratio = Net Credit Revenue from Operations / Average Trade Receivables Average Trade Receivables = (Opening Debtors + Closing Debtors) / 2 Debt Collection Period = 365 / Debtors Turnover Ratio (days) High ratio/Low collection period: Efficient credit management Low ratio/High collection period: Poor credit management; funds blocked (c) Payables (Creditors) Turnover Ratio: • Measures how quickly the firm pays its creditors Formula: Payables Turnover Ratio = Net Credit Purchases / Average Trade Payables Credit Payment Period = 365 / Payables Turnover Ratio Low ratio/High payment period: Firm takes longer to pay — uses trade credit effectively (but may damage supplier relationships) (d) Working Capital Turnover Ratio: • Measures how effectively working capital is used to generate sales Formula: Working Capital Turnover Ratio = Net Revenue from Operations / Net Working Capital Net Working Capital = Current Assets − Current Liabilities Higher is better — more sales generated per rupee of working capital

(a) Gross Profit Ratio: • Measures gross profit as a percentage of revenue from operations • Indicates efficiency of production/purchasing and pricing strategy Formula: Gross Profit Ratio = (Gross Profit / Net Revenue from Operations) × 100 Gross Profit = Net Revenue from Operations − Cost of Revenue from Operations Higher is better — more money available to cover operating expenses and earn profit Useful for comparing pricing and production efficiency across periods/firms (b) Net Profit Ratio: • Measures net profit as a percentage of revenue — overall profitability Formula: Net Profit Ratio = (Net Profit After Tax / Net Revenue from Operations) × 100 Higher is better Shows how much of every ₹100 of sales becomes profit after all expenses and taxes (c) Operating Profit Ratio: • Measures operating profit as a percentage of revenue • Excludes finance costs and tax — shows core operating efficiency Formula: Operating Profit Ratio = (Operating Profit / Net Revenue from Operations) × 100 Operating Profit = Net Profit + Non-operating expenses − Non-operating income = Gross Profit − Operating Expenses = EBIT (d) Return on Investment / Return on Capital Employed (ROCE): • Measures overall efficiency of capital utilisation • Most important profitability ratio — shows how well total capital is employed Formula: ROCE = (Earnings Before Interest and Tax / Capital Employed) × 100 Capital Employed = Shareholders' Funds + Non-current Liabilities = Total Assets − Current Liabilities Higher is better — more profits generated per rupee of capital employed Compared with cost of capital; should be > cost of capital Return on Equity (ROE): ROE = (Net Profit After Tax / Shareholders' Funds) × 100 Shows returns to equity shareholders specifically

Given data: Inventory = ₹40,000 Debtors = ₹30,000 Cash = ₹10,000 Prepaid Expenses = ₹5,000 Current Assets = 40,000 + 30,000 + 10,000 + 5,000 = ₹85,000 Current Liabilities = ₹40,000 Long-term Debt = ₹80,000 Shareholders' Funds = ₹1,20,000 CGS = ₹2,40,000 Assume Average Inventory = ₹40,000 (no opening given) (a) Current Ratio: Current Ratio = Current Assets / Current Liabilities = ₹85,000 / ₹40,000 = 2.125 : 1 ≈ 2.13 : 1 Interpretation: For every ₹1 of current liability, ₹2.13 of current assets available. Above ideal of 2:1 — good liquidity. (b) Quick Ratio: Quick Assets = Current Assets − Inventory − Prepaid Expenses = 85,000 − 40,000 − 5,000 = ₹40,000 Quick Ratio = Quick Assets / Current Liabilities = ₹40,000 / ₹40,000 = 1 : 1 Interpretation: Exactly meets the ideal of 1:1 — adequate liquidity position. (c) Debt-Equity Ratio: Debt-Equity Ratio = Long-term Debt / Shareholders' Funds = ₹80,000 / ₹1,20,000 = 0.67 : 1 (or 2:3) Interpretation: For every ₹1 of equity, ₹0.67 of debt — conservatively financed. Low financial risk. (d) Inventory Turnover Ratio: Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory = ₹2,40,000 / ₹40,000 = 6 times Interpretation: Inventory converted into sales 6 times a year. Inventory Holding Period = 365 / 6 = 60.8 days ≈ 61 days