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Accounting Ratios CA Foundation Notes

Accounting Ratios – CA Foundation, CPT notes, PDF

This article is about Accounting Ratios for CA foundation CPT students. we also provide PDF file at the end.

Accounting Ratios

Accounting Ratios

What we will study in this chapter:

1 MEANING OF RATIO ANALYSIS

The quantitative analysis of the financial statements of a company is known as Ratio Analysis. It has a significant role in the process of decision making. It is used to assess the company’s operating and financial performance. The efficiency, liquidity, profitability and solvency of a company can be measured through ratio analysis.

These ratios are very helpful and effective to the internal management, prospective investors, outsiders and creditors etc.

26.2 IMPORTANCE OF RATIO ANALYSIS

  1. Effective instrument to measure efficiency:- The ratios are useful in measuring the ability of the company to manage its assets and liabilities in an effective manner.

Through the help of efficiency ratios we can compute the capability of the company in regard to the management of the assets and its operations.

  1. Helps to evaluate long term financial solvency:- The accounting ratios are used to know the liquidity position of the company to meet its short term and long term obligations. The outcomes through this analysis are useful to the outsiders in taking investment decisions.
  2. Assists management in decision making:- These accounting ratios throw light on the operational efficiency of the management and its utilization of assets. Thus, they turn out to be a useful tool for the purpose of decision making and while taking corrective action.
  3. Aids in forecasting:- It is possible to plan, forecast and control actions with the help of ratio analysis.

The information derived from the analysis is an invaluable aid to the management.

The ratios are used to formulate different policies, prepare budgets and so on.

  1. Useful tool to measure profitability:- The ability of the company to generate income (profit) during a specific period of time can be evaluated with the help of profitability ratios. These provide valuable information to the analysts and investors in regard to the company’s performance.

26.3 LIMITATIONS OF RATIO ANALYSIS

  1. Accounting policies:- Accounting transactions can be recorded in different manner by different companies following different accounting policies.

Thus, this difference makes the accounting data and ratios of any two firms incomparable.

  1. Historical costs:- The assets valuation in the balance sheet is done according to the historical costs convention. Due to this practice the ratios so calculated may give unrealistic facts.
  2. Ignorance of qualitative factors:- The calculation of ratios involves the inclusion of quantitative or monetary factors only. These completely ignore the qualitative factors while computing the ratios which may give distorted results.
  3. Window Dressing:- The presentation of financial statements in such a way that it shows a better financial position is called window dressing. Thus, if any firm resorts towards this practice, the ratios so computed from its balance sheet will never reveal the true position of the firm.
  4. No fixed standards:- It is not possible to lay down fixed standards for ideal ratios. Th us, the ratios so computed gain no significance as these cannot be compared with other ratios or standards. This turns out to be another limitation of accounting ratios.

26.4 TYPES OF RATIOS

There are two-ways in which financial ratios can be classified:-

  1. There is the classical approach or traditional approach.
  2. The other is the functional approach.

26.4.1  Traditional/Classical Approach

In this approach the ratios are classified on the basis of accounting statements to which they belong.

The approach has been further classified as follows:

  1. Statement of Profit & Loss Ratios:- When the two variables, from which the ratio has to be calculated, are extracted from the Statement of Profit and Loss, the ratio so obtained is known as Statement of Profit and Loss Ratio.
  2. Balance Sheet Ratios:- The ratio been calculated by obtaining both the variables from the balance sheet, is known as Balance Sheet ratio.
  3. Composite Ratios:- When a ratio is obtained by taking one variable from the Statement of Profit and Loss and another variable from the balance sheet, it is known as Composite ratio.

26.4.2  Functional Approach

In this approach the ratios are classified on the basis of the purpose of their computation.

It has been classified as follows

  1. Liquidity Ratios
  2. Solvency Ratios
  3. Activity (Turnover) Ratios
  4. Profitability Ratios
  5. Liquidity Ratios:- Liquidity means the ability of the business to meet its financial obligations of short term nature. Thus, the ability of the enterprise to pay the current liabilities is measured through liquidity ratios.

Liquidity Ratios include:- (a) Current Ratio

(b)   Quick Ratio (Acid test Ratio)

(c)   Cash Ratio (Absolute Liquidity Ratio)

(d)   Net Working Capital Ratio.

  1. Solvency Ratios or Leverage Ratios:- Solvency of the business means its ability to meet the long-terms debts. The solvency position and long term obligations and stability of the business are measured through solvency ratios. These Ratios include:-

(1)   Capital Structure Ratios:-

(a) Equity Ratio

(b)   Debt Equity Ratio

(c)   Debt to total assets Ratio

(d)   Capital gearing Ratio

(e)   Proprietary Ratio

(2)   Coverage Ratios:-

(a) Debt service coverage Ratio

(b)   Interest Coverage Ratio

(c)   Preference dividend coverage Ratio       ,

(d)   Fixed charges coverage Ratio

  1. Activity Ratios (Turnover Ratios):- These ratios measure how effectively the resources of the business have been used by it. In other words these ratios are calculated to measure the efficiency of operations of an enterprise along with optimum and efficient utilization of resources by it. Thus these are also known as efficiency ratios or asset management ratios.

These include:-

(a) Total assets turnover ratio

(b)   Fixed assets turnover ratio

(c)   Capital turnover ratio

(d)   Current assets turnover ratio

(e)   Working capital turnover ratio:-

(i)    Inventory turnover ratio

(ii)   Debtors turnover ratio

(iii) Creditors turnover ratio

  1. Profitability Ratios:- The efficiency of the business can be measured through its profitability. Thus profitability ratios are calculated to determine the profitability of the business or enterprise.

These can be classified as follows:-

(a) Gross Profit Ratio

(b)   Net Profit Ratio

(c)   Operating Profit Ratio

(d)   Expenses Ratio

The overall efficiency is measured with respect to sales.

Profitability Ratios related to Overall Return on Assets/Investments

(a) Return on Investments (ROI)

(b)   Return on Assets (ROA)

(c)   Return on Capital Employed (ROCE)

(d)   Return on Equity (ROE)

Profitability Ratios required for Analysis from Owner’s Point of View

(a) Earnings per Share (EPS)

(b)   Dividend per Share (DPS)

(c)   Dividend Payout (DP) Ratio

Profitability Ratios related to Market/Valuation/Investors (n) Price Earnings (P/E) Ratio

(b)   Dividend and Earning Yield

(c)   Market Value/Book Value per Share (MV/BV)

26.4.2.1 Liquidity Ratios

(a) Current Ratio:-This ratio is computed to measure the short term liquidity of the business. It measures the financial position by evaluating whether current assets in the business are sufficient to meet the current liabilities.

The ratio is calculated as follows:-

Current Ratio =

where,

Current Assets = Cash & Bank balances + Inventories *+ Sundry Debtors⊥ Bills Receivables +Current Investments + Short-terms loans and advances + Other Current assets.

Current Liabilities = Short-term Borrowings + Creditors + Bills payables + Short terms Provisions +Bank Overdrafts Outstanding Expenses + Proposed Dividend + Unclaimed Dividend⊥ Other current liabilities.

‘These exclude loose tools and stores and spares.

Ideal current ratio is 2:1.

Illustration 26.1 : You are required to calculate Current Ratio from the following information:

ParticularsRs.
Inventories1,02,000
Trade receivables1,15,000
Advance Tax3,000
Cash and cash equivalents15,000
Trade payables1,90,000
Short-term borrowings (bank overdraft)13,000

Solution :

Current Ratio =

Current Assets = Inventories + Trade receivables + Advance Tax + Cash and cash equivalents = Rs. 1,02,000 +Rs. 1,15,000 +Rs. 3,000+Rs. 15,000 = Rs. 2,35,000

Current Liabilities = Trade payables + Short-term borrowings = Rs. 1,90,000+ Rs. 13,000 =Rs. 2,03,000

Current Ratio =  = 1.16:1

(b) Quick Ratio: The ratio is computed to assess the short term solvency of the business. It evaluates whether liquid assets in the business are enough to meet the current liabilities.

Ideal quick ratio is 1:1.

The ratio is calculated as follows:-

Quick Ratio =

where,

Quick. Assets = Current assets – Inventories – Prepaid expenses

It considers those current assets that are either in the form of Cash & Bank or are easily and readily convertible into cash & bank balance.

Illustration 26.2 :

Rs.Rs.
Current Liabilities2,00,000Advance Tax20,000
Current Assets2,80,000Prepaid Expenses20,000
Inventories20,000

You are required to calculate “Liquidity Ratio” from the above information:

Solution ;

Liquidity Ratio =

Liquid Assets   = Current assets-(Inventories + Prepaid expenses + Advance tax)

= Rs.2,80,000 – (Rs. 20,000 +Rs. 20,000+ Rs. 20,000)

= Rs. 2,00,000

Liquidity Ratio =  = 1:1

(c) Cash Ratio or Absolute Liquidity Ratio: The ratio measures the ability of the firm to pay its current liabilities with the help of cash and cash equivalents available with the firm.

The ratio is calculated as follows:-

Cash Ratio =

Illustration 26.3 :

ParticularsRs.
Cash8,00,000
Cash Equivalents4,00,000
Accounts Payable4,00,000
Accounts Receivables20,00,000
Current Taxes Payable2,00,000
Long term liabilities10,00,000

You are required to calculate the Cash Ratio

Solution :

Cash Ratio =

Cash Ratio =  =  = 2:1

(d) Net Working Capital Ratio: Net working capital ratio is obtained by subtracting the amount of current liabiliti (excluding short-term bank borrowings) from the amount of current assets of the company. The ratio reveals wheth the business is capable to stay in operation in the short-run.

It is computed as follows:-

Net Working Capital Ratio = Current assets – Current liabilities (excluding short-term bank borrowings)

Illustration 26.4 ;

Current Ratio              3 : 2

Current Assets            2,13,000

You are required to calculate Net Working Capital Ratio.

Solution :

Net Working Capital Ratio = Current Assets – Current Liabilities

= Rs. 2,13,000 – Rs. 1,42,000 = Rs. 71,000

W.N.-

Current Ratio =  =  = 3:2

Current Liabilities = 2,13,000 ×  = 1,42,000

26.4.2.2 Long-Term Solvency Ratios

  1. Capital Structure Ratios:-

(a) Equity Ratio:- The ratio is computed to measure the portion of owner’s funds or capital over the total investment in the business.

It is calculated as follows:-

Equity Ratio =

where,

Shareholders’ Equity = Share capital + Reserve and surplus + Retained earnings

Capital Employed = Total assets -Current liabilities

or

Fixed assets + Working capital

A high equity ratio indicates lower degree of risk.

Illustration 26.5:

Rs.
Share Capital10,00,000
Reserves3,00,000
Surplus(1,00,000)
Current assets5,50,000
Non-current assets3,70,000
Trade payables20,000

You are required to compute Equity Ratio

Solution :

Equity Ratio =  =  = 1.33 : 1

W.N.-

Shareholders Funds =Share Capital + Reserve – Losses carried forward

= Rs. 10,00,000 + Rs. 3,00,000 – Rs. 1,00,000 = Rs. 12,00,000

Capital Employed = Current Assets + Non Current Assets – Trade Payables

= Rs. 5,50,000 + Rs. 3,70,000 – Rs. 20,000 = Rs. 9,00,000

(b) Debt to Equity Ratio:-This ratio indicates the relation of long-term debts with shareholder’s equity. Ideal debt to equity ratio is 2:1.

A high ratio indicates risk involved in the case of financial position and a low ratio indicates safer position. The ratio is considered useful while taking capital structure decisions.

It is calculated as follows:-

Debt to Equity Ratio =

Illustration 26.6:

            Rs.
Share Capital1,50,000
Reserves and surplus(25,000)
Long term liabilities1,80,500
Current liabilities20,500
Fixed assets2,26,000
Non- current investments28,000
Current Assets1,76,000

You are required to compute Debt to Equity Ratio from the above information.

Solution :

Debt Equity Ratio        =

Debt Equity Ratio        =  = 1.44 : 1

W.K.-

Total Debt = Long term liabilities

= Rs.1,80,500

Shareholder’s Equity = Share Capital + Reserves and Surplus

= Rs.1,50,000 – Rs.25,000

= Rs.1,25,000

(c) Debt to Total Assets Ratio:- This ratio measures the percentage of total assets that are financed by creditors, liabilities and debt.

This ratio is a measure of the financial leverage.

It is calculated by dividing the amount of debt by the total assets

Debt to Total Assets Ratio =

Total Debt here includes short-term and long-term borrowings (from banks and financial institutions) & provisions, debentures/bonds & public deposits etc.

Total assets include Non Current and Current Assets. Fictitious assets are not a part of total assets.

Higher ratio reflects risk in investment in the company.

Illustration 26.7: From illustration 6, compute Debt to Total Assets Ratio.

Solution:

Debt to Total Assets Ratio =  =  = 0.42:1

(d) Capital Gearing Ratio:- Capital gearing ratio is used to examine the capital structure of the company.

The ratio is calculated by dividing common stakeholders’ equity funds by funds provided by those who receive a fixed payment of interest or dividend.

It is computed as follows:-

Capital Gearing Ratio =

Illustration 26.8:

Rs.
Shareholders’ equity10,00,000
Preference shareholders6,00,000
10% debentures8,00,000
Loan from bank7,00,000
Reserves5,00,000

You are required to compute the Capital Gearing Ratio.

Solution :

Capital Gearing Ratio =

=  =  =  = 7:5 (highly geared)

(e) Proprietary Ratio:- The ratio shows the portion of total assets financed by proprietor’s funds. It is calculated as follows:-

Proprietary Ratio =

where,

Proprietary fund includes, share capital (Equity or preference) and reserves and surplus of the company. It indicates the financial strength of the company by measuring the extent to which proprietors’ funds are invested in the total assets.

  1. Coverage Ratios:-

(a) Debt Service Coverage Ratio:- This ratio is a measure of the firm’s ability to pay off its current debt obligations. It is computed as follows:-

Debt Service Coverage Ratio =

Here, earnings available for debt services = Net Profit (after tax) + Non cash operating expenses like depreciation and amortization + Interest +Other adjustments.

(b) Interest Coverage Ratio:-This ratio is used to assess the firm’s ability to meet the interest obligations on outstanding debt.

The ratio is calculated as follows:-

Interest Coverage Ratio =

A high interest coverage ratio is considered good as it indicates a better financial position of the company in meeting its interest obligations. A low interest coverage ratio indicates inefficiency in operations. It is also called ‘times interest earned’.

Illustration 26.9 :

You are required to calculate:

  1. Interest coverage ratio and
  2. Debt Service Coverage Ratio with the help of following details:

Net Profit after tax       = Rs.50,000

15% Long-term debt   = Rs.20,00,000 (Principal       amount            is repayable in 20 equal instalments)

Tax rate                       = 60%

Solution :

(i) Interest Coverage Ratio =  =  = 1.42 times

(ii) Debt Service Coverage Ratio =  =

=  = 1.06 times

Working Notes :

  1. Net Profit before tax = × 100 =  × 100 = Rs. 1,25,000
  2. Interest on Long-term Debt = 15% of Rs.20,00,000 = Rs.3,00,000
  3. Net profit before interest and tax = Net profit before tax + Interest

= Rs.1,25,000+Rs.3,00,000

= Rs.4,25,000

(c) Preference Dividend Coverage Ratio: This ratio measures the firm’s ability to pay off the required dividend on its preference shares.

It will be calculated as follows:-

Preference Dividend Coverage Ratio =

A low coverage ratio indicates poor financial health of the company meaning it has fewer funds to make the dividend payment and vice versa.

(d) Fixed Charges Coverage Ratio:- This ratio measures the firm’s ability to pay off its fixed charge obligations. It indicates how many times can a company pay the fixed expenses out of its earnings before interest and taxes.

It is calculated as follows :-

Fixed Charges Coverage Ratio =

(e) Equity dividend coverage Ratio:- This ratio measures the number of times a firm can pay off the required dividend on its equity shares.

It will be calculated as follows:-

Equity dividend coverage Ratio =

Illustration 26.10 :

Rs.
Earnings before interest and taxes90,000
Lease payments46,000
Interest26,000

Solution :

Fixed Charges Coverage Ratio =

=  =  = 1.889:1

(safe; as it is more than 1)

26.4.2.3 Activity Ratios

  1. Total Assets Turnover Ratio:- This ratio measures the value of a company’s sales or revenue in relation to the value of its assets. It is an indicator of the efficiency of the company as to how the company deploys its assets to earn revenue.

It is calculated as follows:-

Total Assets Turnover Ratio =

  1. Fixed Assets Turnover Ratio:- This ratio indicates the efficiency with which the company uses its fixed assets in generating revenue. A higher fixed asset turnover ratio is better as it reflects efficient utilization of fixed assets in generating sales.

It is calculated as follows :-

Fixed Assets Turnover Ratio =

  1. Capital Turnover Ratio:- The ratio is also known as Net Assets Turnover ratio. It measures the ability of the business to use its net asset to generate sales.

It is calculated as follows:-

Capital Turnover Ratio =

Net assets here means, Net Fixed Assets and Net Current Assets [Assets-Liabilities]

  1. Current Assets Turnover Ratio:

This activity ratio measures the ability of the business to generate revenue from operations/sales through the efficient use of its current assets.

It is calculated as follows:-

Current Assets Turnover Ratio =

  1. Working Capital Turnover Ratio:

The ratio is calculated to measure the efficiency of the business in using its working capital. It can be computed as follows:-

Working Capital Turnover Ratio —

It is further divided into:-

(i) Inventory Turnover Ratio

(ii) Debtors Turnover Ratio

(iii) Creditors Turnover Ratio

(i) Inventory Turnover Ratio or Stock Turnover Ratio:- This ratio shows the relationship between the cost of revenue from operations during the year and average inventory held during the year. The ratio indicates the number of times the inventory has been used and sold by the company. It measures how efficient is the company in managing the levels of inventory. A high ratio is considered favourable.

It is calculated as follows:-

Inventory Turnover Ratio or Stock Turnover Ratio =

Average inventory =

In case the stock of raw materials is given, the formula will be

=

(ii) Debtors Turnover Ratio or Trade Receivables Turnover Ratio:- The ratio establishes relationship between Net Credit Sales and Average accounts receivable of the company. Account receivables here refer to the total amount of the average debtors and average bills receivable of the company. The ratio measures how efficient is the company in managing the collection from the accounts receivable.

It is computed as follows:-

Debtors Turnover Ratio =Trade Receivables or Debtors velocity = or Average daily credit sales*

(iii) Creditors Turnover Ratio or Trade Payables Turnover Ratio This ratio shows the relationship between Net Credit purchases and average accounts payable. Average account payables here refer to the total amount of average creditors and average bills payable of the company. This ratio measures the efficiency of the company in managing and making payments to the account payable.

It is computed as follows:-

Creditors Turnover Ratio =Trade Payables or Creditors velocity =or Average daily credit purchase*

Illustration 26.11 :

ParticularsAmount (Rs.)ParticularsAmount (Rs.)
Preference share capital8,50,000Land & Building11,00,000
Equity share capital10,00,000Plant & Machinery15,00,000
General reserve2,65,000Furniture50,000
Statement of Profit and Loss (bal.)6,90,000Motor Car2,50,000
1596 debentures3,50,000Inventory3,75,000
1496 Loan5,50,000Debtors1,90,000
Creditors4,00,000Cash and Bank3,45,000
Outstanding expenses20,000

You are required to calculate :

(i) Net assets turnover ratio,

(ii) Fixed assets turnover ratio, and

(iii)   Working capital turnover ratio,

(iv)  Current Assets turnover ratio,

(v)   Total Assets turnover ratio with the help of above information. Revenue from operations for the year were Rs.60,00,000.

Solution :

(i) Net Assets Turnover Ratio =  1.51 times

(ii) Fixed Assets Turnover Ratio = 1.93 times

(iii) Working Capital Turnover Ratio= 11.43 times

(iv) Current Assets Turnover Ratio = 6.15 times

(v) Total Assets Turnover Ratio = 1.47 times = 1.5 times

Working Notes :

Revenue from Operations — Rs. 56,00,000

(i) Capital Employed

(or Net Assets) = Share Capital + Reserves and Surplus + Long-term debts

= Rs. 10,00,000 + Rs. 8,50,000 + Rs. 2,65,000+ Rs. 6,90,000+ Rs. 3,50,000 + Rs. 5,50,000

= Rs. 37,05,000.

(ii)   Fixed Assets = Rs.15,00,000 + Rs. 11,00,000 + Rs. 2,50,000 + Rs. 50,000 = Rs. 29,00,000

(iii)   Working Capital = Current Assets – Current Liabilities

= (3,75,000 + 1,90,000 + 3,45,000) – (4,00,000 + 20,000)

= Rs. 9,10,000 – Rs. 4,20,000 = Rs. 4,90,000

Illustration 26.12: From the following information, calculate inventory turnover ratio:

ParticularsRs.ParticularsRs.
Inventory in the beginning58,000Inventory at the end70,000
Net purchases2,14,000Revenue from operations3,16,000
Wages39,000Carriage inwards15,000

Solution :

Inventory Turnover Ratio = 4 Times

Working Notes:

  1. Cost of Revenue from Operations = Inventory in the beginning + Net Purchases + Wages + Carriage inwards –

Inventory at the end

= Rs. 58,000 + Rs. 2,14,000 + Rs. 39,000 + Rs. 15,000 – Rs. 70,000

= Rs.2,56,000

  1. Average inventory = (Inventory in the beginning + inventory at the end)/2 = Rs.64,000

Illustration 26.13 : You are required to calculate inventory turnover ratio from the following information:

Rs.
Revenue from operations=9,00,000
Average inventory=90,000
Gross Profit Ratio=10%
Solution :

Inventory Turnover Ratio=  9 Times

Working note:-

  1. Gross Profit = 10% of Rs.9,00,000 = Rs.90,000
  2. Cost of Revenue from operations= Revenue from operations – Gross Profit

= Rs.9,00,000 – Rs.90,000 = Rs. 8,10,000

Illustration 26.14: Calculate the Trade receivables turnover ratio from the following information:

Rs.
Total Revenue from operations5,00,000
Cash Revenue from operations25% of Total Revenue from operations
Trade receivables as at 1.4.201650,000
Trade receivables as at 31.3.20171,00,000

Solution :

Trade receivables Turnover Ratio =  5 times

Working notes :

  1. Credit Revenue from operations = Total revenue from operations – Cash revenue from operations

Cash revenue from operations = 25% of Rs.5,00,000 = 1,25,000

Credit Revenue from operations = Rs.5,00,000 – Rs.1,25,000 = Rs.3,75,000

  1. Average Trade Receivables = Rs.75,000

Illustration 26.15: From the data given in illustration no. 14, find out the average collection period.

Solution :

Average daily credit sales =  Rs. 1041.67

Average Collection Period =  72 days

Therefore, on an average debtors take 72 days to pay.

Illustration 26.16: With the help of following figures you are required to calculate the Trade payables turnover ratio and average payment period:

Rs.
Credit purchases during 2017-18=25,00,000
Creditors on 1.4.2017=4,50,000
Bills Payables on 1.4.2017=2,50,000
Creditors on 31.3.2018=2,00,000
Bills Payables on 31.3.2018=1,00,000

Solution :

Trade Payable Turnover Ratio = Average Trade Payables

=   Rs.5,00,000

Trade Payable Turnover Ratio =  = 5 times

Average payment period =   =72 days

26.4.2.4 Profitability Ratios

  1. Profitability Ratios based on Sales:-

(a) Gross Profit Ratio:-This profitability ratio shows the relationship between gross profit and the revenue from the operations or Net Sales. It is an indicator of the operational efficiency of the business.

It is calculated as follows:-

Gross Profit Ratio =  × 100

A high Gross Profit ratio is considered better.

Illustration 26.17: Following information is available for the year 2017-18, calculate gross profit ratio:

ParticularsRs.ParticularsRs.
Revenue from Operations:Salaries32,000
Cash43,000Decrease in inventory58,000
Credit1,67,000Return Outwards4,000
Purchases:
Cash50,000Wages25,000
Credit2,00,000
Carriage Inwards11,000

Solution :

Gross Profit Ratio =  × 100 =  × 100 = 33.33%

Working notes:-

  1. Revenue from operations — Cash Revenue from Operations + Credit Revenue from Operation

= Rs.43,000 + Rs.1,67,000 = Rs.2,10,000

  1. Net Purchases = Cash Purchases + Credit Purchases – Return Outwards

= Rs.50,000 + Rs.2,00,000 – Rs.4,000 = Rs.2,46,000

  1. Cost of Revenue from Operation

= Purchases + (opening Inventory – Closing Inventory) +

Direct Expenses (Wages + Carriage Inwards)

= Rs.2,46,000 + Rs. 58,000 + (Rs. 25,000 + Rs. 11,000) = Rs.3,40,000

  1. Gross Profit = Revenue from Operations – Cost of Revenue from Operation

= Rs.4,10,000 – Rs.3,40,000 = Rs.70,000

(b) Net Profit Ratio:- This profitability ratio shows the relationship between net profit and the revenue from operations or Net Sales. It is an indicator of the profitability of the business.

It is calculated as follows:-

Net Profit Ratio =  × 100

Or

=  × 100

A high Net Profit ratio is considered favorable.

Illustration 26.18: Gross profit ratio of X Ltd. was 20%. Its credit revenue from operations was Rs.25,50,000 and its cash revenue from operations was 15% of the total revenue from operations.

You are required to calculate its net profit ratio if the indirect expenses of the X Ltd. were Rs.37,000.

Solution :

Cash Revenue from Operations =  × 15 = Rs.4,50,000

Hence, total Revenue from Operations are = Rs. 30,00,000

Gross profit = 0.20 × 30,00,000 = Rs.6,00,000

Net profit = Rs. 6,00,000 – 37,000 = Rs.5,63,000

Net profit ratio =  × 100

=  × 100 = 18.77%

(c) Operating Profit Ratio:- This profitability ratio establishes relationship between the operating profit and the net sales. It measures the efficiency of the business as a controller of costs involved in the business operations.

It is calculated as follows:-

Operating Profit Ratio =  × 100

where,

Operating Profit = Sales – Cost of Goods sold – Operating Expenses.

Illustration 26.19: You are required to calculate (i) Gross profit ratio (ii) Operating profit ratio with the help of following information.

Rs.
Revenue from Operations6,40,000
Cost of Revenue from Operations2,00,000
Selling Expenses98,000
Administrative Expenses75,000

Solution :

(i) Gross Profit Ratio =  × 100 =  × 100 = 68.75%

(ii) Operating profit ratio =  × 100 =  × 100 = 41.72%

Working notes :

  1. Gross profit = Revenue from Operations – Cost of Revenue from Operations

= Rs.6,40,000 – Rs. 2,00,000 = Rs.4,40,000

  1. Operating Cost = Cost of Revenue from Operations + Selling Expenses + Administrative Expenses

= Rs. 2,00,000 + Rs.98,000 + Rs.75,000= Rs. 3,73,000

  1. Operating profit = Sales – Operating cost

= Rs. 6,40,000 – Rs. 3,73,000 = Rs. 2,67,000

(d) Expenses Ratio:- Expenses ratio is based on different concepts of expenses. The different variants of the ratio are expressed below:-

(i) Cost of Goods Sold (COGS) Ratio =  × 100

(ii) Operating Ratio =  × 100

(iii) Financial Expenses Ratio =  × 100

*It excludes taxes, loss due to theft, goods destroyed by fire etc.

Administration Expenses ratio, Selling & Distribution Expenses Ratio also can be calculated in similar manner.

Illustration 26.20: You are required to calculate (i) Cost of goods sold ratio (ii) Operating ratio with the help of following information.

Rs.
Revenue from Operations      •32,00,000
Opening stock4,00,000
Closing stock5,20,000
Selling Expenses50,000
Purchases18,00,000
Wages3,80,000
Carriage inwards1,00,000
Administration Expenses92,000

Solution :

(i) Cost of goods sold ratio =  – × 100 =  × 100 = 67.5%

(ii) Operating ratio =  -× 100 =  × 100 = 72% (approx)

Working notes:

1,         COGS = Opening stock + purchases + wages+ carriage inward – closing stock

= Rs. 4,00,000 + Rs. 18,00,000 + Rs. 3,80,000 + Rs. 1,00,000 – Rs. 5,20,000 = Rs. 21,60,000

  1. Operating Cost — Cost of goods sold + Operating exp. (Selling Expenses + Administrative Exp.)

= Rs. 21,60,000 + Rs. 50,000 +Rs. 92,000= Rs. 23,02,000

  1. Profitability Ratios based on Overall Return on Investments

(a) Return on Investment (ROI): This ratio calculates the percentage of return on owners’ funds being invested in the business. It measures the profitability of the owners’ efforts put into the business.

It indicates the profit or returns earned in relation to the investment of the company. It is calculated as follows:-

Return on investment = Profitability Ratio × Investment Turnover ratio

Or

= Profitability Ratio × 100

Here, Profitability Ratio =  and

Investment Turnover ratio =

(b) Return on Assets (ROA): This ratio establishes the relationship between net profits & the assets utilized to earn that profit. Thus, this ratio measures the profitability of the business in relation to the assets employed by the business.

The ratio can be computed as follows

Return on Assets =

(c) Return on Capital Employed (ROCE): This profitability ratio measures the efficiency with which the company generates profits from its capital employed.

It takes into account earnings before interest and tax (EBIT) and capital employed, i,e„ the total assets less current liabilities, of the company.

Thus, the calculation can be done through the formula:-

Return on Capital Employed =  × 100

(d) Return on Equity (ROE): This ratio reveals how well the shareholder’s funds have been utilized to generate profit. It establishes the relationship between net annual income and shareholder’s equity.

It indicates the profitability of the firm in relation to the equity funds invested in the firm.

It is computed as follows:-

Return on Equity =  × 100

A high return on equity ratio is considered profitable.

Illustration 26.21:

ParticularsRs.
EBIT12,00,000
Interest3,00,000
Taxes paid2,25,000
Preference dividend60,000
Current assets6,50,000
Fixed assets13,50,000
Current liabilities1,50,000

You are required to calculate (i) Return on Assets and (ii) Return on capital Employed.

Solution :

Return on Assets =

=  × 100 = 45%

ROCE (Post-tax) =  × 100

=  × 100 = 48.65%

Working Notes:

  1. Total Assets = Current Assets + Fixed Assets

= Rs.6,50,000 + Rs.13,50,000 = Rs.20,00,000

  1. Capital Employed = Total Assets – Current Liabilities

= Rs.20,00,000 – Rs. 1,50,000 = Rs. 18,50,000

  1. Computation of Tax rate:

EBT     = EBIT – Interest

= Rs. 12,00,000 – Rs.3,00,000 = Rs. 9,00,000

So, Tax Rate =  × 100 = Rs.2,25,000/9,00,000 × 100

t = 25%

Illustration 26.22: Following information is given to you:-

ParticularsRs.
Fixed Assets7,50,000
Current Assets4,00,000
Current Liabilities3,00,000
Revenue from Operations14,50,000
Tax Rate3596
Interest Expenses55,000
10% Preference Share Capital8,50,000
Equity shareholders’ Funds12,00,000

Total Assets in the beginning were Rs.13,00,000

(a)   Calculate Return on Assets

(b)   Calculate Return on Capital Employed

(c)   Calculate Return on Equity

Solution :

(a) Return on Assets   =  × 100

Return on Assets =  × 100 = 74.029

(b) Return on Capital Employed =  × 100

=  × 100 = 170.59%

(c) Return on Equity    =  × 100

=  × 100 = 68.4896

Working Notes: –

Rs.
1.EBIT14,50,000
Less: Interest(55,000)
EBT13,95,000
Less: Tax (30%)(4,88,250)
EAT9,06,750
  1. Average Total Assets = = = Rs.12,25,000
  2. Profitability Ratios from Owner’s Point of View:-

(n) Earnings per Share (EPS): Earnings per share refer to the part of profit that is distributed to each outstanding share of ordinary stock. It indicates the profitability of the company.

It is computed as follows:-

Earnings per Share =

(b) Dividend per Share (DPS): This ratio reflects how much is retained by the business and how much profit is distributed as dividend.

It indicates the profitability of the firm per share.

The ratio is computed as follows:-

Dividend per Share =

(c) Dividend Payout Ratio (DP): The dividend payout ratio establishes the relationship between the amount of dividend distributed to the stockholders and the total net income of the company.

It is calculated to know the amount of earnings (not paid as dividends) retained by the management for the growth of the business.

It is computed as follows:-

Dividend Payout Ratio =

  1. Profitability Ratios related to Investors/Valuation/Market:-

(a) Price-Earnings Ratio: The price earnings ratio establishes the relationship between earnings and company’s stock market price. The expectations of the investors regarding the earnings of the company are indicated through the ratio.

The ratio is used in the valuation of companies which gives investors a better sense.

It is computed as follows:-

Price-Earnings Ratio=

It is helpful in measuring the growth prospective of an investment, risk involved, level of liquidity and corporate image.

(b) Dividend and Earning Yield:- 1. Dividend Yield:-

It measures the amount a company pays out as dividends every year in relation to its share price.

Dividend yield ratio indicates the true return on investment in which the share capital of the company is considered at its market value [MV].

It is expressed as a percentage (%i) and is also known as dividend price ratio.

It is computed as follows:-

Dividend Yield =  × 100

  1. Earning Yield:- It is the reciprocal of the price earnings ratio and is expressed as a percentage.

Earning Yield ratio or Earning Price Ratio establishes relationship between the earnings per share and the market price of each share. It measures the expected return of a company’s stock. It is calculated as follows:-

Earning Yield =  × 100

(c) Market Value/Book Value per Share:- This ratio is used to assess the current share price of the company’s stock held by the public.

The ratio is employed by the current and the potential investors to evaluate the company’s performance and know whether it’s share are underpriced or over-priced.

It is computed as follows:-

Market Value / Book Value per Share            =

Illustration 26.23:

Rs.
Operating Profit (EBIT)30,00,000
Tax rate50%
Equity Share Capital (FV=Rs. 1O)40,00,000
10% Preference Share Capital25,00,000
15% Debentures15,00,000
PE Ratio15
Retained Earnings Ratio6096
Find Out:

(a) Earnings per share (h) Market Price Per Share

(c)   Dividend Per Share

(d)   Dividend Payout Ratio

(e)   Earnings Yield

Solution :

Rs.
EBIT30,00,000
Less: Interest (Deb.)(2,25,000)
EBT27,75,000
Less: Tax (50%)(13,87,500)
EAT13,87,500
Less: Pref. Dividend(2,50,000)
Earnings for Equity Shareholders11,37,500
Less : Retained Earnings(60%)(6,82,500)
Dividend Paid4,55,000

(a) EPS =  =  = Rs. 2.84

(b) Market Price = PE Ratio × EPS = Rs.15 × 2.84 = Rs.42.6

(c) Dividend Per Share =  =  = 1.1375

(d) Dividend Payout Ratio =  × 100 =  × 100 = 40%

(e) Dividend Yield =  × 100 =  × 100 = 2.67%

(f) Earnings Yield =  × 100 =  × 100 = 6.67%

*This article contains all topics about Accounting Ratios.

For notes on all CA foundation topics, you can visit this article CA foundation note

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