Accounting ratios or ratio analysis in accounting these terms are quite often used interchangeably. These accounting ratios are indicators of certain data or activity in a business. Accounting ratios are the most common indicators of profitability, liquidity, and financial position of a business. Using accounting ratios, the management can easily identify if there is a problem in a specific domain of business.
Ratio analysis in accounting is used to evaluate the relationship among financial statement items. The ratios are used to identify trends over time for one organisation or to compare two or more organisations at a specific period of time.
Did you know?
The word accountant in the English language is derived from the Old French word “compter”, which means “to count”.
Objectives of Accounting Ratios or Ratio Analysis in Accounting
- One of the major objectives of using accounting ratios is to assess the efficiency of the business.
- Ratio analysis indicates factual efficiency.
- It helps to manage the activities inside a business based on ratio analysis results. It provides an indication of operational efficiency.
- Accounting ratios also work as a measurement of profitability
- It helps to compare the performance with the standard by facilitating comparative analysis
- It helps in simplifying the financial figures and accounting figures
- It helps to understand the numbers better to make a better decision while preparing budgets and forecasts for the company or the business
Types of Accounting Ratios
- Profitability ratio
- Activity ratio
- Liquidity ratio
- Solvency ratio/ debt ratio or leverage ratio
There are about 5 types of profitability ratios
- Gross profit ratio
- Net profit ratio
- Operating ratio
- Operating profit ratio
- Return on investment
Below each of these accounting ratios is their respective formulas.
(i) Gross Profit Ratio:
Gross Profit = Revenue from operations Closing Stock – (Opening Stock Purchases Direct
Expenses) = Revenue from operations – Cost of Goods Sold.
Gross Profit Ratio = Gross Profit/Revenue from operations or Net Sales × 100
(ii) Net Profit Ratio:
Net Profit = Gross Profit Operating and Non-Operating Income – Operating and Non-Operating Expenses
Operating income: Income earned in the ordinary course of the business from trading activities is Gross Profit.
Non-operating income: It includes income from non-trading operations, such as refund tax, dividend received, gain on sale of assets, compensation received, etc.
Operating expenses: It includes the selling, administrative and distribution expenses incurred.
Non-operating expenses: These expenses include financial expenses such as interest on debt, dividend, depreciation loss on sale of an asset, abnormal losses such as loss by fire, discount or loss on issue of shares and debentures, goodwill and preliminary expenses written off, reserves, dividend and interest paid, etc.
Net Profit Ratio = Net Profit / Revenue from operations x 100
(iii) Operating Profit Ratio:
Operating Profit = Net Profit (Before Tax) – Non-Operating Expenses – Non-Operating Income
(iv) Operating ratio: The operating ratio indicates the ratio of operational cost to revenue from operations.
Operating Ratio = Operating Cost / Revenue from operations X 100
Operating cost = Cost of Revenue from operations Operating Expenses.
(v) Return on Investment (ROI)
It is for the measure of overall profitability. It indicates the relationship of net profit with capital employed in the business. This means the income (output) compared to the capital employed (input), indicating the return on investment. This ratio is also known as the overall profitability ratio or return on capital employed. It shows how much the company is earning on its investment.
Capital Employed = Equity Share Capital Preference Share Capital Reserve Accumulated profit Long-term Loans.
Capital Employed = Non-current Assets Working Capital
Working Capital = Current Assets – Current Liabilities
ROI= Net Profit Before Tax and Interest / Capital Employed × 100
Turnover or Activity Ratios
Turnover means sales, so turnover ratios are related to sales. It is an accepted contact that has a direct relationship with the performance of the business. Higher sales mean better performance, which means efficiency and productivity of the business.
- Working Capital Turnover Ratio:
The ratio measures the relationship between working capital and Revenue from operations. Working capital, as usual, is the excess of current assets and current liabilities.
W.C.TR. = Revenue from operations / Working Capital
(ii) Stock or Inventory Turnover Ratio
= Cost of Goods Sold / average stock
Cost of Goods Sold = Opening Stock Purchases Direct Expenses - Closing Stock
Cost of Revenue from operations = Revenue from operations - Gross Profit
Average Stock = Opening Stock Closing Stock / 2
Stock Velocity = Days in a year / Stock or Inventory Turnover Ratio
(iii) Debtor or Receivables Turnover Ratio:
It establishes a relationship between credit revenue from operations and average debtors.
Debtor Turnover Ratio = Net Credit revenue from operations / Average Trade Receivables
Average Collection period = Days in a year / Debtors or Receivables Turnover Ratio
Average Trade Receivables = Opening Trade Receivables Closing Trade Receivables / 2
(iv) Creditors or Payables Turnover Ratio:
The ratio explains the velocity with which creditors are paid and establishes a relationship between creditors and the amount paid to them.
Creditors Turnover Ratio = Net Credit Purchase / Accounts Trade Payables
Average Payment Period = Days in a year / Creditors or Payables Turnover Ratio
Liquidity ratios are calculated to measure the short-term financial soundness of the business. The ratio assesses the capacity of the company to repay its short-term liabilities. Banks and other finances for a short period are interested in the company's current assets.
- Current Ratio
The ratio indicates the short-term financial soundness of the company. It judges whether current assets are sufficient to meet the current liabilities.
Current Ratio = Current Assets / Current Liabilities
(ii) Liquid or Quick Ratio:
This ratio is also known as the acid test or quick assets ratio. Liquid assets mean those which are intermediaries converted into cash without much loss. All current assets except inventories and prepaid expenses are categorised as liquid assets. This ratio can be computed as: -
Liquid Ratio = Liquid Assets / Current Liabilities
Liquid or Quick Assets Current Asset - (Stock Prepaid Expenses)
Solvency Ratios, Debt Ratios or Leverage Ratios
Solvency means the ability of the business to repay its outside liabilities.
- Debt Equity Ratio:
This ratio is calculated to judge the long-term financial policy of the business. The ratio establishes a relationship between long-term loans and shareholder funds.
Long-term Loan = Debentures Loans from specialised financial institutions, Banks and Corporations Public Deposits Loans and Mortgages Term Loans Secured Loans.
Long-term Loans = Total Debt - Current Liabilities
Shareholder's Funds = Equity share capital Preference share capital Capital Reserve Securities Premium General Reserve and Balance in Statement of Profit & Loss.
Debt. Equity Ratios
Debt. / Equity or Long-term Debts / Shareholder's Funds or Net Worth
- Total Assets to Debt Ratio
The ratio shows the relationship between total Assets and long term debts.
Total Assets = Non-Current Assets Current Assets
Debt = Long Term Borrowings Long Term Provisions
Total Assets to Debt. Ratio = Total Assets / Debt.
Total Assets / Long term Debts.
- Proprietary Ratios:
This ratio indicates the relationship between the proprietor's fund and total assets. The proprietor's funds include equity share capital, preference share capital, capital reserve and accumulated surplus. Total Assets include fixed current and fictitious assets.
proprietary Ratio = Equity or Shareholder's Funds or proprietary funds / Total Assets Non -Current Assets Current Assets
- Interest Coverage Ratio:
This ratio shows how often the interest charges are covered by the profits available to pay interest charges.
Interest Coverage Ratio = Profit before charging interest and Tax / Fixed Interest Charges.
Accounting ratios are very helpful for financial professionals trying to make good economic decisions. It helps to derive meaningful information from a big chunk of data so that the decision-maker is only concerned with the key insights or financial areas that help with the decision-making directly. Accounting ratios are widely popular even though they don't have a standard framework. Accounting ratios are a good tool to analyse a company or a business's position and help show the bigger picture.
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