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Ratio: Analysis
Ratio: Analysis
ANALYSIS
MEANING OF RATIO
AND ACCOUNTING
RATIO
• ‘Ratio’ is an arithmetical expression of relationship
between two interdependent or related items.
• “The term accounting ratio is used to describe the
significant relationship which exist between figures
shown in Balance Sheet, in a Statement of Profit
and Loss, in a budgetary control system or in any
part of the accounting organization”.
EXPRESSION OF RATIOS'
Accounting ratio can be expressed in any of the following terms:
1. Pure: It is expressed as a quotient. For example Current Ratio which expresses the
relationship b/w Current Assets and Current Liabilities is 2.
2. Percentage: It is expressed in percentage. For example , Net profit ratio which relates
Net Profit to Revenue from Operations.
3. Times: It is expressed in number of times a
particular figure is when compared to another figure.
4. Fraction: It is expressed in fraction say ¾ that is 0.75.
MEANING OF RATIO
•
ANALYSIS
“Ratio Analysis is a study of relationship among various financial factors in a
business”
• Ratio Analysis is a process of determining and interpreting relationship between the
items of financial statements to provide a meaningful understandings of the
performance and financial position of the enterprise.
• Thus it is a technique of analyzing the financial statements by computing ratios.
ADVANTAGES OF RATIO
ANALYSIS
A. Useful in analysis of Financial Statements: Accounting ratios are useful for
understanding the financial position of an enterprise.
B. Simplifying Accounting Data: Ratios simplifies, summarizes and systematize
accounting data to make it understandable. Its main contribution lies in
communicating precisely the interrelationship which exist between various elements
of financial statements.
C. Useful for Forecasting: Ratios are helpful in
business planning and forecasting. Trend ratios are
analyzed and used as guide to future planning.
LIMITATION OF RATIO ANALYSIS
A. False result: Ratios are calculated from the financial statements, so the reliability of ratio
and its analysis is dependent upon the correctness of the financial statement.
B. Qualitative Factors are Ignored: Ratio analysis is a technique of quantitative-analysis
and thus ignores qualitative factors which may be important to decision making.
C. Lack of Standard Ratio: There is almost no standard ratio against which the ratio
may be measured and compared.
D. May not be Comparable: Ratios may not be
comparable if different firms allows different accounting policies and procedures.
E. Lack of Standard Ratio : There is almost no
standard ratio against which the ratio may be
measured and compared.
F. May not be Comparable : Ratios may not be
comparable if different firms allows different
accounting policies and procedures.
TYPES OF RATIOS
1. Liquidity Ratio: These ratio show the ability of the enterprise to meet its short term
financial obligations.
2. Solvency Ratio: These ratio are calculated to assess the long term financial position of
the enterprise. Solvency means the ability of the enterprise to meet its long term financial
obligations that is liabilities.
3. Activity or Turnover Ratio: These ratios show how efficiently a company is using its
resources.
4. Profitability Ratios: Profitability of a firm can be measured by its profitability ratios.
LIQUIDITY RATIO
These ratios analyze the short-term financial position of a firm and indicate
the ability of the firm to meet its short-term commitments (current
liabilities) out of its short-term resources (current assets) . These are also
known as 'solvency ratios' The ratios which indicate the liquidity of a firm
are:
CURRENT RATIO
The current ratio is a liquidity ratio that measures a company’s ability to pay short-term
obligations or those due within one year
Current ratio = Current asset/Current liabilities
Conventionally a current ratio of 2:1 is considered satisfactory
A ratio of 2: 1 would imply the firm has Rs 2/- of assets to cover every R 1/- in
liabilities
A ratio of 0.75: 1 would suggest the firm has
only 75p in assets available to cover every Rs. 1/- it owes
QUESTION :-
WHAT IS ACTIVITY
RATIO?
Activity ratios are used to determine the efficiency of the
organization in utilizing its assets for generating cash and
revenue. It is used to check the level of investment made on an
asset and the revenue that it is generating.
TYPES OF ACTIVITY
RATIO
• Inventory Turnover Ratio
• Trade Receivable Turnover Ratio
• Trade Payable Turnover Ratio
• Working Capital Turnover Ratio
Activity Ratio 27
INVENTORY
TURNOVER RATIO
Inventory Turnover Ratio establishes relationship between Cost of
Revenue from Operations, i.e., Cost of Goods Sold and average
inventory carried during that period.
Question:
Calculate Inventory Turnover Ratio from the following information:
Opening Inventory is ₹50,000; Purchases ₹3,90,000; Revenue from
Operations, i.e., Net Sales ₹6,00,000; Gross Profit Ratio 30%.
Solution:
Cost of Goods Sold = Net Sales – Gross Profit
= Rs 6,00,000 – 30% of Rs 6,00,000
= Rs 6,00,000 – Rs 1,80,000 = Rs 4,20,000
Cost of Goods Sold = Opening Inventory + Purchases – Closing Inventory
Rs 4,20,000 = Rs 50,000 + Rs 3,90,000 – Closing Inventory
Closing Inventory = Rs 50,000 + Rs 3,90,000 – Rs 4,20,000
= Rs 20,000
Average Inventory
= Opening Inventory + Closing Inventory = 50000+20000 = Rs. 35000
2 2
Inventory turnover = COGS = 420000 = 12times
Ratio Average Inventory sss 35000
Activity Ratio 30
TRADE RECEIVABLE
TURNOVER RATIO
Trade receivable Turnover Ratio establishes the relationship between
Credit Revenue from Operations, i.e., Net Credit Sales and Average
Trade Receivable, i.e., average of debtors and bill receivable of the
year.
Question:
Ajay Industries Ltd has a beginning account receivable balance of
₹250,000 and the ending accounts receivable balance of ₹320,000. The
total credit sales for the year was ₹500,000, while returns amounted to
₹30,000. Find the accounts receivable turnover ratio.
Solution:
Net Credit Sales = Total Credit Sales – Returns
= 500,000 – 30,000
= 470,000
Average Trade Receivable
= Opening Trade Receivables + Closing Trade Receivables
2
= 250000 + 320000 = 285000
2
Trade Receivables Turnover Ratio = Net Credit sales
Avg Trade Receivable
= 470000 = 1.65times
285000
Activity Ratio 33
TRADE PAYABLE
TURNOVER RATIO
Trade Payable Turnover Ratio establishes the relationship between Net
Purchase Sales and Average Trade Payables, i.e., average of creditor
and bill payable of the year.
Question:
Calculate Trade Payables Turnover Ratio from the following
information :
Credit Purchases during the year 6,20,000, Purchase Returns (Out of
credit purchase) 20,000,Opening Creditors 1,00,000, Closing Creditors
1,40,000, Opening Bills Payable 25,000,Closing Bills Payable 35,000
Solution:
Net Credit Purchases = Rs. 6,20,000 - Rs. 20,000 = Rs. 6,00,000
Average Trade Payables
= Opening Trade Payables + Closing Trade Payables
2
= 100000+140000+25000+35000 = Rs. 150000
2
Trade Payables Turnover Ratio
= Net Credit Purchase = 600000 = 4times
Average Trade Payables 150000
Activity Ratio 36
WORKING CAPITAL
TURNOVER RATIO
Working Capital Turnover Ratio helps determine how efficiently the
company is using its working capital (current assets – current
liabilities) in the business and is calculated by dividing the company’s
net sales during the period by the average working capital during the
same period.
Activity Ratio 37
Question:
Eastern Company has the following information provided from its
operations.
Sales = ₹500,000, Sales return = ₹80,000, Current assets = ₹100,000,
Current Liabilities = ₹40,000
Calculate the working capital turnover ratio based on the above
information
Solution:
Net Sales = Total Sales – Sales Return
= 500000 – 80000 = 420000
Working capital = Current assets – Current liabilities
= 100000 – 40000
= 60000
Working Capital Turnover Ratio
= Net Sales = 420000 = 7times
Working Capital 60000
PROFITABILITY RATIOS 39
Gross Profit Ratio establishes the relationship of Gross Profit and Revenue from
Operations. The ratio is calculated and shown in percentage.
Gross Profit Ratio is computed as follows
Gross Profit Ratio = Gross Profit x 100 = …%
Revenue from Operations
Revenue from Operations means revenue earned by the enterprise from its
operating activities. It includes net sales (i.e. Sales-Sales return) and commission,
etc., in the case of non-finance companies and interest earned, dividend, profit on
sale of securities, etc.
Gross Profit is the difference between Revenue from Operations, i.e. Net Sales
and Cost of Revenue from Operations (Cost of Goods Sold).
40
1. Higher selling price with constant Cost of Revenue from Operations (Cost of
Goods Sold).
2. 2. Lower Cost of Revenue from Operations (Cost of Goods Sold) with constant
selling price.
QUESTION 41
OPERATING RATIO
Operating Ratio establishes the relationship between Operating Cost (i.e., Cost of
Revenue from Operations + Operating Expenses) and Revenue from Operations .
Operating Cost includes those expenses which are incurred for operating activities
of the business.
Examples being employees benefit expenses and other expenses.
Non-operating incomes and expenses, i.e., incomes and expenses which are not
incurred for operating activities of the business are excluded. Examples being
interest and dividend received, interest on loans and debentures and gain (profit) or
loss on sale of fixed assets .
Solution:
Operating Ratio = Cost of Revenue from Operations + Operating
Expenses x 100
Revenue from Operations
= ₹6,00,000+ ₹40,000 x100
₹ 8,00,000
= ₹ 6,40,000 x 100
₹ 8,00,000
= 80%
45
Net profit
Net Profit ratio = ________________________ x 100
Revenue from operations
4,80,000
= -----------------× 100 = 24%
20,00,000
RETURN ON INVESTMENT RATIO