Types of Ratios

Liquidity
Ratios
Solvency/Leverage Profitability Activity/Turnover
Ratios Ratios
Ratios

i) Current Ratio
i) Quick Ratio i) Debt Equity Ratio i) Gross Profit Ratio i) Fixed Assets Turnover
Acid Test or ii) Proprietary/Equity ii) Net Profit Ratio Ratio
Liquid Ratio) Ratio ii) Operating Ratio ii) Stock Turnover Ratio
ii) Interest Coverage iv) Operating Profit Ratio. i)Debtors/Receivables
Ratio v) Expense Ratio
Turnover Ratio
iv) Capital Gearing vi) Retum on Capital
Ratio
Employed Ratio iv)Creditors/Payables
vii) Retum on Equity Ratio Turnover Ratio
viii) Earnings Per Share v) Working Capital Tumover
ix) Market Capitalization Ratio
Ratio vi) Total Assets Turnover Ratio
x) Price-Earning Ratio
6.1.6.1. Current Ratio
Meaning: This ratio is also known as "Working Capital Ratio' and is used for determining the short-tem financial
position of the firn. It is done by matching the total current assets of the firm with its current liabilities.

Following is the formula used for calculating current ratio

Cument Ratio=Cument Assets
Current Liabilities
The components of current assets and current liabilities are as follows:
Current Assets Current Liabilities
i) Cash-in-hand i) Bank Overdraft
i) Cash at Bank i) Bills Payable
iii) Bills Receivable ii)Creditors
iv) Short-term Investments iv)Provision for Taxation
or v) Proposed Dividend
Marketable Securities vi)Outstanding Expenses
v Debtors vii) Short-term Loans
vi) Stock vii) Long-tem Loans Maturing within a Year
ri) Prepaid Expenses ix) Unclaimed Dividend

vii) Accrued Incomes

6.1.6.2. Quick or Acid Test or Liquid Ratio
Meaning: This ratio is also known as "Liquid or Acid Test Ratio'. Quick ratio is used to determine short-termsolven.
liabilities'and qui:
of the firm. This ratio is more precise than current ratio as it describes the relationship between current
assets. The quick ratio measures the firm's ability to meet its curent obligaions. This ratio is generally used in conjuncti
with the current ratio.

This ratio can be calculated as bclow:

Quick Assets Quick Assets
Quick Ratio =.
Or Quck Ratio = -

Quick Liabilities
Current Liabilities

Quick assets have the characteristic of easy conversion into cash and include cash, debtors, temporary investments
bills receivable. It does not include inventory and since these assets take considerable time and effor
prepaid expenses ir

conversion into cash.

Quick Assets = Current Assets - (Stock + Prepaid Expenses)

The distincton between quick liabilities and curent liabilities is of Bank Overdraft and Cash Credit. It is because they
f
sccured by Inventories. Theretore, quick liabilities are defined as current liabilities less the value overdraf
of bank
cash credit.
Quick Liabilities = Current Liabilities -(Bank Overdraft + Cash Credit)
Interpretation: Quick ratio is considered to be a better measure of short-term liquidity than current ratio. Current rat
quantitative in its scope and does not adequately address the liquidity concems of the fim. Quick ratio, on the otherI
is qualtative and offers a more rule of thumb.
stringent test as it uses only cash and near-cash assets. As a
qunck iatf
t:i is considered ideal. This ratio is widely used by banks and financial institutions. It should be used in conjunction tin

cure ratuo in order to assess short-term solvency and financial soundness of the fim.
 6.1.7. Solvency/Leverage Ratios
These ratios offer an insight into financial
performance business. These ratios also deal with long-term solvency
of a
position of thebusiness as these help to know whether the business would be able to honour its interest
principle payment commitments. payment and

Debt-equity ratio, interest coverage ratio, proprietary ratio and capitaB gearing ratio are included in this
category.
Solvency/everage Ratins

Debt-Fquity Ratto
Propnetary Rutio
Interest Coverage Ratio
Cspital Gearing Ratio

6.1.7.1. Debt-Equity Ratio

Meaning: This ratio is also known as 'External-Intermal Equity Ratio'. This ratio is used to
firm's long-term financial planning. It als0 determine the efficiency ofa
compares the stakes held by the insiders as well as the Thisoutsiders. ratio
shows the relationship between equity funding and debt
The ratio is calculated as below:
funding.
Debt
Debt-Equity Ratio=0tl Long-term Or Debt-Equity Ratio = ExternalEquities
Shareholders' Funds
Internal Equities

where.
Total iong-term Deb/External Equities =
Debentures +Tem Loans +Loan on
Mortgage + Loans from Financial
nstitutions+Other Long-term Loans +
Redeemable Preference Share Capital
Sharehoiders' FundsIntemal Equities Equity Snare Capital + rredeemable Preference Share Capital+
=

+Retained Earnings + Any Earmarked Capital Reserves

etc.-Fictitious Assets Surplus like Provision for Contingencies,
6.1.7.2. Proprietary Ratio
Meaning: This ratio establishes the relationship between proprietors' funds and the total assets of the business. The main
purpose of this ratio is to determine the sources for financing the assets.

Following are the two main components of this ratio

1) Proprietors' Funds (excluding fictitious assets like preliminary expenses), and
2) Total Assets.
This ratio is computed by
dividing the proprietors' funds by total assets in the following way:
Proprietory Ratio=0prietors Funds/Shareholder Funds
Total Assets
Interpretation: Higher proprietary ratio shows that assets are mainly funded using shareholders' money, which is
considered good for the company's long-term
its assets and not
solvency. The ratio also shows the extent to which the company rmay loose
impact the interest of its creditors.
Example 4: From the following information, calculate the proprietary ratio. Proprietors' funds are 76,00,000 and total
assetsare800,000.

Proprietary Ratio Proprietors

Solution: Funds 6,00,000 =
3:4 or 0.75: 1
Total Assets 8,00,000
This ratio can also be represented in percentage which indicates the percentage of owner's capital total
firm as follows: to capital of the

RatioFfoprietor's Funds x 1 0 0 6 . 0 0 , 0 0 0
Proprietary
Total Assets x100 75%
8,00,000
 Ralio Anaiysts (CAapter b)
117
Interest Coverage Ratio/ Debt-Service Ratio
6.1.7.3.
ratio establishes a relationship between interest on
Meann
tis
determining the capability of a business in meeting itslong-term debt and net
fixed interest
profits before interest and taxes.
obligations for its long-term loans.
The ratio is expressed as 'n number of tumes and is calculated using the following formula:

Ratio= rroit before Interest as

Interest Coverage
Interest on Long-term Debt
Tdoraretation: Low interest coverage ratio shows that the company is under high burden of
ohahility of default or insolvency. Interest coverage ratio o1 1.5 or below indicates that thedebt.
proba
It also indicates higher
eling its interest payment obligations. 1he company faces trouble in
ratio below I shows that the company's interest
or camings and thus the company may have problems in discharging its interest obligations obligations exceeds its EBIT

A hich ratio shows financial soundness of the business. It shows that the
company generates
hipher than its interest obligations. However, a very large ratio also suggests that the companyoperating income which is
is not making full use of
leverage.
vamnle 5: The net profit (after taxes) of a fim is R75,000 and its fixed interest charges on long-term borowings are
R30,000. The rate of income-tax is S0%. Calculate interest coverage ratio.

Solution: Interest Coverage Ratio=et Profit

before Interest and Taxes
Interest on Long- term Debt
75,000+(75.000x 50% Tax)+ 30.000 interest)
30,00x0
75,000+37,500+30.000 142.500 4,75 tines
30,000 30,00

6.1.7.4. Capital Gearing Ratio

Meaning: This ratio explains the relationship between cquity share capital and fixed interest bearing securitüies including
preference shares. For the purpose of this ratio, cquity share capital includes reserves.

The formula to caleulate this ratio is as follows:

Cupital CGiearing Rutio= Equity Share Capital +Reserve &Surplus

Preserence Share Capital + Long -Term Debt Bearing Fixed lnterest
Nole: The long-term instrnments that have fixed interest bearing are debt/debentures and long-term loan.

firm is highly geared or leveraged. Similarly,

if the ratio is low then the firm
nerprelation: A high ratio indicates that the
RAS
leverage. A highly geared fim has its preference sbare capital and other fixed interest bearing
loans
more than its
low ratio. The company
for a low geared firm. It is an important
S r e capilal and reserves. The situation is reversed its A gearnng rauo
Strive to achieve opimal gearing in order to maintain profitability and long-temm solvency. high
L
auso shows high fixed interest obligations, which is good for future contingency in business.

Sxample 6: From the information given as under find outcapital geanng ralo
2017 2018
Particulars 6,00,000 4,00,000
Equity Share Capita!
3,00,000 2,00.000
Reserves & Surplus 4,00,000
8% Preference Share Capital 2.50.000
2,50.000 4,00.000
6% Debenrures
Equity Share Capital Reserve &
+ Surplus
Solution: Capitsl eanng Ratio = term Debt Bearing
Fixed Interest
Preference Share Capital + Long-

Captal Geaing Ratio 6,00.000+3.00.0009.00.09:5or1.8:1(Low Gear)

(2017)2.50.000+250,08 5.00.000

Cpal Gearieg Rstie 2018) =-400,t00+2,00,000 6.00,000 h:8or 0.75:1(High Gear

8,00,000
400,000-4,00,000
 6.1.8. Profitability Ratios
A business cxists to make profits. Itrequires profits not only for survival but also for expansion and diversification. Prolit
can be used for determining the efficiency of management and employees. It is aiso useful for providing security to the
creditors. The profiabilitystatus of the business conveys various meanings. It shows the efficiency of management, wort
ofinvestment.the tax paying capacity of the business and its overall eftectiveness. The profitability is also important t
determine the impact of various decisions such as price cuts, increase in selling price and change in tax strnucture on the
efficiency of the business.

For the purpose of determining profitability status of a business, various ratios are used. These ratios are:

Profitability Ratios

Gross Profit Ratio

Net Profit Ratio
Operating Ratio
Operating Profit Ratio
Expenses Ratio
Retum on Capital Enmployed/Return
Retum on Equity or Return on on Investnent
Equity Shrehokders Funds
Earnings Per Share

Market Capitalization Ratto

Price Eamings Ratio or P/E Ratio
(Earning Yield Ratio)

6.1.8.1. Gross Profit Ratio

Meaning: This ratio is also known as "Gross Margin Ratio' or Trading Margin Ratio'. This ratio is generally expressed in
percentage and shows the relationship tetween the net sales and gross profit.
Gross profit ratio is helpful for determining the ability of the husiness to meet its operating expenses. It also show
shareholder's share after meeting operating expenses. The ratio is caiculated as below:
oross Prolit Ratio =urOSs Profit x 100
Net Sales
Where. Gross Profit = Net Sates - Cost of Gonds Sold, and
Cost of Goods Sold = Opening Stock + Purchases (Net) + Direct Expenses - Closing Stock, and
Net Sales = Total Sales - Sales Returns

Interpretation: Gross profit ratio shows the average margin on products sold. The ratio shows the general profitability of
the business, A high ratio indicates that the concerm is abile to generate high margin on the products sold. This ratio can be
used for making temporal analysis. It can also be used for comparing the performance of
multiple firms. The firm shoule
maintain proper profitability ratios to keep its financial position and demand stable.

Example 7: The trading and profit & loss account and the balance sheet of ABC Ltd. are as under:
Trading and Profit & Loss Account
Dr.
for the year endingon31 March 2018) Cr.
Particulars Particulars
To Opening Stock 50.000 By Sales 18,00,000
To Purchascs 11S0.000 By Closing Stock 1,00,000
To Wages 80,000 By Interest& Dividend on Long-term investment 3.000
Te Cariage Inward 20,000 By Protit on Sales of Long tem investnent 20.000
To Otfice & Administrative Expenses 1,00,000 By Compensation of acquisition of Land 1,000
To Finance Expenses 80000 By Rent Received 2.00,000
To Cash Discount albowed to customers 10,000 By Interest Received 2,00,00
To Bad Debis 6,000
To interest on Bills Payatble 4,000
To interest on Dehentures 1,20.000
To Value of Furmiare lost by fire 6,000
Fo Provision for Tax 2,40,000
To Ner Prosit (After interest and Tax 4.58.000
23.24.000 23.24,000
Pepare staterzient showing the cemput2tion of gross profit and cakculate gross profit raio
6.1.8.2. Net Profit Ratio
Meaning: This ratio is aBse known as "the net profit to sales ratio" or "net profit margin" and expresses the rate of the net
of revenuc. The ratio is calculated by dividing net profit by net sales for the concerned period. it can be
xo fotever unit
cApressed as below:
Net Protit Ratio= Net Prolit 0
x100
Net Sales

wo differen approaches may be used for this purpose as net profit may be defined as net profit before tax or net profit
atier tax:
Net Profit= Net Profit betore Tax 00 Profit before Tax
Or x100
Net Sales Net Sales
Net Profit= Net Profit After 1at100 Profit After Tax
x100 Or x100
Net Sales NetSales

interpretation: Net profit ratio measures the overall profitability of the business. A temporal analysis
he trend in profitabiity of the firm, where one may be done to see
year's net profit ratio is
atto shouid be used in conjunction with other ratios such as compared with another year's net profit ratio. This
turnover ratios to get overall
arnd to see how efficientdy the business assets are picture of the business concern
being used.

Example 8: From the following details, calculate net profit ratio:

Particulars
Total Sales
1,00,000
Sales Retums 6,000
Cost of Sales
70,000
IndirectExpenses 10,000

Sodution: Net Profit Ratio Net Profit

x100
Net Sales

e Profil =Net Sales (Cost of Sales + Indirect

Expenses)
et Sales =Totai Sales Saies Returns =
1,00,000 6,000 = 94,000
Ne Profit 94,000 (70.0K0+ 10,00)
=94,000- 80,000= 14.000
et Profit Ratis = 14,0Mxitk) = 1489%
94,0

5.1.8.3. Operating Ratio

leaning: This ratio measures he reläioi helween sales änd the
RIula used for expenses incurred for making such sales.
cakulating operaling ratio Following is the

Cperating Ratio
Cost
-
of ioods Soid +Operaliung Eapenses
Net Sales xI00
Interpretation: This ratio shows the cost stnucture of a fim.
Higher operating ratio indicates that the firm has less margin
mecting its non-operating expenses and thus is in unlhealthy financial for
condition. Efficient firms show Jow operaung ratits,
Example 9: From the following details, calculate operating ratio:
P'Sales
articulars
8,50,000
Opening stock 99,5
Purchases 5,50,500
Cariage nwards 10,000
Closing Stock 1,40,000
Depreciation 20,000
Administrative Expenses 1,50,000
30,000
Selling Expenses
Loss
onthe Sale of Assets 4,000

Solution:
Sellings& Distribution Expenses+ Depreciation0
Operating Ratio = OStot Good Sold+ Administrative Expenses+ Net Sales

Cost of Goods Sold = Sales Gross Profit

Gross Profit (Sales +Closing Stock) -

(Opening Stock + Purchases +Carriage Inward)

=9,90,000 -6,60,000 = 73,30,000
=

(8,50,000+ 1,40,000) (99,500 +5,50,500+ 10,000)

Gross Profit 8,50,000 3,30,000
= T5,20,000
Cost of Goods Sold = Sales -

2 0 , 0 0 0 + 1 , 5 0 , 0 0 0 + 3 0 , 0 0 0 + 2 0 , 0 0 0

-40,000x100 = 84.70%
Operating Ratio 8,50,000 8,50,000

6.1.8.4. Operating Profit Ratio ratio and determines the relationship betwecn operating profits and sales. The
Meaning: This ratio is a type of profit net

following formula:
ratio is caiculated using
peratingProfits1
Operating Profit Ratio= Net Sales
and
such as cost of goods sold, selling
revenue and operating expenses
difference between operating incomes. Financial
Operating profit is the administration expenses. It ignores non-operating
expenses and
and office and are used for
distribuion expenses
and losses due to fire are also excluded. Following equations
expenses such as
interest, taxation, dividend
calculating operating profits:
Office Expenses + Selling and Distribution
Operating Profit Sales-(Cost of Goods Sold+ Administrative
Expenses)
Or
Net Profit= Net Profit+ Non-Opcrating
Expenses -Non-Operating Incomes
Operating Or
Gross Profit +Operating Incomes Operating Expenses
Operating Net Profit
=

determining operating
ratio is than the net profit ratio for the purpose of
appropriate
Interpretation: Operating profit
more
results as it includes non-operating expenses
and incomes as well. Hign
ratio give mislcading
efficiency. Net profit may
ratio indicates that the business is being managed efficiently.
operating profit
information given below, calculate operating profit ratio:
Example 10: From the
Particulars
Cost of Goods Sold 4,00,000
Administrative & Office Expenses 40,000
Seling & Distribution Expenses 40,000
Net Sales 6,00,000
6.1.8.5 Expenses Ratio
Meaning: This ratio shows the relauonship between
decrease of expense. Lower expense ratio show several expenses and net sales. This ratio depicts the increase
efficiency in operations. ad

Following fornula is used to caleulate

expense ratio:
Expense Ratio= unt ot Expenses
Net Sales x100

Different expense heads can be used for this purpose. Various

ratios included under this
Expenses to Net Sales, Ratio of Selling and Distribution category are Administrative
can be calculated as below: Expenses to Sales, Financial
Expenses to Sales etc. These ratios
For Administrative Expenses to Net Sales Administrative and Office Expenses
Ratio=*
NetSales x100
For Selling and Distribution Expenses to Net Sales Ratio =Cingand Distribution Expenses
NetSales
For Financial Expenses to Net Sales Ratio= Financial Expenses and Interestx10
-

Net Sales

Interpretation: The expense ratio can be used as a control measure as well. A steady or declining ex pense ratio shows that
the firm is
endeavouring to control its expenses.
Example 11l: Following is the profit and loss account of ABC Trading House for the year ended 31.3.2018:
Profit and Loss Account
Dr.
for the yearended 31.3.2018) Cr.
Particulars Particulars
To Administrative Expenses 80,000 By Gross Profit b/d 2,00,000
To Selling and Distribution
Expenses 50,000 By Interest on Investments 5,000
To Financial Expenses 6,000
To Other Non-Operating
To Net Profit
Expenses 4,000
65,000
2,05,000 2,05,000
net sales during the year were 5,00,000. You are required to calculate:
1)
2)
Administrative Expenses Ralio
Selling
and Distribution Expenses Ratio
3) Financial
Expenses Ratio
Sulution:
Administrative Expenses Rati0=
atio- Ad ministrativeExpenses00=
80,000
x100 16%.
Net Sales 5,00,000
Seliling and Distribution Selling&Distribution Expenses
-XI00=U,000
-x100 10%
Expeuses Ratio= NetSales 5,00,000
3 Financial Expenses Ratio= Financial Expensesv10M0.0x
NetSales
6,00000= 1.2% 5,00,000
 MBA First Semester (Mana
gement Accounting). GTU
6.1.8.6. Return on Capital Employed/Return on Investment
Meaning: Returm on capital employed is calculated by using net income and total
assessing the firm's ability to generate sufficient return on its capital employed. The ratio is useful for
the formula used for the capital invested. It is expressed as a percentage. Following is
purpose of calculating
this ratio:
Return on .Net Income before Interest and Tax100
Capital Employed=-
.Capital Employed
The term Capital Employed may be interpreted in different ways as follows:
1) Gros Capital Employed: This term includes fixed well
as as current assets. Fixed assets are caiculated after
deducting depreciation.
Gross Capital Employed = Fixed Assets+Current Assets
2) Net Capital Employed: It refers to the sum of working capital and fixed assets. It may also be defined as total assets
minus current liabilities.

Interpretation: This ratio is used to measure the efficiency of a business in generating return on its investment. The
the ratio, the better it is, as it shows robust overall higher
profitability.
Temporal analysis may be done to see whether the business has improved its performance or not.
Example 12: From the following details, calculate Return on Investment:
Particulars
Share Capital
Equity 4,00,000
Preference 1,00,000
General Reserve 1,89,000
10% Debentures 4,00,000
Current Liabilities 1,00,000
Discount on Shares 5,000
Net Profit (after dcbenture interest but before income tax) 80,000
Net Profit before Interest and Taxt00
Solution: Return on
Investment =-
Capitil Employed
Net Profit before Interest and Tax Net Profit + Debenture Interest
=
80,000+ 10% of 4,00,000 780,000 +740,000
= =
TI1.20,000.
Capital Employed = Equity Share Capital + Preference Share Capital+ 10% Debentures + General Reserve+ Protit -
Discount on Shares
=
4,00,000 + 1,00,000+ 4,00,000+1.89,000+ 40,000 (50% of Net Profit i.e. T80,000) 5,000 -

= 711,24,000

Thus, Return on Investment = 1,20.000100= 10.68%

I1,24,000
Note:
) Net Profit is takcn after assuming income tax rate @ 50%.
2) Debentures are included in the capital employed in order to find out total investment.

6.1.8.7. Return on Equity or Return on Equity Shareholders' Funds

Meaning: Thus ratio is calculated to know the firm's profitability from the perspective of shareholders.
Following is the formula used for the purpose of calculating this ratio:

Return on Shareholder's Funds= ~

Net Profit after Interest and Tax
x100
Shareholder's Funds
iHere
Shareholders' Funds = Equity Share Capital + Preference Share Capital + Share Premium + Revenue Reserve +
Capital Reserve + Retained Earnings - Accunulated Losses
Or
Sharcholders' Funds = Fixed Assels + Current Assets -

Current and Long-term Liabilities

Interpretation: This ratio is lciptul for making inier-frn comparison. It cam also be used for comparing pertormance oser
a perid of time, This ralja helps in determinjng whether a fim is pertorming well in conparison to iS peers, it also
determines whether thhe sharcholders are caning adequate retum on their inyestment.
6.1.8.8. Earnings per Share (EPS)
Meaning: This ratio is calculated to find prolitability per share. The formula for calculating Earnings per Share are as
foilows:
Net Profit after Tax, Interest and Preference Dividend
Earnings per Share =

Number of Equity Shares

fnterpretation: Earmings per Share is useftul to detenine the market price of equity shares. It also shows the business 's
ability to pay dividends to its investors.

ExampBe 14: From the extracted data, calculate earnings per share from the following data:

Particulars
20.000 Equity Shares of T10 each 2,00,000
20.000 10% Preference Shares of 710 each 2,00,000
Net Profit before paying dividend to Preference Shares
1,00,000
Solution:
Particulars
Net Profit as per Profit& Loss A/c 1,00,000
Less: Dividend Preference Shareholders 10% on 2,00,000
to
20,000
Balance of Profit Available to Equity Sharcholders
80,000
Net Profit after Dividend on Preterence
Earings per Share = e n d on Preference Shares 80,000
4 per share
Number of Equity Shares 20,000
 C ACC
124 (Module-11)
Market Capitalisation Ratio
6.1.8.9. between earnings per share and
market price. This is also
Meaning: This ratio
establishes the relationship
referred t
"mid cap"
below:
The ratio is caBculated as
Earmings per SharexLO0
Market Capitalisation Ratio
=

Market Price perShare

Where, Dividend
Net Profi after Tax, Interest and Preference
Earnings per Share =
-

Number of Equity Shares

When the market price is received with dividend, it is referred to as dividend yield ratio. Dividend yield ratio is calel
by comparing market price of the share with the dividend paid. The formula for this purpose is calculated as below alculae
Dividend per Share
Dividend Yield Ratio = - x 1000
Market Price per Share

Where, Dividend per Share = Unit per Share x % of Dividend

Interpretation: If the company share pice is high, the di'vidend payout is low and vice versa.

Example 15: From the following data, calculate dividend yield ratio:
Particulars
10,000 Equity Shares of 100 each 10,00,000
Dividend paid during the year 20%
Market price per share _ 120
Solution: Dividend Yield Ratio= Dividend per Share
Market Price per Share x100=16.67%
120

6.1.8.10. Price Earning Ratio or P/E Ratio (Earning Yield Ratio)

Meaning: This ratio establishes the
relationship between market price of the share and its eamings. Following formuli
used for this purpose:
Price Earning Ratio=arket PriceperShare
Earnings per Equity Share
Interpretation: This ratio is very widely used. It helps the investors in deciding whether the shares are
High P/E ratio shows that the firm will take fairly priced or B
longer to recover its market price. This ratio is affected by various na
factors. It can also be used for predicting future market
price of the share.
Example 16: The capital of Star ABC 1Ltd,is as follows:
Particulars
80.000 Equity Shares of T10 each
8,00,000
10%3 ,000 Preference Shares of 10 each
3,00,000
The
11,00,000
following information has been obtained from the books of the company:
Profit after tax at 60%
2,70,000
Depreciation 60,00
Equity Dividend paid 20%
Market Price of Equity share 40
You are
required to calculate the pnce earnings ratio
Sohution: Price Eamings Ratio-Market Price per Share
Earnings per Share
Eamings per Share = .Net Profit after Tax, Interest and Preference Dividend
2,70,000- 30,0003
Number of Equity Shares
80,000
Price 40
Earmings Ratio 13.3:1
6.1.9. Activity/lurnover Ratios
Various assets employed the business to generate revenue and profits. These assets need to be
are in
for thispurpose. Better managed assets help to generate higher profits for the business. These nmanaged efficientdy
as turnover ratios as these ratios show the
activity ratios are also known
intensity with which the assets are converted into sales.
Several activity ratios are as follows:
Activity/Turnover Ratios

Fixed Assets Turnover Ratio

Stock Turnover Ratio
Debtors Tumover Ratio
Creditors Turmover Ratio
Working Capital Turnover Payables Turnover Ratio
Ratio
Total Assets Tumover Ratio

6.1.9.1. Fixed Assets Turnover Ratio

Meaning: Fixed asset tumover ratio matches fixed assets with sales revenue. This ratio shows the efficiency with which
the business uses its fixed assets for the
purpose of generating revenue and profits. A high fixed asset turnover ratio shows
that the company is quickly tuning its fixed assets into sales.

In other words, it shows that higher sales per unit of tixed assets are being achieved. Fixed assets are an
important criterion
as they form the largest portion of thbe total assets of the firm.
Following is the formula used for the calculation of this ratio:
Fixed Assets Turnover Ratio=-
Net Sales
Net Fixed Assets
Net Sales=Gross Sales-Sales Retum
Net Fixed (Operating) Assets =
Gross Fixed Assets Depreciation
Fixed assets are definedto include land and building, furmiture and
fixture, plant and equipment. However, long-term
defered tax, goodwill and other unrelated assets are not included for the
purpose of presenting more meaningful fixed
assets position.

Interpretation: This ratio can be used for making temporal study as well as for making inter-firm comparisons.
A low ratio shows that either the fim has made
high investment in fixed assets or that it is not able to utilise the assets in
efficient manner. Similarly, high fixed asset ratio shows that the
company is efficient but may also be operating at over
capacity.
Example 17: ABC Company has gross fixed assets of 75,00,000 and accumulated depreciation of 72.00.000. Sales over
the last 12 months totalled 9,00,000. The calculation of ABC's fixed asset
turnover ratio is:

Solution: Fixed Assets Turnover Ratio=- Net Sales

Net Fixed Assets

Net Sales=79,00,000
Net Fixed (Operating) Assets Gross Fixed Assets
= -

Depreciation 5,00,000-2,00,000 73,00,000

= =

Fixed Assets Turnover Ratio= 9,00,000 3 times

3,00,000

6.1.9.2. Stock Turnover Ratio

Meaning: This ratio is also known
as Invetory Turnover Ratio' or "Stock Velocity Ratio', It shows the relationship
between cost of goods sold and
average inventory.
The fomula for calculating stock turnover ratio is
shown below:
Stock Turnover Ratio OStof Goods Sold
Average Inventory
 MBA First Semester
(Management Accounting) GTU
Cost of Goods Sold =
Sales Gross Profit
-

Or
Cost of Guods Sold =
Opening Stock+ Purchases+Direct Expenses Closing Stock -

Average Stock pening Stock+Closing Stock

=

Note
1)Closing stock figure may be used if opening stock amount is not available.
2) Net sales nu:nbers may be used in place of Cost of Goods Sold.

Net Sales
Stock Turnover Ratio
Average Stock

Ipterpretation: This ratio shows the speed with which stock is converted into sales. A high ratio indicates that the
company generates higher sales per unit of investment made in stocks. Conversely, low ratio shows that the inventory is
lying idle, poor performance of the business, over capitalisation of stock, other expenses related to storage of stock are
high, etc. It is important for a business to maintain proper inventory turmover ratio.

Inventory Conversion Period (Stock Velocity)

This ratio shows the number of days taken by the inventory to be converted into sales. It shows the average time taken by
the lirm to clear its stock. The formula for calculating this ralio is shown below:

Weeks/365 Days
Inventory Conversion Period=Months/52
Stuck Tumover Ratuo

I 365 days are used then the ratio shows the number of days in which the stock is converted into sales.
365
? No. of Days
Inventory Conversion Period =

InventoryTurmover Ratio

Example 18: M/s. XYZ & Co. supplies the tollowing infomation for the year ending 31st Dec. 2016
Particulars
Credit Sales 1,75,000
Cash Sales 2.50,000
Rerums Inward 25,000
Opening Stock 25,000
Closing Stock 35,000
Find out
i)Stock Turnover when Gross Profit Ratio is 20%, and
2) Stock Conversion Period.

Solution: Stock Tumover Ratio =

Cost of Goods Sold
Average Stock

Cost ofCoods Sold = Net Sales - Gross Profit

Cash Sales Retum Inwards = 1.75,000+2.50.000 25,000 = 4,00,000

Credit Sales
-

Net Sales = +

Gross Profit on Sales = 400,000x20 z80,000

80.000 3,20,000
of Cionds sold Net Sales -Gross Profit 4,00,000-
= =

Cost =

pening Stock+ClosingStock 25,0000 +35,00020 0

2

3,20. 1057 umes

30,000
?hat durng tize yeat, tie aveage stock is being sold l0.67 times.
s e
365 65
34,21 or 34 days.
Stck n o e r R.i
 127
Ratio Analysis (Chapter 6)

6.1.9.3. Debtors Turnover Ratio

Debtors
Meaning: This ratio is also known as 'Ratio of Net Sales to Gross Receivable', 'Receivable Turnover' or
The ratio shows the relationship between average accounts receivable and net credit sales. This ratio is used to
Velocity'.
determine the efficiency of business in collecting its eredis.

The fomula for calculating the ratio is given below

Net Credit Sales
Debtors Tumover Ratio =
-
Average Accounts Receivable or Average'Trade Debtors

Where,
Accounts Receivable =Debtors+ Bills Receivable
Opening Account Receivable+Closing Account Receivable
Average Accounts Receivable =

If information relating to credit sales and average debtors is not available, the ratio can be worked out asfollows
Debtors Turmover Ratio = Total Sales
Closing Debtors

Interpretation: This ratio shows the frequency of debtor turmover during the year. Higher turnover shows better credit
policies and eficiency. It also shows that the debtors are more liquid. However, a very high ratio may also indicate that
firm is not able to sell goods on credit and may be losing its revenue.
Conversely, low turnover indicates problems in the collection of debts. This ratio can be used for temporal studies and for
determining trend. Similarly, this can be used for making inter-firm comparisons as well.

There is no set rule for interpreting this ratio as different firms operate under different conditions. While making inter-firm
comparison, it should be ensured that the firms belong to the same industry.

Debt Collection Period (or Debtors' Velocity)

The debt collection period shows the average number of days a firm takes to collect its debt. There are several ways to
calculate this ratio:

1) Debt Collection Period =AVerage lrade Debtors (Debtors+Bills Receivable)

Sales per Day
Net Sales
2) Sales per Day = -

Number of Working Days

Or
Debtors
Debt Collection Period=AVerage Trade Average Trade DebtorsxNumberof Working Days
Net Sales Net Sales
Number of WorkingDays

If the period is in months:

Number of Months
Debt Collection Period - Avergeirade Debtors x
Net Sales
Or
Debt Collection Period
Numberof Working Days Number of Days
Debtors Turnover Ratio

Example 19: Calculate the debtor's turnoyer ratio and average debi collection period tor the year 207-2018 from the
following inforimation:

Particulars 2017 () 2018 ()

Sundry Debtors 15,000 45,000
Bills Receivable 5,000 15,000
Provision for Doubiful Debix ,500 ,500

2,20,00M, Sales Reurns 20,000, Cash Sales 40,000

Total Sales

Net Credit Sales

Rat0
Solution: Debtors Turmover A verage Trade Debtors
 128 {Modulc-Il) ianagementnt Accounting i

Net Credit Sales = Total Sales -

Sales Returns -
Cash Saies
= 2,20.000-20,000-40,000 1,60,000

Average Debtors =Opening Debtors+Closing Debtors+ OpeningBills Receivable +Closing Bills Receivahable
15,000+45,000+5,000+15,000=R40,000
2

Debtors Turmover Ratio = - 1,60.000

4 times
40,000

Average Debt Collection Perod=-Debtors Tumover Ratio 12Months

12 Months
=3 months
4 Times

6.1.9.4. Creditors Turnover Ratio/Payables Turnover Ratio

Meaning: This ratio shows the relationship between net credit purchase and average trade creditors. This ratio is
related to the concept of float. It also measures the efficiency of the business in clhe
utilising its cash in proper manner.
Computation: It may be calculated as under
Creditors Turnover Ratio .
Net Credit Purchases
Average Trade Creditors
Net Credit Purchases = Gross Credit Purchases Purchases Returns
Average Purchases =Creditors+ Bills Payable
Average Trade Creditor =OpeningIrade Creditor+ClosingTrade Creditor
2
If opening figure for creditors is not available, then the closing figure may be used. In such cases, the fornula will be s
follows:
Total Purchases
Creditors Turnover Ratio=
Closing Creditors

Interpretation: This ratio shows the number of days taken by the firm to pay to its creditors. Lower credit rumover
shows that the firm is able to better
manage its liquidity position. It shows that the company enjoys longer credit
rato
However, may also indicate that the fim loses out a discount and other incentives for
it penu
comprehensive conclusion, time based comparison should be made. This ratio can beprompt payment. For reachmg
used for making inter-nt
comparison as well.

Debt Payment Period (or Creditors'

This
Velocity)
period shows the average period for which the credit purchases remain
actually availed of. outstanding or the average credit pu

Debt Payment Period Average Trade Creditors 12 Months/52 Weeks/365 Days

Average Net Credit Purchases Per Day Creditors Tumover Ratio

Average Net Credit Purchases Per Net

Credit Purchases for the Year
day
Number of Working Days in the Year

Example 20: Calculate the creditor's turnover ratio and debt

payment period from the following information:
Particulars
Cash Purchases
1,00,000
Opening Sundry Creditors 25,000
Closing Bills Payable 25,000
Purchases Returns 7,000
Total Purchases (Subject to Returns) 4,07.000
Closing Sundry Creditors 30,000
Opening Bills Payable 20,000
6.1.9.5. Working Capital Turnover Ratio
Meaning: This ratio explains the relationship between net sales and working
working capital was tumcd over to capital. The ratio depicts the number of times
generate the given sales volume during the time period under consideration. This ratio
can be used for making temporal and inter-firm
comparisons. With this ratio, a business can gauge its future capital
requirements.

The working capital is taken as:

Working Capital = Curent Assets Cument Liabilities

The main objective of this ratio is to determine the velocity with which net
the number of times the working capital was revolved over in a given
working capital is utilized. The ratio shows
It
year. indicates the efficiency of a firm in utilizing
its working capital.

The formula for calcuiating the ratio is given below:

Net Sales Cost of goods sold
Working Capital Turnover Ratio =-
Working Capital Net Working Capital
Net Sales= Gross Sales-Sales Retum
Working Capital = Current Assets -Current Liabilities

Interpretation: This ratio shows the fim's capacity to generate revenue for each rupee of its working capital. Higher ratio
indicates better efficiency and vice versa.

Example 21: Calculate working capital tumover ratio, from the following information:
Current Assets 6,00,000
Current Liabilities 1,20,000
Credit Sales 12,00,000
Cash Sales 2,60,000
Sales Retums 20,000
Net Sales
Solution: Working Capital Tumover Ratio =-
Working Capital
Net Sales = Cash Sales+ Credit Sales - Sales Returns
= 2,60,000+ 12,00,000-20,000 714,40,000

Working Capital = Current Assets -

Current Liabilities
6,00,000-1,20,000 = 74,80,000

Working Capital Turnover Ratio 14,40,00=3Times

4,80,000
3imes
6.1.9.6. Total Assets Turnover Ratio
Meaning: This ratio is the relationship between sales and total assets. This ratio is used to measure the overall activity and
periomance of the business concern.
The fonmula for calculating the raio is given below:
Sales
Total Assets Turnover Ratio :
Total Assets

Interpretation: As a ule of thumb, lower asset turnover ratio indicates poor management of resources in the form of
excess production capacity and inventory management. Increase in this ratio may show that the company is on the path of
growth. Purchase and sale of assets in anticipation may drastically change the ratio for the firm. Low margin industries
show higher ratio as these companies need to maintain high unit-sales to offset the impact of low margin per unit. Capital
intensive industries tend to have lower turnover ratios. Due to these factors, it is advisable to compare the companies
working within similar industrial sector.

Example 22: Compute Total Assets Tumover from the following particulars:
Sales 3,00.000
Sales Retun 40,000
Fixed Assets 2.00.000
CuTent Assets 1.50.000

Net Sales
Solution: Total Assets Turnover=
Total Assets
Net Sales = Sales Sales Return 3,00.000-40.000 = 2.60.000
Total Assets = Fixed Asscts + Current Assets = 2,00.000 1.50.000 = ?3,50,000

2,60,000
Total Asscts Turnover = 3,50,00 0.74:

6.1.10. Summary of Ratios Hatis ie be Computed Formula

Objective of Analysis Current Assets
1) Liquidity Ratio: Short-term FinancilCurrent Ratio
Position or Test of Liquidty Current Liabilities

Quick or Acid Test Liquid/Quick Asscts

Or Liqud Rato Current Liabilites

Rauo Outsiders' Funds External Equities

2) Solveney Ratio: Analysis of Long-tem Debe-Equity Dr
Financial Position or Test of Soivency Sharcholders'Funds Internal Equities

Proprietary or Shareholders' Funds

Bquity Rado Total Assets

Interest Coverage ratio Net Profit before Interest& Taxes)

Interest on Long-Term Debt

Capital Gearing Ratio Equity Share Capitai + Reserve &Surplus

Preference Capital + Long - Tenn Debt

bearing fixed interest

3) Profitability Ratio: This ratio measares Gross Profit Ratio Gross Prot100
the Profit eaming capacity of the Net Sales

Company Net Pr ofit afier tax[00

Net Profit Ratio
Net Sales
Operaüng Ratio Operuting Costt00
Net Sales
Operating Profit Raiio Operating P ont100
Net Sales
Return on Capital Net Profs before interest tax-x}i
EmployedReturn on investmeat Captal EnmpBoyed
Ratio Ánalysis (Chapter 6) 131

Return on Shareholder's Net Profit after Interest, Tax &

Fund/Retum on equity
Shareholder fund Preference Dividend
-x100
Equity Shareholder's Fund
Earnings Per Share (E. P.S.) Net Profit after Interest, Tax and
PreferenceDividend
xi00
Number of Equity Share
Market Capitalization Ratio
Earnings per share
-x100
Market price pershare
Price-Earning Ratio (P/E Ratio) Market Pr ice per Equity Share
Earnings per share
4) Activity Ratio: These ratios measure the Fixed Assets Turnover Ratio
efficiency or effectiveness with which a Net Sales
firm manages its resources or assets Net Fixed Assets
Stock Tumover Ratio Cost of Goods Sold
Average Inventory
Debtor Turnover Ratio Net Credit Saies
Average Trade Debtors
Creditor Turnover Ratio Net Credit Purchases
Average Trade Creditors
Working Capital Turnover Ratio Cost of goods sold
Net Working Capital