SYBCOM Semester III
Subject: Introduction to Management Accounting
Chapter 3 - Ratio analysis and Interpretation
BALANCE SHEET RATIOS
1. Current Ratio (Solvency Ratio)
A. Introduction: Current Ratio is also known as ‘Working Capital Ratio’ or ‘2 to 1’ ratio or solvency
ratio. This ratio measures the short-term solvency of the business by comparing current assets with
the current liabilities. It is expressed in the form of a pure ratio.
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑨𝒔𝒔𝒆𝒕𝒔
B. Formula: 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑹𝒂𝒕𝒊𝒐 = 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔
C. Components:
Current Assets will include:
(i) Cash and Bank balances
(ii) Sundry Debtors
(iii)Accrued income
(iv) Bills Receivable
(v) Marketable investments
(vi) Closing stocks of
- Raw Material
- Work in progress
- Finished goods
- Stores & spare parts
Pre-Payments (i.e. Pre-paid expenses & Advance tax)
Current Liabilities will include:
(i) Sundry creditors
(ii) Bills payable
(iii)Outstanding Expenses
(iv) Unclaimed dividends
(v) Provision for taxation
(vi) Proposed dividend
(vii) Advance received
(viii) Bank overdraft
Dr. Anupama Gawde,
Head, Department of Accountancy,
S. N. College of Arts and Commerce Page 1
D. Example:
Current assets of a company are ₹4,50,000 and on the same date, current liabilities are
₹2,05,000. Then-
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 4,50,000
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑅𝑎𝑡𝑖𝑜 𝑤𝑖𝑙𝑙 𝑏𝑒 = = = 2.20 ∶ 1
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 2,05,000
E. Interpretation:
This ratio of 2.20:1, indicates that of every one rupee of current liability, the company has
₹2.20 in the form of current assts. In other words, it means that after paying current liability of
₹1 out of current assets of ₹2.20, company will have working capital of ₹1.20
F. Importance:
1. Measure of solvency:
This ratio measures the ability of the business to meet its short-term obligations e.g. a company
having current assets of ₹1,80,000 and current liabilities of ₹,2,20,000 will have current ratio
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑨𝒔𝒔𝒆𝒕𝒔
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑹𝒂𝒕𝒊𝒐 =
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔
1,80,000
= = 0.82 ∶ 1
2,20,000
1. This ratio is not satisfactory because it indicates that the company does not have
sufficient current assets to pay its short-term obligations.
2. Situation will become dangerous if some of the debtors turn bad or if stock is not
saleable.
3. Because of non-payment of current liabilities, it will be difficult for the company to get
further credit on purchases. Ultimately it may lead to insolvency of the company.
4. This ratio is therefore called a solvency ratio. It measures the short-term solvency of the
company.
2. Adequacy of working capital:
This ratio is also used for judging the adequacy of working capital. E.g. when current ratio is 2.20:1
it means after payment of current liabilities of ₹1 surplus current assets will be ₹1.20 (i.e. ₹2.20-1)
This ratio emphasises the fact that amount or quantum of working capital is not important.
Comparison of current assets with current liabilities is more significant.
Dr. Anupama Gawde,
Head, Department of Accountancy,
S. N. College of Arts and Commerce Page 2
G. Standard Ratio:
Current ratio 2:1 is regarded as standard current ratio. It means under ideal conditions; current assets
should be twice the amount of current liabilities. 2:1 ratio is considered safe because even if current
assets realise only half of its value the company will be able to meet its current obligations fully.
2. Liquid Ratio Or Quick Ratio or Acid Test Ratio
A. Introduction
Liquid ratio is also known as Acid Test Ratio or near money ratio or ‘1 to 1’ ratio. This ratio is designed
to indicate liquid financial position of an enterprise. Thus the ratio shows the firms’ ability to meet its
immediate obligations promptly. It measures the relationship between Quick assets and Quick liabilities.
𝑸𝒖𝒊𝒄𝒌 𝑨𝒔𝒔𝒆𝒕𝒔
H. Formula: 𝑸𝒖𝒊𝒄𝒌 𝑹𝒂𝒕𝒊𝒐 = 𝑸𝒖𝒊𝒄𝒌 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔
A. Components:
Quick Assets = Current Assets Less Closing stock less Pre-payments(Prepaid expenses, Advance
Tax, Advance for Goods etc)
Quick assets would include:
a) Cash and Bank
b) Debtors
c) Accrued income
d) Bills receivable
e) Marketable Investments
Quick Liabilities = Current Liabilities Less Bank overdraft- Income received in advance
Quick liabilities would include:
a) Sundry creditors
b) Bills payable
c) Provision for taxation
d) Unclaimed dividend & proposed dividend
e) Outstanding expenses
f) Advance received.
Dr. Anupama Gawde,
Head, Department of Accountancy,
S. N. College of Arts and Commerce Page 3
Example:
Current assets of a company are ₹5,000,000 and on the same date, current liabilities are
₹6,00,000, Stock 1,00,000 and Bank Overdraft -2,50,000.
Calculate Current Ratio and Quick Ratio
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 5,00, ,000
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑅𝑎𝑡𝑖𝑜 𝑤𝑖𝑙𝑙 𝑏𝑒 = = = 0.83 ∶ 1
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 6,00,000
𝑄𝑢𝑖𝑐𝑘 𝑎𝑠𝑠𝑒𝑡𝑠 4,00,000
𝑄𝑢𝑖𝑐𝑘 𝑅𝑎𝑡𝑖𝑜 𝑤𝑖𝑙𝑙 𝑏𝑒 = = = 1.14: 1
𝑄𝑢𝑖𝑐𝑘 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 3,50,000
Quick Assets = Current Assets – Stock = 5,00,000 – 1,00,000 = 4,00,000
Quick Liabilities = Current Liabilities – Bank Overdraft = 6,00,000 – 2,50,000 = 3,50,000
B. Interpretation:
Company’s current ratio is 0.83:1 which is below the standard ratio of 2:1 which shows that working
capital position is not satisfactory. But Quick ratio of 1.14:1 means every rupee of a quick liability; the
company has got ₹1.14 in the form of quick assets. So, company can pay all immediate liabilities out of
its liquid assets.
C. Standard Quick Ratio:
a. Quick ratio of 1:1 is considered quite satisfactory implying that quick assets of the company
should at least be equal to quick liabilities.
b. Quick ratio considers only liquid assets. All quick assets can be converted into cash at any time.
So quick liabilities can be paid out of quick assets as and when they arise.
c. Margin, in the form of greater quick assets than quick liabilities is therefore not required.
Dr. Anupama Gawde,
Head, Department of Accountancy,
S. N. College of Arts and Commerce Page 4
3. Proprietary Ratio / Net worth to Total Assets Ratio / Equity Ratio
A. Introduction
Proprietary ratio measures the long-term solvency of the company. It compares proprietor’s funds with
total liabilities (or total assets). This ratio measures the extent of proprietor’s investment in total assets
of business. It is usually expressed in the form of percentage. It is also known as Asset Backing Ratio.
B. Formula:
𝑃𝑟𝑜𝑝𝑟𝑖𝑒𝑡𝑜𝑟𝑠 ′ 𝐹𝑢𝑛𝑑𝑠 𝑜𝑟 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ′ 𝐹𝑢𝑑
𝑃𝑅𝑂𝑃𝑅𝐼𝐸𝑇𝑂𝑅𝑌 𝑅𝐴𝑇𝐼𝑂 = 𝑥 100
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
C. Components:
Proprietors’ Funds will include
Share Capital
(a) Paid up Equity capital
(b) Paid up preference capital
Add: Reserves & Surplus
Less: Fictitious Assets like Miscellaneous Expenditure not written off.
Accumulated losses –Profit and Loss A/c (Dr. Balance)
Total Assets = Total Liabilities = Total of the Balance Sheet excluding fictitious assets & Accumulated
losses (if any) or
Total Assets = Total Fixed Assets + Investment + Total Current Assets
D. Example
From the following information calculate proprietary ratio of A ltd.
₹
Equity Share Capital 1,30,000
Preference Share Capital 50,000
Reserves 20,000
Current Assets 1,00,000
Fixed Assets 2,00,000
Dr. Anupama Gawde,
Head, Department of Accountancy,
S. N. College of Arts and Commerce Page 5
𝑃𝑟𝑜𝑝𝑟𝑖𝑒𝑡𝑜𝑟𝑠 ′ 𝐹𝑢𝑛𝑑𝑠 𝑜𝑟 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ′ 𝐹𝑢𝑑
𝑃𝑅𝑂𝑃𝑅𝐼𝐸𝑇𝑂𝑅𝑌 𝑅𝐴𝑇𝐼𝑂 = 𝑥 100
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
= 200,000 X 100 = 66.66% = 67%
3,00,000
E. Interpretation:
The above ratio means 67% of the total assets are finance out of Proprietors’ Funds and balance 33% are
finance by outsiders.
F. Standard Proprietary Ratio:
Standard proprietary ratio, depends upon the management policy for capital structure. It can be said that
approximately 65% to 75% of the total assets should be financed out of proprietors’ funds.
4. Debt – Equity Ratio :
A. Introduction:
This ratio compares long-term debt with shareholder’s equity, Debt-equity ratio helps us to comment on
the capital structure of the company.
It is usually expressed as a pure ratio
B. Formula
This ratio is calculated in two-ways
𝑫𝒆𝒃𝒕 𝑫𝒆𝒃𝒕
𝑶𝒓
𝑬𝒒𝒖𝒊𝒕𝒚 𝑫𝒆𝒃𝒕 + 𝑬𝒒𝒖𝒊𝒕𝒚
Both ways are acceptable. Students should interpret the ratio according to the formula used.
C. Components:
Debt includes
(a) Debentures
(b) Long-term loans
Equity includes:
(a) Equity share capital
(b) Preference share capital
Add: Reserves & Surplus
Less: Fictitious Assets(Profit & Loss A/c Dr. Balance (loss)
Less: ( Miscellaneous Expenditure not written off)
Dr. Anupama Gawde,
Head, Department of Accountancy,
S. N. College of Arts and Commerce Page 6
D. Example:
From the following information, compute Debt – Equity Ratio of A ltd.
₹
5% Debentures 6,00,000
8% Preference capital 3,00,000
Equity capital 5,00,000
𝐷𝑒𝑏𝑡 𝐷𝑒𝑏𝑡
𝑫𝒆𝒃𝒕 − 𝒆𝒒𝒖𝒊𝒕𝒚 𝑹𝒂𝒕𝒊𝒐 = 𝑜𝑟
𝐸𝑞𝑢𝑖𝑡𝑦 𝐷𝑒𝑏𝑡 + 𝐸𝑞𝑢𝑖𝑡𝑦
6,00,000 6,00,000
= 𝑜𝑟
3,00,000 + 5,00,000 6,00,000 + 3,00,000 + 5,00,000
6,00,000 6,00,000
= 𝑜𝑟
8,00,000 14,00,000
= 0.75 𝑜𝑟 0.43
E. Interpretation
Debt – equity ratio shows the long-term financial policy followed by the concern. It tells us about the
dependence of the concern on outside finance.
5. Stock Working Capital Ratio:
A. Introduction:
This ratio expresses the relationship between the closing stock and the working capital. It helps to judge
the quantum of inventories in relation to the working capital of the business. It is expressed as a
percentage.
B. Formula
𝑺𝑻𝑶𝑪𝑲
𝑺𝑻𝑶𝑪𝑲 − 𝑾𝑶𝑹𝑲𝑰𝑵𝑮 𝑪𝑨𝑷𝑰𝑻𝑨𝑳 𝑹𝑨𝑰𝑻𝑶 = 𝑿 𝟏𝟎𝟎
𝑾𝑶𝑹𝑲𝑰𝑵𝑮 𝑪𝑨𝑷𝑰𝑻𝑨𝑳
C. Components:
Stock would mean Closing stock.
Working capital = Current Assets Less Current Liabilities
Dr. Anupama Gawde,
Head, Department of Accountancy,
S. N. College of Arts and Commerce Page 7
D. Example:
If inventory is ₹70,000 and working capital ₹1,00,000 the stock – working capital ratio would be
𝑆𝑡𝑜𝑐𝑘 70,000
= 𝑥 100 = 𝑥 100 = 70%
𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 1,00,000
E. Interpretation:
a. If stock-working capital ratio is 70%, it means 70% of the working capital is blocked in stocks
and 30% in other liquid assets.
b. This ratio indicates the quality of working capital. If investment in stock is higher it means
balance working capital in liquid assets is lower and vice versa.
c. Every organisation needs working capital for smooth functioning of business. It is therefore
necessary that working capital should not be locked up in stocks, specially not in slow moving or
obsolete stocks.
d. Heavy inventories can lead to failure of business. So, each business must establish a fixed
relationship between the inventory and the working capital.
F. Standard Ratio:
The standard stock working capital ratio differs from industry to industry.
Stock working capital ratio should be less than 100%. Exceeding 100% shows unsatisfactory liquidity
position as funds are blocked up in stock which may not be saleable in time to pay off the creditors and bad
inventory management.
6. Capital Gearing Ratio / Capital Structure Ratio:
A. Introduction:
Capital Gearing Ratio brings out the relationship between two types of capital. Capital carrying fixed
rate of interest or fixed dividend and capital that does not carry fixed rate of interest or fixed dividend.
This ratio is also known as Leverage ratio. This ratio shows the relationship between two types of capital
(i) Equity capital including reserve and
(ii) Preference capital and Loan Fund(Long-term borrowings).
Dr. Anupama Gawde,
Head, Department of Accountancy,
S. N. College of Arts and Commerce Page 8
B. Formula:
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑛𝑡𝑖𝑡𝑙𝑒 𝑡𝑜 𝐹𝑖𝑥𝑒𝑑 𝑅𝑎𝑡𝑒 𝑜𝑓 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑜𝑟 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐺𝑒𝑎𝑟𝑖𝑛𝑔 𝑅𝑎𝑡𝑖𝑜 =
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑛𝑜𝑡 𝑠𝑜 𝐸𝑛𝑡𝑖𝑡𝑙𝑒𝑑 𝑡𝑜 𝐹𝑖𝑥𝑒𝑑 𝑅𝑎𝑡𝑒 𝑜𝑓 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑜𝑟 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑
C. Components:
Capital entitled to fixed interest or dividend =
Preference capital
+ Debentures
+ Long term loans.
Capital not entitled to fixed interest or dividend =
Equity capital
+ Reserves & surplus
- Profit & Loss A/c Dr. Balance
- Fictitious Assets
D. Example:
The following are the relevant extracts from Balance sheet of X Ltd. as on 30th June, 2018. Compute the
capital gearing ratio:
Liabilities ₹
8,000 Equity shares of ₹10 each fully paid 80,000
9% Preference shares of ₹100 each fully paid 1,50,000
Share premium A/c 10,000
Capital Reserve 16,000
10% Debentures 50,000
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑛𝑡𝑖𝑡𝑙𝑒 𝑡𝑜 𝐹𝑖𝑥𝑒𝑑 𝑅𝑎𝑡𝑒 𝑜𝑓 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑜𝑟 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐺𝑒𝑎𝑟𝑖𝑛𝑔 𝑅𝑎𝑡𝑖𝑜 =
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑛𝑜𝑡 𝑠𝑜 𝐸𝑛𝑡𝑖𝑡𝑙𝑒𝑑 𝑡𝑜 𝐹𝑖𝑥𝑒𝑑 𝑅𝑎𝑡𝑒 𝑜𝑓 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑜𝑟 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑
𝑃𝑟𝑒𝑓𝑟𝑒𝑛𝑐𝑒 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 + 𝐷𝑒𝑏𝑒𝑛𝑡𝑢𝑟𝑒𝑠 + 𝐿𝑜𝑎𝑛
𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝑮𝒆𝒂𝒓𝒊𝒏𝒈 𝑹𝒂𝒕𝒊𝒐 =
𝐸𝑞𝑢𝑖𝑡𝑦 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 + 𝑅𝑒𝑠𝑒𝑟𝑣𝑒 𝑎𝑛𝑑 𝑆𝑢𝑟𝑝𝑙𝑢𝑠 − 𝐹𝑖𝑐𝑡𝑖𝑡𝑖𝑜𝑢𝑠 𝐴𝑠𝑠𝑒𝑡𝑠
1,50,00 + 50,000 2,00,000
= = 1.89
80,000 + 10,000 + 16,000 1,06,000
Dr. Anupama Gawde,
Head, Department of Accountancy,
S. N. College of Arts and Commerce Page 9
E. Interpretation
a. The above ratio of 1.89 means for every one rupee of Equity share holder’s funds, company has
₹1.89 of fixed interest-bearing securities; so, the company is highly geared.
b. This ratio indicates the extent of trading on equity. Equity share capital is held as a base for
getting more finance in the form of debentures or preference capital.
c. In other words, the technique of raising finances for the company by resorting to fixed interest or
dividend bearing securities is called gearing of capital.
d. If capital carrying fixed rate of interest o interest or dividend is greater than equity capital, then
capital structure of the company is said to be highly geared.
e. On the other hand, if Equity capital including reserves is higher than the preference capital and
debentures, the capital is said to low geared.
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Dr. Anupama Gawde,
Head, Department of Accountancy,
S. N. College of Arts and Commerce Page 10
