5. Analysis of Accounting Ratios, Liquidity Ratios, Profitability Ratios, Solvency Ratios, Efficiency Ratios, Market Ratios, Return on Investment Ratios, Different Ratios and their Formulas, Practice Questions for Understanding

In this post, Analysis of Accounting Ratios such as Liquidity Ratios, Profitability Ratios, Solvency Ratios, Efficiency Ratios, Market Ratios, Return on Investment Ratios, Different Ratios and their Formulas, Practice Questions for Understanding will be discussed with detail explanation.

Analysis of Accounting Ratios

Accounting ratios serve as numerical indicators that depict the correlation between diverse financial variables and figures within a company’s financial statements. These ratios play a crucial role in scrutinizing and appraising various facets of a company’s performance, financial well-being, and effectiveness. By offering valuable insights into the operational efficiency, profitability, liquidity, solvency, and overall financial stability of a company, these ratios aid in making informed decisions. The computation of accounting ratios involves dividing one financial metric by another, typically expressed as a percentage, ratio, or fraction. These ratios are further classified into distinct types based on the financial elements they evaluate. Some commonly observed categories of accounting ratios encompass:

Liquidity Ratios:

Liquidity ratios serve as financial indicators that assess a firm’s capacity to fulfill its immediate financial responsibilities and promptly convert its assets into cash. These ratios offer valuable insights into the company’s short-term financial well-being and its capability to address immediate obligations. Maintaining adequate liquidity is of utmost importance for businesses as it guarantees seamless operations, timely settlement of short-term debts, and effective management of unforeseen expenditures.

There are three types of liquidity ratios:

Current Ratio
Quick Ratio (Acid-Test Ratio)
Cash Ratio

Profitability Ratios:

Profitability ratios are financial indicators that measure a firm’s capacity to produce profits in relation to its expenditures and other outlays over a given timeframe. These ratios offer significant perspectives into a company’s financial performance and effectiveness. Profitability ratios are utilized by investors, creditors, and management to appraise a company’s triumph in generating profits and competently managing its resources.

Some of the commonly used profitability ratios include:

Gross Profit Ratio
Operating Profit Ratio
Net Profit Ratio
Operating Ratio
Expense Ratio
Return on Equity (ROE)
Return on Assets (ROA)

Solvency Ratios:

Solvency ratios are financial indicators that evaluate a firm’s capacity to sustain its long-term financial stability and fulfill its long-term debt responsibilities. These ratios offer valuable insights into the company’s overall financial framework, leverage, and its reliance on debt for funding its business activities. For creditors and investors, solvency ratios play a vital role in assessing the level of risk associated with a company’s ability to meet its long-term financial obligations. Below are a few commonly used solvency ratios:

Debt-to-Equity Ratio
Interest Coverage/Debt Service Ratio
Capital Gearing Ratio
Debts to Total Funds/Solvency Ratio
Reserves to Capital Ratio
Fixed Assets Ratio
Proprietary Ratio

Efficiency Ratios:

Efficiency ratios, also referred to as operational or activity ratios, gauge a company’s ability to utilize its resources and assets to generate income and sales. These ratios offer valuable insights into a company’s operational efficiency and effectiveness in managing its resources and assets. By examining efficiency ratios, stakeholders can evaluate a company’s capacity to optimize its inventory, working capital, and receivables, which can significantly impact its overall financial performance.

Here are some common efficiency ratios are:

Inventory Turnover Ratio
Inventory Conversion Period
Receivables/Debtors Turnover Ratio
Receivables/Debtors Collection Period
Payables/Creditors Turnover Ratio
Payables/Creditors Payment Period
Working Capital Turnover Ratio

Market Ratios:

Market ratios, also referred to as valuation ratios, are financial indicators that offer valuable insights into the market’s perception of a company’s stock. These ratios play a crucial role in assisting investors and analysts in evaluating the investment appeal of a company and its relative performance within the stock market. By comparing a company’s stock price to different financial metrics, such as earnings and book value, market ratios enable the assessment of its market value and growth potential.

Here are some common market ratios are:

Price-to-Earnings (P/E) Ratio
Earnings per Share (EPS)
Dividend Yield
Price to Book (P/B) Ratio
Market Capitalization
Dividend Payout Ratio

Return on Investment Ratios:

Return on Investment (ROI) ratios serve as financial indicators that gauge the profitability of an investment and evaluate its performance in relation to the initial investment amount. Widely utilized by investors and analysts, ROI is expressed as a percentage and plays a crucial role in assessing the effectiveness and triumph of an investment. Diverse forms of ROI ratios exist, each designed to cater to specific contexts and provide valuable insights.

The adaptability of ROI ratios is noteworthy as they can be utilized in a multitude of investment types such as stocks, real estate, projects, and business ventures. These ratios serve as a tool for investors to evaluate the performance of their investments, compare different investment opportunities, and make informed decisions regarding capital allocation. However, it is crucial to acknowledge that ROI solely measures investment profitability and disregards the time factor and risk associated with the investment. Hence, investors should supplement ROI analysis with other metrics and consider the investment’s risk profile, holding period, and other pertinent factors for a more comprehensive assessment. Here are some ratios given below:

Overall Profitability Ratio
Return on Shareholder’s Fund
Return on Gross Capital Employed
Return on Investment ROI

Different Ratios and their Formulas

Liquidity Ratios:

Current Ratio

$\mathbf{Current\ Ratio =}\frac{\mathbf{Current\ Assets}}{\mathbf{Current\ Liabilities}}\$

Quick Ratio/Absolute Liquid/ Acid-Test Ratio

$\mathbf{Absolute\ Liquid\ Ratio =}\frac{\mathbf{Absolute\ Liquid\ Assets}}{\mathbf{Current\ Liabilities}}\$

Cash Ratio

$\mathbf{Cash\ Ratio =}\frac{\mathbf{\ }\mathbf{Cash\ and\ Cash\ Equivalents}}{\mathbf{Current\ Liabilities}}\mathbf{\ }\$

Profitability Ratios:

Gross Profit Ratio

$\mathbf{Gross\ Profit\ Ratio =}\frac{\mathbf{Gross\ Profit}}{\mathbf{Net\ Sales}}\mathbf{\ \times \ 100}\$

Operating Profit Ratio

$\mathbf{Operating\ Profit\ Ratio =}\frac{\mathbf{Operating\ Profit}}{\mathbf{Net\ Sales}}\mathbf{\times 100}\$

Net Profit Ratio

$\mathbf{Net\ Profit\ Ratio =}\frac{\mathbf{Net\ Profit}}{\mathbf{Net\ Sales}}\mathbf{\ \times \ 100}\$

Operating Ratio

$\mathbf{Operating\ Ratio =}\frac{\mathbf{Cost\ of\ Goods\ Sold + Operating\ Expenses}}{\mathbf{Net\ Sales}}\mathbf{\ \times \ 100}\$

Expense Ratio

$\mathbf{Expense\ Ratio =}\frac{\mathbf{Specific\ Expense}}{\mathbf{Net\ Sales}}\mathbf{\ \times \ 100}\$

Return on Equity (ROE)

$\mathbf{Return\ on\ Equity\ Ratio\ ROE =}\frac{\mathbf{Net\ Profit\ \ after\ Tax}}{\mathbf{Average\ Stockholde}\mathbf{r}^{\mathbf{'}}\mathbf{s\ Equity}}\mathbf{\ \times \ 100}\$

Return on Assets (ROA)

$\mathbf{Return\ on\ Assets\ Ratio\ ROA =}\frac{\mathbf{Net\ Income}}{\mathbf{Average\ Total\ Assets}}\mathbf{\ \times \ 100}\$

Solvency Ratios:

Debt-to-Equity Ratio

$\mathbf{Debt\ to\ Equity\ Ratio =}\frac{\mathbf{Long\ Term\ Debt}}{\mathbf{Equity}}\$

Interest Coverage/Debt Service Ratio

$\mathbf{Interest\ Coverage\ or\ Debt\ Coverage\ Ratio =}\frac{\mathbf{Earning\ Before\ Interest\ }\&\ Tax\ EBIT}{\mathbf{Fixed\ Interest\ Charges}}\$

Capital Gearing Ratio

$\mathbf{Capital\ Gearing\ Ratio =}\frac{\mathbf{Equity}}{\mathbf{Fixed\ cost\ bearing\ securities}}\$

Where Equity = Share Capital + Free Reserves + Profit

Where Fixed cost-bearing securities = Debentures + Long-term Loans

Debts to Total Funds/Solvency Ratio

$\mathbf{Debts\ to\ Total\ funds\ or\ Ratio =}\frac{\mathbf{Total\ Liabilities}}{\mathbf{Total\ Assets}}\$

Reserves to Capital Ratio

$\mathbf{Reserves\ to\ Capital\ Ratio =}\frac{\mathbf{Total\ Reserves}}{\mathbf{Capital}}\$

Fixed Assets Ratio

$\mathbf{Fixed\ Assets\ Ratio =}\frac{\mathbf{Net\ Fixed\ Assets}}{\mathbf{Long\ Term\ Funds}}\$

Proprietary Ratio

$\mathbf{Proprietory\ Ratio =}\frac{\mathbf{Share\ Holde}\mathbf{r}^{\mathbf{'}}\mathbf{s\ Fund}}{\mathbf{Total\ Assets}}\$

Efficiency Ratios:

Inventory/Stock Turnover Ratio

$\mathbf{Stock\ Turnover\ Ratio =}\frac{\mathbf{Cost\ of\ Sales}}{\mathbf{Average\ Stock}}\$

Inventory Conversion Period

$\mathbf{Average\ Age\ or\ Conversion\ Period\ of\ Inventory = \ }\frac{\mathbf{Days\ of\ the\ Year}}{\mathbf{Stock\ \ Turnover\ Ratio}}\$

Receivables/Debtors Turnover Ratio

$\mathbf{Debtors\ Turnover\ Ratio =}\frac{\mathbf{\ Net\ Credit\ Sales}}{\mathbf{Average\ Trade\ Debtors}}\$

Receivables/Debtors Collection Period

$\mathbf{Debtors\ Collection\ Period\ =}\frac{\mathbf{Average\ Total\ debtors}}{\mathbf{Net\ Credit\ Sales}}\mathbf{\times 365}\$

Payables/Creditors Turnover Ratio

$\mathbf{Creditors\ Turnover\ Ratio\ =}\frac{\mathbf{Net\ Credit\ Purchases}}{\mathbf{Average\ Total\ Creditors}}\$

Payables/Creditors Payment Period

$\mathbf{Average\ Payment\ Period\ =}\frac{\mathbf{Average\ Total\ Creditors}}{\mathbf{Net\ Credit\ Purchases}}\mathbf{\times 365}\$

Working Capital Turnover Ratio

$\mathbf{Wokring\ Capital\ Turnover\ Ratio\ =}\frac{\mathbf{Cost\ of\ Sales}}{\mathbf{Net\ Working\ Capital}}\$

Market Ratios:

Price-to-Earnings (P/E) Ratio

$\mathbf{Price\ Earning\ Ratio =}\frac{\mathbf{Market\ Price\ Per\ Share}}{\mathbf{Earning\ Per\ Share}}\$

Earnings per Share (EPS)

$\mathbf{Earning\ Per\ Share\ EPS =}\frac{\mathbf{Net\ Profit\ after\ giving\ Preferred\ Dividend}}{\mathbf{Number\ of\ Shares}}\$

Dividend Yield

$\mathbf{Dividend\ Yield = \ }\frac{\mathbf{Dividends\ per\ Share}}{\mathbf{Market\ Price\ per\ Share}}\$

Price to Book (P/B) Ratio

$\mathbf{Price\ to\ Book\ }\left( \frac{\mathbf{P}}{\mathbf{B}} \right)\mathbf{Ratio =}\frac{\mathbf{Market\ Price\ per\ Share}}{\mathbf{Book\ Value\ per\ Share}}\$

Market Capitalization

$\mathbf{Market\ Capitalization = \ }\mathbf{Market\ Price\ per\ Share\ \times \ Number\ of\ Outstanding\ Shares}\$

Dividend Payout Ratio

$\mathbf{Dividend\ Payout\ Ratio = \ }\frac{\mathbf{Dividends\ per\ Share}}{\mathbf{EPS}}\$

Return on Investment Ratios:

Overall Profitability Ratio

$\mathbf{Overall\ Profitability\ Ratio = \ }\frac{\mathbf{Operating\ Profit}}{\mathbf{Capital\ Employed}}\mathbf{\times 100}\$

Return on Shareholder’s Fund

$\mathbf{Return\ on\ Shareholde}\mathbf{r}^{\mathbf{'}}\mathbf{s\ Fund =}\frac{\mathbf{Net\ Profit\ after\ interest\ and\ Tax\ }}{\mathbf{Shareholde}\mathbf{r}^{\mathbf{'}}\mathbf{s\ Fund}}\mathbf{\times 100}\$

Return on Gross Capital Employed

$\mathbf{Return\ on\ Gross\ Capital\ Employed =}\frac{\mathbf{Net\ Profit\ before\ interest\ and\ Tax\ }}{\mathbf{Gross\ Capital\ Employed}}\mathbf{\times 100}\$

Return on Investment ROI

$\mathbf{Return\ on\ Investment\ ROI =}\frac{\mathbf{Net\ Profit\ before\ interest\ and\ Tax\ }}{\mathbf{Average\ Capital\ Employed}}\mathbf{\times 100}\$

Analysis of Accounting Ratios, Liquidity Ratios, Profitability Ratios, Solvency Ratios, Efficiency Ratios, Market Ratios, Return on Investment Ratios, Different Ratios and their Formulas, Practice Questions for Understanding

Practice Questions for Understanding

Practice Question 1

From the following balance sheet, calculate current ratio:

Liabilities	Rs.	Assets	Rs.
Equity Share Capital	150,000	Land & Building	100,000
Reserves & Surplus	50,000	Plant & Machinery	80,000
Debentures	60,000	Goodwill	20,000
Trade Creditors	6000	Cash	5,000
Bills Payable	5000	Investments (Short Term)	15,000
Bank Overdraft	5000	Bills Receivable	5,000
Outstanding expenses	1000	Sundry Debtors 22,000
Income Tax Payable	3000	Less Provision 2,000	20,000
Proposed Dividends	10,000	Inventories	30,000
		Work in Progress	15,000

	290,000		290,000

Solution:

$\mathbf{Current\ Ratio =}\frac{\mathbf{Current\ Assets}}{\mathbf{Current\ Liabilities}}\mathbf{=}\frac{\mathbf{90000}}{\mathbf{30000}}\mathbf{=}\frac{\mathbf{3}}{\mathbf{1}}\mathbf{= 3:1}\$

Calculation of Current Assets & Current Liabilities

Current Assets	Rs.	Current Liabilities	Rs.
Cash in hand	5000	Trade Creditors	6000
Stock	30,000	Bills Payable	5000
Investments	15,000	Bank Overdraft	5000
Sundry Debtors (Net)	20,000	Outstanding expenses	1000
Bills Receivable	5000	Income Tax Payable	3000
Work in Progress	15000	Proposed Dividends	10,000

Total	90,000	Total	30,000

Calculation of Current Assets & Current Liabilities

Practice Question 2

From the following balance sheet, calculate (i) Current Ratio (ii) Quick Ratio:

Liabilities	Rs.	Assets	Rs.
Equity Share Capital	200,000	Land & Building	80,000
General Reserve	90,000	Machinery	120,000
Sundry Creditors	60,000	Cash	10,000
Bills Payable	20,000	Bank	30,000
Bank Overdraft	30,000	Stock	140,000
Provision for Tax	5000	Short Term Investments	25,000
Proposed Dividend	10,000	Sundry Debtors 40,000
Outstanding Salaries	5000	Less Provision 4,000	36,000
Long Term Loans	60,000	Bills Receivable	10,000
		Prepaid Insurance	9,000
		Preliminary Expenses	20,000
	480,000		480,000

Solution:

Calculation of Current Assets & Current Liabilities

Current Assets	Rs.	Current Liabilities	Rs.
Cash	10,000	Sundry Creditors	60,000
Bank	30,000	Bills Payable	20,000
Stock	140,000	Bank Overdraft	30,000
Short Term Investments	25,000	Provision for Tax	5000
Sundry Debtors 40,000		Proposed Dividend	10,000
Less Provision 4,000	36,000	Outstanding Salaries	5000
Bills Receivable	10,000
Prepaid Insurance	9,000
Total	260,000	Total	130,000

Calculation of Current Assets & Current Liabilities

$\mathbf{Current\ Ratio =}\frac{\mathbf{Current\ Assets}}{\mathbf{Current\ Liabilities}}\mathbf{=}\frac{\mathbf{260,000}}{\mathbf{130,000}}\mathbf{=}\frac{\mathbf{2}}{\mathbf{1}}\mathbf{= 2:1}\$

$\mathbf{Quick\ Ratio =}\frac{\mathbf{Quick\ Assets}}{\mathbf{Current\ Liabilities}}\mathbf{=}\frac{\mathbf{111,000}}{\mathbf{130,000}}\mathbf{=}\frac{\mathbf{0.85}}{\mathbf{1}}\mathbf{= 0.85:1}\$

Quick Assets = Current Assets – (Stock + Prepaid Expenses) = 260,000 – (140,000 + 9000) = 111,000

Practice Question 3

From The following balance sheet calculate Absolute Liquid Ratio.

Liabilities	Rs.	Assets	Rs.
Share Capital	500,000	Goodwill	50,000
Reserves	190,000	Plant & Machinery	400,000
Bank Overdraft	100,000	Trade Investments	200,000
Sundry Creditors	140,000	Marketable Securities	150,000
Bills Payable	50,000	Bills Receivable	40,000
Outstanding Expenses	10,000	Cash	45,000
		Bank	30,000
		Inventories	75,000

	9,90,000		9,90,000

Solution:

$\mathbf{Absolute\ Liquid\ Ratio =}\frac{\mathbf{Absolute\ Liquid\ Assets}}{\mathbf{Current\ Liabilities}}\mathbf{=}\frac{\mathbf{225000}}{\mathbf{300000}}\mathbf{=}\frac{\mathbf{0.75}}{\mathbf{1}}\mathbf{= 0.75:1}\$

W 1: Absolute Liquid Assets = Marketable Securities + Cash in Hand + Cash at Bank = 150,000 + 45,000 + 30,000 = 225000

W 2: Calculation of Current Liabilities

Current Liabilities	Rs.
Bank Overdraft	100,000
Sundry Creditors	140,000
Bills Payable	50,000
Outstanding Expenses	10,000
Total	300,000

Practice Question 4

From the following balance sheet of X Ltd.; as on December 31, 2001 calculate (a) current ratio (b) acid test ratio (c) absolute liquid ratio

Liabilities	Rs.	Assets	Rs.
Equity Share Capital	10,00,000	Cash & bank	48600
General Reserve	100,000	Marketable Securities	82000
Profit & Loss account	217,000	Stock	272800
Secured Debentures	250,000	Debtors	523000
Trade Creditors	405750	Bills Receivable	22600
Bills Payable	18000	Advance Tax	100000
Provision for Taxation	264000	Land & building	800000
Bank Overdraft	52000	Plant & Machinery	544000
Proposed Dividend	86250


	23,93,000		23,93,000

Solution:

Working 1: Current Assets & Current Liabilities

Current Assets	Rs.	Current Liabilities	Rs.
Cash & bank	48600	Trade Creditors	405750
Marketable Securities	82000	Bills Payable	18000
Stock	272800	Provision for Taxation	264000
Debtors	523000	Bank Overdraft	52000
Bills Receivable	22600	Proposed Dividend	86250
Advance Tax	100000


Total	1049,000	Total	8,26,000

Working 2: Absolute Liquid Assets

Absolute Liquid Assets = Marketable Securities + Cash & Bank =82,000 + 48600 =130,600

Working 3: Liquid Assets

Liquid Assets = Current Assets – (Stock + Prepaid Expenses)

Liquid Assets = 1049000 – (272800 + 100,000) = 676,200

$\left( \mathbf{a} \right)\mathbf{Current\ Ratio =}\frac{\mathbf{Current\ Assets}}{\mathbf{Current\ Liabilities}}\mathbf{=}\frac{\mathbf{1049000}}{\mathbf{826000}}\mathbf{= 1.27:1}\$

$\left( \mathbf{b} \right)\mathbf{Acid\ Test\ Ratio =}\frac{\mathbf{Liquid\ Assets}}{\mathbf{Current\ Liabilities}}\mathbf{=}\frac{\mathbf{6762000}}{\mathbf{826000}}\mathbf{= 0.82:1}\$

$\left( \mathbf{c} \right)\mathbf{Absolute\ Liquid\ Ratio =}\frac{\mathbf{Absolute\ Liquid\ Assets}}{\mathbf{Current\ Liabilities}}\mathbf{=}\frac{\mathbf{130600}}{\mathbf{826000}}\mathbf{= 0.16:1}\$