What is a ratio and why use it?
An accounting ratio is a mathematical relation between two related items of financial statements. It can be shown as a pure ratio (2 : 1), a percentage (40%) or a rate (6 times).
Uses: simplifies data, shows trends, helps compare firms, and signals strengths and weaknesses. Limits: based on past data, affected by accounting choices and price changes, and ignores quality factors.
Liquidity ratios
Current ratio = Current assets ÷ Current liabilities. Ideal about 2 : 1.
Quick (liquid) ratio = Quick assets ÷ Current liabilities, where Quick assets = Current assets − Inventories − Prepaid expenses. Ideal about 1 : 1.
A very high ratio may mean idle money; a very low ratio means trouble paying bills.
Solvency ratios
- Debt-equity ratio = Long-term debts ÷ Shareholders' funds. Safe up to about 2 : 1.
- Total assets to debt ratio = Total assets ÷ Long-term debts. Higher = safer for lenders.
- Proprietary ratio = Shareholders' funds ÷ Total assets. Higher = owners fund more.
- Debt to capital employed = Long-term debts ÷ Capital employed (long-term debts + shareholders' funds).
- Interest coverage ratio = Net profit before interest and tax ÷ Interest on long-term debt. Higher = interest is safer.
Shareholders' funds = Share capital + Reserves and surplus. Capital employed = Shareholders' funds + Long-term debts (or Non-current assets + Working capital).
Activity (turnover) ratios
- Inventory turnover = Cost of revenue from operations ÷ Average inventory. Cost of revenue = Revenue − Gross profit (or Opening stock + Purchases + Direct expenses − Closing stock).
- Trade receivables turnover = Net credit revenue ÷ Average trade receivables (debtors + bills receivable). Average collection period = 12 months (or 365 days) ÷ turnover.
- Trade payables turnover = Net credit purchases ÷ Average trade payables. Average payment period = 365 ÷ turnover.
- Fixed asset turnover = Revenue from operations ÷ Net fixed assets.
- Net asset (capital employed) turnover = Revenue from operations ÷ Capital employed.
- Working capital turnover = Revenue from operations ÷ Working capital (Current assets − Current liabilities).
Average = (Opening + Closing) ÷ 2. Answer in 'times'.
Profitability ratios
- Gross profit ratio = Gross profit ÷ Revenue from operations × 100.
- Operating ratio = (Cost of revenue + Operating expenses) ÷ Revenue × 100.
- Operating profit ratio = Operating profit ÷ Revenue × 100 = 100 − Operating ratio.
- Net profit ratio = Net profit (after tax) ÷ Revenue × 100.
- Return on investment (ROI / return on capital employed) = Net profit before interest and tax ÷ Capital employed × 100.
Operating expenses = office, administration, selling and distribution expenses, depreciation, employee benefits (not finance costs or losses on sale of assets).
Key formulas and definitions
- Current ratio = Current assets ÷ Current liabilities
- Quick ratio = (Current assets − Inventories − Prepaid expenses) ÷ Current liabilities
- Debt-equity = Long-term debts ÷ Shareholders' funds
- Total assets to debt = Total assets ÷ Long-term debts
- Proprietary ratio = Shareholders' funds ÷ Total assets
- Debt to capital employed = Long-term debts ÷ (Long-term debts + Shareholders' funds)
- Interest coverage = PBIT ÷ Interest on long-term debt
- Inventory turnover = Cost of revenue ÷ Average inventory
- Trade receivables turnover = Credit revenue ÷ Average trade receivables
- Trade payables turnover = Credit purchases ÷ Average trade payables
- Fixed asset turnover = Revenue ÷ Net fixed assets
- Net asset turnover = Revenue ÷ Capital employed
- Working capital turnover = Revenue ÷ (Current assets − Current liabilities)
- GP ratio = GP ÷ Revenue × 100; Operating ratio = (Cost of revenue + Operating expenses) ÷ Revenue × 100
- Operating profit ratio = 100 − Operating ratio; NP ratio = NP ÷ Revenue × 100
- ROI = PBIT ÷ Capital employed × 100
Worked examples
1. Current assets ₹4,00,000 (inventory ₹1,40,000, prepaid ₹10,000); current liabilities ₹2,00,000. Current and quick ratio.
Current = 2 : 1. Quick assets = 2,50,000 → 1.25 : 1.
2. Share capital ₹5,00,000, reserves ₹1,00,000, 10% debentures ₹3,00,000, total assets ₹11,00,000. Debt-equity, total assets to debt, proprietary ratio.
SHF 6,00,000. D/E = 0.5 : 1. TA/Debt = 3.67 : 1. Proprietary = 6/11 = 0.55 : 1.
3. Same firm: debt to capital employed.
3,00,000 ÷ 9,00,000 = 0.33 : 1.
4. Net profit after tax ₹1,80,000; tax ₹60,000; debenture interest ₹30,000. Interest coverage.
PBIT = 1,80,000 + 60,000 + 30,000 = 2,70,000 ÷ 30,000 = 9 times.
5. Revenue ₹15,00,000; GP 40%; opening inventory ₹1,40,000; closing ₹1,60,000. Inventory turnover.
Cost of revenue 9,00,000; average inventory 1,50,000 → 6 times.
6. Credit revenue ₹12,00,000; debtors: opening ₹1,80,000, closing ₹2,20,000; bills receivable ₹0. Receivables turnover and collection period.
Average 2,00,000 → 6 times; 12 ÷ 6 = 2 months.
7. Revenue ₹15,00,000; net fixed assets ₹7,50,000; capital employed ₹10,00,000; working capital ₹2,50,000. Fixed asset, net asset, working capital turnover.
2 times; 1.5 times; 6 times.
8. Revenue ₹15,00,000; cost of revenue ₹9,00,000; operating expenses ₹3,00,000; NP ₹1,80,000; PBIT ₹2,70,000; capital employed ₹9,00,000. All profitability ratios.
GP 40%; operating ratio 80%; operating profit ratio 20%; NP 12%; ROI 30%.
Common mistakes
- Taking total debts instead of long-term debts in debt-equity.
- Forgetting to remove prepaid expenses from quick assets.
- Using revenue instead of cost of revenue in inventory turnover.
- Using net profit after tax in ROI and interest coverage; both need profit before interest and tax.