4 Main Types of Accounting Ratios

The following points highlight the four main types of accounting ratios. The types are: 1. Return on Investment 2. Profitability Ratios 3. Return on Proprietors’ Funds 4. Return on Equity Capital.

Accounting Ratios: Type # 1. Return on Investment:

Profitability or the Return on Investment is the basic casual ratio. It is ascertained by a comparison of profit earned and capital employed to earn it. The resultant ratio, usually expressed as a percentage, is called Rate of Return or Net Profit to Capital employed or, more commonly, Return on Investment. The purpose is to ascertain how much income, use of Rs 100 of capital generates.

Therefore, for this purpose:—

(i) Capital employed means total capital including that borrowed from outsiders but excluding non-trading assets; in other words, it means the total of net fixed assets (that is, fixed assets less depreciation) and working capital (that is, current assets less current liabilities).

Taking the liabilities side, it would include share capital, both equity and preference, reserves and debentures less non-trading and fictitious assets [See Note (1) below].

(ii) Net profit should mean operating profit before interest, tax on profits and dividends; income- tax is not considered because its incidence is not at all certain—the income-tax rates can be changed almost at will by the Government. However, most authorities calculate the Rate of Return on the basis of profit after tax.

[Notes: (1) There is no unanimity about the term, ‘capital employed’ or even the profit earned. Capital employed may mean any one of the following:—

(i) Net fixed assets + working capital.

(ii) Net fixed assets + current assets.

(iii) Gross fixed assets + current assets,

(iv) Gross fixed assets + working capital.

Most people use (i) as the meaning of capital employed but one must always specify how capital employed has been arrived at. Similarly one must state what the figure of profit used really signifies.

(2) The ratio judges the overall performance of the concern. The rate of return from the point of view of equity shareholders, however, is different since for them profit including non-operating income, after income-tax and preference dividend, is relevant.

They are interested in the following ratio:

Net Profit/Sales is the net margin on sales; and Sales/Capital is the turnover of capital. Using common-sense also, one can see that the total profit earned is a function of both the factors—the difference between selling price and the costs as well as the quantum and rapidity of sales.

Hence, the return on investment may be expressed as net margin on sales (percentage) x rate of turnover of capital (showing the effectiveness with which the resources at the disposal of the firm are being used).

Consider Are following figures:—

Through Company B does not have the highest margin on sales, it has the highest return on investment because of (more than proportionate) better utilisation of the facilities for effecting sales, probably brought about by offering price concessions to customers.

Company C has the best utilisation but, due to a very low margin on sales, its return on investment is also the lowest. Thus, one has to pay attention to both the factors to optimise the return on investment.

In other words, the management must:

(i) Fix selling prices, at a level where higher sales will be encouraged but not at the cost of total profit;

(ii) Control operating cost; and

(iii) Ensure optimum utilisation of the facilities so as to ensure maximum production and sales consistent with adequate profit margins.

The ratios given below will indicate whether points (i) and (ii) above are being given adequate attention.

Accounting Ratios: Type # 2. Profitability Ratios:

The figures in the Profit and Loss Account (including the Trading Account) enable one to calculate a number of ratios.

The most important of these are the following:—

(i) Gross Profit Ratio:

This is the most common ratio calculated. The method is Gross Profit X 100/Sales. A major change in this ratio over a period of years should be investigated— the change may be due to a change in the economic situation (changes in costs without a change in selling price or vice versa) or due to errors or due to a change in the basis of accounting—say, valuing stock on a different basis.

For comparison over a number of years, the method of calculating gross profit should not change and, if the figures for a number of firms are to be compared, the firms should follow the same accounting system and practice. Of course, higher the gross profit ratio, the better.

(ii) Net Profit Ratio (or Margin):

These measures the rate of net profit earned on sales. The profit is usually only the operating profit, that is, income from non-trading assets and expenses, which do not relate to trading or manufacturing, are not included.

The ratio is calculated as:

Higher the ratio the better it is, but what has been said above in regard to gross profit ratio should be kept in mind.

Some firms calculate the ratio on the basis of net profit after deducting the tax payable on the profit but this is not the usual practice.

(iii) Operating Ratio:

This ratio measures the extent of costs incurred for making the sale. It is ascertained as:

Cost of goods sold plus all other operating expenses, i.e., manufacturing, administrative and selling expenses

Operating ratio plus net profit ratio is 100 — obviously the two ratios are interrelated. A rise in the operating ratio indicates a decline in efficiency; lower the ratio, the better it is. Operating ratio should be analysed further—in fact such an analysis will throw good light on the levels of efficiency prevailing in different aspects of the work.

The ratios that analyse the operating ratio are the following:

The total of these four ratios will be equal to the operating ratio. Since revenue expenditure may be either fixed or variable, it is also useful to work out ratios of fixed and variable expenses to sales separately.

The ratio of variable cost to sales will and should remain constant—a reduction in it indicates efficiency and a rise in it is a sigh of declining efficiency unless it is due to changes in prices such as material prices and wage rates.

It should be noted that the ratio 1—Variable costs/Sales is the same as cost-volume profit ratio, measuring the effect on profit of a given change in sales. Suppose, the figures for a firm for the year ended 31st March, 2001 are as follows:—

The ratio of variable costs to sales is 0.6, i.e., 30,00,000/50,00,000. The cost-volume profit ratio is 0.4, i.e., 1 – 0.6, indicating that out of every rupee of sale, 40 paise will be left for meeting fixed expenses and for profit since 60 paise will be spent for producing the sale of one rupee. If sales increase by Rs 5 lakh, the profit will be Rs 7,00,000, as shown below:

The increase in profit is Rs 2,00,000 which is equal to Rs 5,00,000 (the increase in sales) x 0.4. That is why this ratio is called the cost-volume profit ratio.

The ratio of fixed expenses to sales should decline when sales increase, since an increase in sales should not lead to an increase in fixed expenses. Also, since a fall in sales cannot result in a saving in fixed expenses, a reduction in sales will be accompanied by an increase in the fixed expenses ratio.

There is inefficiency if the fixed expenses ratio does not decline when sales go up and there is efficiency when a decline in sales is not accompanied by a rise in the fixed expenses ratio.

Accounting Ratios: Type # 3. Return on Proprietors’ Funds:

This ratio is also called Return on Shareholders’ Funds or Return on Shareholders’ Investment.

It shows the relationship between net profits after interest and tax and the proprietors’ funds or shareholders’ funds. Proprietors’ funds include equity share capital, preference share capital, all the reserves (capital redemption reserve, capital reserve, securities premium account, general reserve, credit balance of profit and loss appropriation account etc.) less accumulated losses and miscellaneous expenditure not yet written off (preliminary expenses, underwriting commission, discount on issue of shares or debentures, interest paid out capital etc.).

The formula to calculate this ratio is as follows:-

In this ratio, the net profits which are taken into consideration are the net profits arrived at after deducting interest on the borrowings and income tax. These are the net profits which are available to the shareholders. This ratio tells us the rate at which net profits have been earned on proprietors’ funds.

Accounting Ratios: Type # 4. Return on Equity Capital:

In a joint stock company, equity shareholders bear the greatest risks. Preference shareholders enjoy a preference over the equity shareholders both in the payment of dividend and return of capital. However, they are entitled to a fixed rate of dividend even when the company earns profits at a very high rate.

High profitability of the company’s business benefits the equity shareholders only. The performance of the company will be judged by the equity shareholders on the basis of the return on equity capital of the company.

Return on equity capital is calculated as follows:

Return on Shareholders’ Total Equity:

Return on equity capital considers only paid-up equity share capital and ignores reserves, surplus etc. which belong to equity shareholders and are used to earn profits. An issue of bonus shares will bring down the return on equity capital without a decline in the profitability of the company’s business.

Return on Shareholders’ Total Equity does not suffer from this defect. Shareholders’ total equity means paid-up equity share capital plus reserves and surplus minus accumulated losses and miscellaneous expenditure not yet written off Return on Shareholders’ Total Equity is worked out as follows:

where Shareholders’ Total Equity = Paid-up Equity Share Capital + Reserves + Surplus – Debit balance of Profit and Loss Account (if any) – Miscellaneous Expenditure not yet written off (if any).

Thus, to the paid up equity share capital all items under Reserves and Surplus are added and from the total all items under ‘Miscellaneous Expenditure’ and debit balance of Profit and Loss Account is deducted to ascertain Shareholders’ Total Equity.

Earnings Per Share (E.P.S.):

This ratio measures profit after tax and preference dividend per equity share. It serves the same purpose as is served by return on equity capital whereas return on equity capital reveals profit on total paid-up equity share capital, earnings per share is another version of return on equity capital.

The formula to calculate earnings per share may be expressed as follows:

Earnings Per Share =

The Council of Institute of Chartered Accountants of India has issued Accounting Standard (AS) 20, ‘Earnings Per Share’. It is effective in respect of accounting periods commencing on or after 1.4.2001 and is mandatory in nature. According to it, an enterprise should show basic and diluted earnings per share in its income statement for each class of its equity shares.

Basic earnings per share is calculated by dividing the net profit for the year which is available to the equity shareholders by the weighted average number of equity shares outstanding during the year. Basic earnings = Net profit for the year after tax — preference dividend which pertains to the preference shareholders for the year – corporate dividend tax at the existing rate on the preference dividend so calculated.

Weighted/number of equity shares has to be calculated if new equity shares have been allotted during the year or there has been buyback of shares during the course of the year.

Suppose, in the beginning of an accounting year there are 18 lakh fully paid equity shares of Rs 10 each and after 4 months, 6 lakh fully paid equity shares of Rs 10 each are allotted for cash; then weighted average number of shares will have to be calculated which will be 18 lakh + (6 lakh x 8/12) =22 lakh.

If on the other hand instead of issuing fresh shares, the company buys back 3 lakh equity shares 4 months after the beginning of the accounting year, the weighted average number of shares will be 181akh-(3 1akh x 8/12) = 161akh.

If a company has issued convertible debentures or convertible preference shares, it will also be required to calculate diluted earnings per share. Let us assume a company has issued 1 lakh 12% debentures of Rs 100 each, each debenture being convertible into 10 equity shares of Rs 10 each.

It should be noted that before conversion, the company would incur an expenditure of Rs 12 lakh by way of interest on debentures and will not be paying income tax on the amount of interest, it being an allowable expense in Income Tax Act. No dividend is payable in respect of such debentures.

After conversion, the company will save interest on debentures but will pay income tax on the amount of interest saved. However, after conversion, dividend will have to be paid on 10 lakh equity shares resulting due to conversion.

Such debentures are recognised as potential equity shares. In such a case diluted earnings per share has also to be calculated and shown in the profit and loss account.