5 Main Classification of Ratios (With Formula)| Financial Accounting

This classification is based on the purpose for which an analyst computes these ratios. For easy understanding and to achieve the purpose of ratios effectively, ratios may be classified as:- 1. Profitability Ratios 2. Coverage Ratios 3. Turnover Ratios/Activity Ratio 4. Financial Ratios/Liquidity Ratio 5. Leverage Ratios/Long-Term Solvency Ratios.

These are discussed one by one below:

1. Profitability Ratios:

The primary objective of any business undertaking is to earn profits. Profit-making is essential for its survival and existence, but also for its expansion and diversification. In the words of Lord Keynes, “Profit is the engine that drives the business enterprise.”

Profits are, thus, a useful measure of overall efficiency or performance of a business. Profits to the management are the test of efficiency and a measurement of control. Generally, profitability ratios are calculated either in relation to sales or in relation to investment.

The various profitability ratios are generally classified into:

(a) General profitability ratios

(b) Overall profitability ratios

(a) General Profitability Ratios:

i. Gross Profit Ratio:

This ratio measures the relationship of gross profit to net sales and is usually represented as a percentage.

Gross profit ratio = (Gross profit/Net sales) x 100

Gross profit = Sales – Cost of goods sold

Net sales = Total sales – Sales return

For example, if gross profit is Rs.21,000 and net sales is Rs.1,50,000, the gross profit ratio will be 14%.

If we deduct gross profit ratio from 100, we obtain the ratio of the cost of goods sold to sales, thus ratio of cost of goods sold to sales = 100 – 14% = 86%.

Higher the ratios better the efficiency of a firm. It reflects how efficiently the firm produces its products.

There is no standard norm for gross profit ratio but the gross profit should be adequate to cover the operating expenses, provide for fixed charges, dividends, and accumulation of reserves.

A low gross profit ratio, generally, indicates high cost of goods sold due to unfavorable operations of the firm. The ratio may also be affected as when the management increases or reduces the sale price of goods sold without controlling other factors that affect gross profit.

ii. Operating Ratio:

This ratio establishes the relationship between cost of goods sold and other operating expenses with that of sales. It measures the cost of operations per rupee of sales and is represented in a percentage.

Operating ratio = (Operating cost/Net sales) x 100

Operating cost = Cost of goods sold + Operating expenses

Cost of goods sold = opening stock + purchases + direct expenses + manufacturing expenses – closing stock – gross profit

Operating expenses = Administration expenses + Selling and distribution expenses

Administration and office expenses consist of rent, salaries to staff, insurance, director’s fees, etc.

Selling and distribution expenses consist of advertisement cost, salaries of salesmen, etc.

For example, if cost of goods sold is Rs.3,00,000, operating expenses are Rs.1,200,00 and net sales is Rs.5,00,000, then operating ratio is 84% higher the ratio. It is less favorable, because it would result in small margin of operating profit to cover interest, income tax, dividend, and reserve. In the above, the operating profit is 16% (100 – 84%). There is no rule of thumb for this ratio; however, 75-85% may be considered to be a good ratio.

iii. Operating Profit Ratio:

This ratio is calculated by dividing operating profit by sales.

Operating profit ratio = (Operating profit/Net Sales) x 100

Where

Operating profit = Net sales – Operating cost

Or,

Net sales – (Cost of goods sold + Administrative and office expenses + selling and distribution expenses).

Operating profit = Net profit + non-operating expenses – non-operating income

Gross profit – Operating expenses

Alternatively,

Operating profit ratio = 100 – Operating ratio

For e.g., cost of goods sold = Rs.8,00,000

Administrative expenses = Rs.70,000

Selling and distribution expenses = Rs.90,000

Net sales = Rs.12,00,000

Operating profit ratio = (Operating profit/Net sales) x 100

Operating profit = Sales – Cost of goods sold + Administrative expenses + Selling and distribution expenses

= 12,00,000 – (8,00,000 + 70,000 + 90,000)

= Rs.2,40,000

Thus, operating profit ratio = (2,40,000/12,00,000) x 100 = 20

This ratio indicates the position of sales remaining after all operating costs and expenses have been met. In the above, 20% of sales remain as operating profit after 80% of costs are met. Higher the ratio, the better is the result.

iv. Expenses Ratio:

This ratio indicates the relationship of various expenses to net sales. Expense ratios are calculated for each individual item of expenses or a group of items of a particular type of expenses like cost of sales ratio, administrative expenses ratio, selling expenses ratio, material consumed ratio, etc., with that to net sales.

Particular expense ratio = (Particular expense/Net sales) x 100

The following ratios will help in analyzing operating ratio:

(i) Material consumed ratio = (Material consumed/Net sales) x 100

(ii) Conversion cost ratio

(Cost of goods sold) = (Labour expenses + Manufacturing expenses/Net sales) x 100

(iii) Administrative expenses ratio = (Administrative expenses/Net sales) x 100

(iv) Selling and distribution expenses ratio = (Selling and distribution/Net sales) x 100

The total of these four ratios is equal to operating ratio.

v. Net Profit Ratio:

This ratio reveals the overall profitability of the concern. It is a ratio of net profit after taxes to net sales.

Net profit ratio = (Net profit after tax [PAT]/Net sales) x 100

Net profit after tax = Net operating profit

= Net profit – Income tax

(Non-operating incomes and expenses are deducted in calculation of net profit)

Higher the ratio, the better it is because it gives the improved efficiency of the business. This ratio indicates the firm’s capacity to face adverse economic condition such as price competition, low demand, etc. Thus, higher the ratio, the better is the profitability.

vi. Cash Profit Ratio:

The net profits of a firm are affected by the amount/method of deprecation charged. Depreciation being a non-cash expense, cash profit differs from net profit. This ratio measures the relationship between cash generated from operations and net sales –

Cash profit ratio = (Cash profit/Net sales) x 100

where, cash profit = Net profit + Depreciation

(b) Overall Profitability Ratio:

i. Return on Shareholder Fund:

This ratio is popularly known as ROI or return on shareholder/proprietors funds. It is the relationship between net profits (after interest and tax) and the proprietors’ fund.

Thus, Return on shareholder’s investment = Net profit (after interest and tax)/Shareholder’s funds

Shareholder’s investment = Equity share capital + Preference share capital + Reserve and surplus – (Accumulated losses, if any)

For example, if net profit after interest and tax is Rs.2,00,000 and shareholder’s fund is Rs.10,00,000, then the ratio will be 20%. (Rs.2,00,000 + 10,00,000 x 100)

The ratio of net profit to shareholder’s fund shows the extent to which profitability objective is being achieved. Higher the ratio, the better it is.

ii. Return on Equity Shareholder’s Funds:

This ratio measures the percentage of net profit to equity shareholder’s funds. The ratio is expressed as follows.

Return on equity capital = Net profit after tax, interest and preference dividend/Equity shareholder’s funds –

Where equity shareholder’s fund = Equity share capital + Capital reserves + Revenue reserves + Balance of profit and loss account – Fictitious assets – Non-business assets.

Suppose profit after interest, taxes, and preference dividend is Rs.5,00,000, and equity shareholder’s fund is Rs.25,00,000, the return on equity shareholder’s fund will be 20% [i.e., Rs.(5,00,000 – 25,00,000) x 100]

iii. Earnings per Share (EPS):

This helps in determining the market price of equity share of the company and in estimating the company’s capacity to pay dividend to its equity shareholder’s.

It is calculated as follows.

EPS = (Net profit after tax – preference dividend)/(Number of equity shares)

The earnings per share is a good measure of profitability and when compared with EPS of similar other companies, it gives a view of the comparative earnings or earnings power of a firm. EPS calculated for a number of years indicates whether earning power of the company has increased.

iv. Return on Capital Employed (Overall Profitability Ratio):

This ratio is an indicator of the earning capacity of the capital employed in the business. This ratio is calculated as follows –

Return on capital employed = (Operating profit/Capital employed) x 100

Here operating profit = Profit before interest on long borrowings and tax

Capital employed = Equity share capital + Preference share capital + Undistributed profit + Reserves + Surplus + Long-term liabilities – Fictitious assets – Non-business assets.

For example, if the capital employed is Rs.1,00,000 and operating profit before interest and tax is Rs.15,000, then return on capital employed will be 15% (15,000 ÷ 1,00,000 x 100).

This ratio is considered to be the most important ratio because it reflects the overall efficiency with which capital is used. Higher the ratio, the better it is for shareholders, creditors, employees, company, and government. This ratio is a helpful tool for making capital-budgeting decisions; a project yielding higher return is favored.

v. Capital Turnover Ratio:

It is the relationship between cost of goods sold and the capital employed. It measures the efficiency with which a firm utilizes its resources or the capital employed. As capital is invested in a business to make sales and earn profits, this ratio is a good indicator of overall profitability of a concern.

Capital turnover ratio = Cost of goods sold or sales/Capital employed

Capital turnover ratio can be classified as:

(a) Fixed assets turnover and

(b) Working capital turnover

Fixed assets turnover is the relationship between sales/cost of goods sold and fixed/capital assets employed in a business.

Fixed assets turnover ratio = Cost of goods sold or sales/Fixed assets/capital employed

Working capital turnover ratio indicates the velocity of the utilization of net working capital.

Working capital turnover ratio = Cost of goods sold or sales/Average working capital

vi. Dividend Yield Ratio:

Shareholders are the real owners of a company and are interested in real sense in the earrings distributed and paid to them as dividends. Therefore, dividend yield ratio is calculated to evaluate the relationship between dividend per share paid and the market value of the share.

Dividend yield ratio = Dividend per share/Market price per share x 100

For example, if a company declares 15% dividend and its share is of Rs.6, paid-up and the market price of which is Rs.9, then the yield will be calculated as under –

Dividend per share = (15/100) x Rs.6 = Rs.0.90

Dividend yield ratio = (Dividend per share/Market price per share) x 100

= (0.90/9.00) x 100 = 10%

This ratio is important for those investors who are interested in the dividend income. Thus, in the above case, the effective earning rate to the investor in equity shares is 10% and not 15% as declared by the company.

vii. Dividend Payout Ratio:

Dividend payout ratio is calculated to find the extent to which earnings per share have been retained in the business. It is an important ratio because ploughing back of profits enables a company to grow and pay more dividends in future.

Dividend payout ratio = Dividend per equity share/Earning per share

Complementary of this ratio is retained earning ratio. It is calculated as follows –

Retained earning ratio = (Retained earnings/Total earnings) x 100

This ratio indicates as to what proportion of earnings per share has been used for paying dividend and what has been retained for ploughing back. An investor who is interested in capital appreciation must look for a company having low payout ratio.

viii. Price Earnings (Earning Yield) Ratio:

Price earnings ratio is the ratio between market price per equity share and earnings per share. The ratio is calculated to make an estimate of appreciation in the value of a share of a company and is widely used by investors to decide whether or not to buy shares of a particular company.

Price earnings ratio = Market price per equity share/Earnings per share

Higher the price earnings ratio, the better it is; if the ratio falls, the management should look into the causes that have resulted in the fall.

Earning yield ratio = (Earnings per share/Market price per share) x 100

This ratio also shows a relationship between earnings per share and market value of shares. For example, market price of a share of Rs.10 is Rs.50. The profit available for equity shareholders is Rs.2,00,000 and number of equity shares is Rs.50,000.

EPS = Profits available for equity shareholders/No. of equity shares

= 2,00,000/50,000 = Rs.4

Earning yield ratio = (EPS/Market price per share) x 100

= (4/50) x 100 = 8%

Here, 8% indicates that for every Rs.100 investments as per market price Rs.8 is the return.

2. Coverage Ratios:

These ratios indicate the extent to which the interests of the persons entitled to get a fixed return (i.e., interest or dividend) or a scheduled repayment as per agreed terms are safe.

Higher the cover, the better it is under these ratios:

i. Fixed Interest Cover:

This an important ratio from lender’s point of view and indicates whether the business would earn sufficient profits to pay periodically the interest changes. It is calculated as below.

Fixed interest cover = Net profit before interest and tax/Interest charges

For example, if the net profit before interest and tax is Rs.32,000 and interest charges are Rs.4,000, then fixed interest cover will be 8 times (i.e., 32,000 ÷ 4,000).

The higher the ratio, the more secured the lenders will be in respect of their periodical interest income.

ii. Fixed Dividend Cover:

This ratio is important for preference shareholders entitled to get dividend at a fixed rate in priority to other shareholders.

Fixed dividend cover = Net profit after interest and tax/Preference dividend

For example, if the profit after interest and tax is Rs.2,70,000 and dividend on preference shares is Rs.27,000, then fixed dividend cover will be 10 times (i.e., Rs.2,70,000 ÷ Rs.27,000). The ratio indicates that preference dividend has 10 times coverage with available net profit.

iii. Debt Service Coverage Ratio:

This ratio is calculated to know the ability of a company to make payment of principal amounts on time.

Debt service coverage ratio = Net profit before interest and tax/Interest + (Installment ÷ 1 – tax rate)

Interest ÷ [Instalment/(1 – tax rate)]

For example, if the net profit before interest and tax is Rs.1,00,000, 10% debentures (payable in 10 years in equal installments) are Rs.2,00,000. The tax rate is 50% then debt service coverage ratio is –

This ratio indicates the net profit before interest and tax and covers adequately both interest and principal repayment installment. Higher the ratio, better it is.

3. Turnover (or Performance or Activity) Ratios:

Activity ratios are calculated to measure the efficiency with which the resources of a firm have been employed. These ratios are also called turnover ratios.

The various activity or turnover ratios are as under:

i. Stock Turnover Ratio/Inventory Turnover Ratio:

This ratio establishes the relationship between cost of goods sold during a given period and the average amount of inventory held during that period. This ratio reveals the number of times finished stock is turned over during a given accounting period. Higher the ratio, the better it shows that finished stock is rapidly turned over. A low stock turnover ratio is not desirable as it reveals the accumulation of obsolete stock or carrying of too much stock.

Stock turnover ratio = Cost of goods sold/Average stock held during the period

Where

Cost of goods sold = Opening stock + Purchases + Manufacturing expenses – Closing stock or sales – Gross profit

Average stock = (Opening stock + Closing stock)/2

For example, cost of goods sold is Rs.4,50,000 and average stock is Rs.1,50,000. Stock turnover ratio will be 3 times, i.e., (Rs.4,50,000 + Rs.1,50,000). Cost of goods sold is 3 times the average stock held during the period, which indicates a favorable stock level.

ii. Debtors Turnover/Receivable Turnover Ratio:

This ratio measures the trade debtors and bills receivables in terms of number of days of credit sales during a particular period.

Debtors turnover/velocity = Net credit annual sales/Average trade debtors

where

Trade debtors = Sundry debtors + Bills receivable and Accounts receivables

Average turnover ratio = (Opening trade debtors + Closing trade debtors)/2

Note – Debtors should always be taken at gross value. No provision for bad and doubtful debts to be deducted.

Along with debtors velocity, average collection period ratio is also computed, which represents the average number of days for which a firm has to wait before its receivables are converted into cash.

Average collection period = Average trade debtors/Sales per day or 365/Debtors turnover ratio

where sales per day = Net sales/No. or working days

For example, in 2008 debtors in the beginning are Rs.20,000, debtors at the end are Rs.25,000, credit sales during the year is 1,12,500, The debtors turnover ratio is = Credit sales/Avg. debtors = 1,12,500/22500 = 5 times

Collection period = Days in a year/Debtors turnover ratio = 365/5 = 73 days

Debtors turnover indicates the number of times the debtors are turned over during a year. There is no rule of thumb to interpret the ratio as it may be different from firm to firm, depending upon the nature of business.

Generally, the higher the value of debtors turnover, the more efficient is the management of debtors; lower turnover implies inefficient management of debtors and less liquid are the debtors.

In the case of average collection period, the shorter the average the better is the quality of debtors, as it implies quick payment by debtors; higher the average, adverse is the quality of debtors.

iii. Creditors/Payables Turnover Ratio:

This ratio gives the average credit period enjoyed from the creditors.

Creditors turnover ratio = Net credit annual purchases/Average trade creditors

where net credit annual purchases = Credit purchases – Sales returns

For example, if credit purchases during 2008 are Rs.1,00,000 and accounts payable on 1 January 2008 and 31 December 2008 are Rs.23,000 and Rs.4,17,000, respectively, then –

A high ratio indicates that creditors are not paid in time, while a low ratio indicates that the business is not taking full advantage of credit period allowed by the creditors.

Along with creditor’s turnover ratio, average payment period rate is computed to know the speed at which payment for credit purchases are made.

where average daily purchases = Annual purchase/No. or working days in a year

Or

Alternatively average daily purchases = No. of working days/Creditors turnover ratio

Assuming 365 working days in a year in the above example

Average daily purchases 365/5 times = 73 days

Average daily purchases, which is 73 days, indicates the speed at which payments for credit purchases is made to creditors.

iv. Working Capital Turnover Ratio:

Working capital of a concern is directly related to sales, the current assets like debtors, B/R, cash, stock, etc., change with the increase or decrease in sales.

Working capital = Current assets – Current liabilities

Working capital turnover ratio indicates the velocity of the utilization of net working capital. This ratio indicates the number of times the working capital is turned over in the course of a year.

Working capital turnover ratio = Cost of sales/Average working capital

Average working capital = (Opening working capital + Closing working capital)/2

A higher ratio indicates efficient utilization of working capital and low ratio indicates otherwise.

However, a very high turnover of working capital is a sign of overtrading and may put the concern into financial difficulties; a low working capital turnover ratio indicates that working capital is not efficiently utilized.

v. Sales to Capital Employed or (Capital Turnover) Ratio:

This ratio shows the efficiency of capital turnover in the business by computing how many times capital employed is turned over in a stated period.

The ratio is ascertained as follows –

Sales/Capital employed (i.e., shareholders fund + long-term liabilities)

Higher the ratio, the greater are the profits. A low capital turnover ratio shows sufficient sales are not being made and profits are lower.

vi. Sales to Fixed Assets (or Fixed Assets Turnover) Ratio:

The ratio expresses the number of times fixed assets are being turned over in a stated period. It is calculated as below –

Sales/Net fixed assets (i.e., fixed assets less depreciation)

This ratio shows how well the fixed assets are being used in the business. The higher the ratio, the better is the performance, a low ratio indicates that fixed assets are not efficiently utilized.

vii. Total Assets Turnover Ratio:

This ratio is calculated by dividing the net sales by the value of total assets (i.e., Net sales ÷ Total assets). A high ratio is an indicator of over trading, while a low ratio indicates idle assets. The standard for this ratio is two times.

4. Financial Ratios/Liquidity Ratios:

These ratios are computed to judge the financial position of the concern. Liquidity refers to the ability of a concern to meet its current obligations as and when these become due.

These ratios can be divided into two broad categories:

i. Liquidity ratios

ii. Stability ratios

i. Liquidity Ratios:

These ratios are used to measure the firm’s ability to meet short-term obligations. These ratios give an insight into the present cash solvency of the firm and the firm’s ability to remain solvent in the event of adversity.

The important liquidity ratios are as follows:

(a) Current Ratio (or Working Capital Ratio):

This ratio defines the relationship between current assets and current liabilities. This ratio measures the general liquidity and is most widely used to make the analysis of a short-term financial position or liquidity of a firm. It is calculated by dividing the total of current assets by total of the current liabilities.

Current ratio = Current assets/Current liabilities

Or

Current Assets Current liabilities

Current assets = Cash + Assets which can be easily converted into cash in one year such as marketable securities, bills receivables, sundry debtors, inventories, work in progress, etc + Prepaid expenses

Current liabilities = Outstanding expenses + Accrued expenses + B/P + Sundry creditors + Short-term advances + Income tax payable + Dividends payable + Bank o/d.

Generally, 2:1 is considered ideal for a concern, i.e., current assets should be twice of that of current liabilities. If the ratio is less than 2, difficulty may be experienced in the payment of current liabilities and day-to-day operation of the business may suffer. If the ratio is higher than 2, it is an indicator of idle funds and a lack of enthusiasm for work.

(b) Liquid Ratio, Quick or Acid Test Ratio:

High current ratio is not an indicator of high liquidity, as at times current assets, which are investments, may not be easily marketable and sold in cash so as to pay of current liabilities.

Hence, the ratio acid test ratio shows the firm’s ability to meet current liabilities with its most liquid (quick) assets. Ratio of 1 : 1 is considered ideal ratio for a concern where liquid assets are at least equal to the liquid liabilities at all times. Liquid assets are those assets which are easily and readily converted into cash and will include cash balances, B/R, sundry debtors, and short-term investments.

Inventories and p/p expenses are not included in this list of liquid assets.

Liquid liabilities include all items of current liabilities except bank overdraft. This ratio is calculated as –

(c) Absolute Liquidity (or Super Quick) Ratio:

Although receivables are generally more liquid than inventories, there may be debts having doubt regarding their real stability in time. Both receivables and inventories are excluded from current assets and only absolute liquid assets, such as cash in bank, bank balance, and readily realizable securities, are taken into consideration. Absolute liquidity ratio is calculated as follows –

(Cash in hand and at bank + Short-term marketable securities)/Current liabilities

The desirable norm for this ratio is 1:2, i.e., absolute liquid assets of worth Rs.1 are sufficient for current liabilities of worth Rs.2. Though the ratio gives a more meaningful measure of liquidity, it is not in much use because the idea of keeping a large cash balance or near cash items has long since been disproved. Cash balance yields no return, so it’s of no use.

(d) Internal Measure or Defensive-Internal Ratio:

In addition to the comparison of current or liquid assets to current liabilities, the liquidity position of a firm may also be examined to measure whether the liquid assets are sufficient relative to the firm’s daily cash requirements for operating expenses.

Thus, Internal measure = Quick or liquid assets/Average daily cash operating expenses

where liquid assets = Cash + Short-term securities + Receivables

Average daily expense = Cost of goods sold + Administration and office expenses + Selling and distribution expenses – depreciation and other non­cash expenses/Number of days in a year (365 or 360)

(less depreciation and other non-cash expenses)/Number of days in a year (365 or 360)

This ratio measures the time period for which a firm can operate on the basis of present liquid assets without resorting to next year’s revenue. The higher the ratio, the better it is.

(e) Ratio of Inventory to Working Capital:

In order to ascertain that there is no over stocking, the ratio of inventory to working capital should be calculated.

The ratio is thus calculated as = Inventory/working capital

Working capital = Current assets – Current liabilities

Increase in volume of sales requires increase in size of inventory, but from a sound financial point inventory should not exceed amount of working capital. The desirable ratio is 1:1.

ii. Stability Ratios:

These ratios ascertain the long-term solvency of a firm. Solvency depends on the firm’s adequate resources to meet its long-term funds requirements, appropriate debt equity mix to raise long-term funds and earnings to pay interest and installments of long-term loans.

The following ratios are computed for purpose of ascertaining stability of the firm:

(a) Fixed Assets Ratio:

This ratio explains whether the firm has raised adequate long-term funds to meet its fixed assets requirements.

Fixed assets ratio = Fixed assets/Capital employed

This ratio explains as to what extent of capital employed has been utilized for purchasing the fixed assets. The ideal ratio is 0.67. It is always good if the ratio is less than one.

(b) Ratio of Current Assets to Fixed Assets:

The ratio reveals the ratio of current to fixed assets. An increase in the ratio indicates that current inventories and debtors are unduly increased or fixed assets are intensively been used. An increase in the ratio when accompanied with increase in profit indicates expansion of business.

Ratio of current assets to fixed assets = Current assets/Fixed assets

(c) Debt Equity Ratio:

This ratio ascertains the soundness of long-term financial policies of the company, hence also known as external-internal equity ratio. It measures the proportion of outsider’s funds and shareholders’ funds invested in the firm.

Debt equity ratio = Long-term debts/Shareholders funds (including long-term debts)

Shareholders’ funds = Preference share capital + Equity share capital + P&L a/c (credit balance) + Capital reserves + Revenue reserves + Reserves (surplus) + Contingencies reserves + Sinking funds maintained for fixed assets or debenture redemption funds for fictitious assets.

A low ratio is generally viewed as favorable from long-term creditor’s point of view, as it indicates a large margin of protection for creditors but the same low ratio may also indicate neglected interest of the management for using low-cost outsider’s funds to acquire fixed assets from point of view of shareholders.

Ideally from creditors point, the ratio 2 : 1 is favorable.

From shareholders point an ideal ratio is 2 : 3, which is acceptable.

(d) Proprietary Ratio:

This ratio shows the relationship between shareholders’ funds and total tangible assets.

Proprietary ratio = Shareholders’ funds/Total tangible assets

Generally, accepted standard for this ratio is 1: 3, which indicates that one- third of the assets current liabilities should be acquired from shareholders’ funds and the other two-third should be financed by outsider’s funds. This ratio focuses on the general financial strength of the firm.

(e) Capital Gearing Ratio:

This ratio measures the relationship between the fixed interest-bearing securities and equity shares of a company.

Capital gearing ratio = Fixed interest-bearing securities/Equity shareholders fund

A company is said to be highly geared if the major share of the total capital is in the form of fixed interest-bearing securities, or if this ratio is more than one. If this ratio is less than one, it is said to be low geared. If it is exactly one, it is evenly geared.

5. Leverage Ratios:

These ratios refer to employment of funds to accelerate rate of return to owners.

A favorable ratio is when earnings are more than the fixed cost of the funds. An unfavorable coverage exists if the rate of return remains to be lower.

These ratios are a helpful tool for financial planning.

Leverage may be of three types:

i. Operating leverage

ii. Financial leverage and

iii. Composite leverage

i. Operating Leverage:

It shows the extent of change in earnings before interest and tax (EBIT) as a result of change in sales volume. Operating leverage is related to fixed costs of the firm. The significance of operating leverage lies in the fact that it tells the finance manager about the impact of change in sales revenue and operating income.

Operating leverage = Marginal contribution/Earning before interest and tax (EBIT)

A firm with high degree of operating leverage will experience much large effect on EBIT because of small change in sales. A firm should avoid operation under conditions of a high degree of operating leverage as it is a high risk situation. The degree of operating leverage goes on decreasing with every increase in sales volume above break-even point.

ii. Financial Leverage:

Where a firm procures debt capital to finance its needs, it is said to have financial leverage. It measures the change in earning before tax (EBT) due to change in operating income (EBIT).

Financial leverage = Earnings before interest and tax/Earnings before tax

If return on investments of a firm is higher than the cost of debt capital, it is said to have favorable financial leverage and unfavorable leverage if otherwise. This leverage is also referred to trading on equity.

iii. Composite Leverage:

Both the financial and operating leverage magnify the revenue of the firm. The composite leverage focuses attention on the entire income of the firm. The risk factor should be properly assessed by the management before using the composite leverage. The high financial leverage may be offset against low operating leverage or vice-versa.

Composite leverage = Operating leverage x Financial leverage

Or

Degree of composite leverage (DCL) = Percentage change in RPS/Percentage change in sales