Accounting Ratios: Uses and Types (With Calculations)

In this article we will discuss about Accounting Ratios:- 1. Uses of Accounting Ratios 2. Types of Accounting Ratios.

Uses of Accounting Ratios:

Some of the possible uses of accounting ratios are summarized below:

1. Accounting ratios may be very useful for forecasting likely events in the future since past ratios indicate trends in costs, sales, profit and other relevant facts.

2. Ideal ratios can be established and the relationships between primary ratios may be used to establish the desirable co-ordination or balance. Normally, this is linked with the Budgetary Control.

3. Control may be materially assisted by the use of ratios and can be made effective.

4. “Communication” is the process used to impart knowledge within the business or to outside shareholders or other interested parties. Accounting ratios can play vital role in informing what has happened from one period to another.

5. Accounting ratios may be used as measures of efficiency. In fact, accounting ratios aid uniformity and, therefore, can made comparisons much more valid.

6. Ratio analysis helps investment decisions. An investor is interested in both solvency and profitability of a firm. The investor can take his investment decision studying both solvency as well as profitability ratios.

There is no doubt that ratios can be an invaluable aid to management and others who are interested in analysing the operations and the state of affairs of a business. Absolute figures may be misleading unless compared one with another, ratios provide the means of showing the interrelationships which exist.

According to W.H. Beaver, “Ratio analysis is being as a device to diagnose the financial health of a business concern”. It facilitates the work of gauging the profitability, solvency and activity of the concern. Undoubtedly, it is a powerful tool for both internal and external analysis and can be used as guidelines for managerial and other economic decisions.

Types of Accounting Ratios:

In view of the requirements of the various users of ratios, we may classify them into the following four important categories:

1. Liquidity Ratios,

2. Leverage or Capital Structure Ratios,

3. Activity Ratios, and

4. Profitability Ratios.

The following is the summary of some of the most important financial ratios:

1. Liquidity Ratios (They are also know as Balance Sheet Ratios):

The very object of liquidity ratio is to measure the firm’s short-term solvency. The measure the firm’s capability to pay off its current liabilities. A firm must have sufficient current assets so that it can liquidate current liabilities as and when required.

The following are the liquidity ratios which are determined from the figures of the Balance Sheet:

(i) Current Assets consists of:

a. Cash in hand;

b. Cash at Bank;

c. Sundry Debtors or Book Debts;

d. Bills Receivable;

e. Inventories;

(a) Raw Materials

(b) Work-in-progress

(c) Finished goods

f. Prepaid expenses.

(ii) Current Liabilities include the following:

a. Sundry creditors

b. Bills payable

c. Outstanding liabilities

d. Provision for taxation

e. Proposed Dividend.

Current assets are those which are expected to be converted into cash or are realisable within the next financial year in the usual course of business activities.

Current liabilities are those financial obligations of the firm that are payable in the next financial year.

Is Bank overdraft in a current liability or long-term liability? There is a controversy over the matter nevertheless consistency is expected to be followed.

2. Leverage Ratios (they are also known as Balance Sheet Ratios):

The object of leverage ratios is to measure the long-term solvency of the firm.

3. Activity Ratios: These Ratios Indicate how the Resources of the Firm have been used for Earning Profits:

4. Profitability Ratios:

Now, we propose to discuss the nature of each ratio their interpretation.

Liquid Ratios:

1. Current Ratio = *Current Assets/*Net Liabilities

a. Current Assets include cash, bank, and other assets that can be converted into cash within a year, such a marketable securities, debtors and inventories. Prepaid expenses are also treated as current assets as they have to be paid in the near future.

b. Current liabilities include all financial obligations that have to be made within a year, such as trade creditors, bills payable, short-term loans, outstanding expenses, income-tax liability and long-term debts maturing in the current year.

Interpretation:

Current ratio measures the firm’s ability to meet short-term obligations. It indicates the availability of current assets in rupees to meet the current liabilities.

The higher the ratio, greater the margin of safety. In fact, the main weakness of this ratio is that it does not reckon the quality of assets but the quantity of assets, which is not rational. Therefore, too much of reliance on current ratio should not be placed in measuring firm’s short- term solvency.

Conventionally, a current ratio of 2: 1 is ideal ratio but in practice there is no logic to follow this ratio. Firm with less than 2 to 1 ratios may do well. The current ratio fails to measure the quality of assets. For example, if the firm’s currents assets consist of slow paying debtors or slow moving stock or obsolete stock, then the firm’s ability to pay its current obligations will be impaired.

Nonetheless, the current ratio is a crude-and-quick measure of the firm’s liquidity.

2. Acid Test Ratio or Quick Ratio =

In the opinion of some authors =

Interpretation:

Acid Text Ratio establishes a relationship between quick or liquid assets and current liabilities. Liquid assets refer to those assets, which can be converted into cash quickly and easily without a loss in value. In that sense, cash and bank balances are more liquid than the other assets.

Other current assets that are reckoned relatively liquid are book debts, bills receivable and marketable securities. For this purpose inventories normally cannot be or may not be converted into cash immediately.

Normally, one is to one ratio is considered as an ideal quick ratio. It does mean liquid assets = current liabilities. It is a more penetrating test of liquidity than the current ratio but is to be used cautiously. Practically speaking, in some cases inventories may be more liquid than book debts in case of some firms.

Nevertheless, the quick ratio is an important index of measuring firm’s liquidity.

3. Cash Ratio =

Problem1:

The Balance Sheet of Y Ltd. shows the following current assets and liabilities as on 31.3.2003:

From the above data you are required to find out the liquid ratios.

Leverage Ratios:

There are two types of leverage ratios. They are structural ratios and coverage ratios. Structural ratios are based on the proportions of debt and equity in the capital structure of the firm, whereas coverage ratios are derived from the relationship between debt servicing commitments and sources of funds for meeting theses obligation.

Interpretations:

(i) Total Debt Ratio or Debt Equity Ratio:

The above ratio is an important tool of financial analysis to appraise the financial structure of a firm. It has important implications from the view point of creditors, owners and the firm itself.

The high Debt Equity Ratio indicates a danger signal for creditors because in case of failure of business, the creditors will lose heavily.

This ratio indicates the relationship or role of outsiders in financing the business of the firm.

In case of low debt-equity ratio, creditors claim a high stake and implies sufficient safety margin against shrinkage in assets.

On the other hand, the servicing of debt becomes less burden some for the company. It is evident that both high and low debt-equity ratios are not desirable. It can be rationally said that other’s money should be in reasonable proportion to the owner’s capital and the owners should have sufficient stake in the fortunes of the firm.

Capital structure ratios establish the relationship between the Creditors’ Fund and Owners’ Capital. Therefore, to judge the long-term financial position of the firm, financial leverage or capital structure ratios are calculated.

Problem 2:

Following is the Balance Sheet of X Ltd. as on 31.3.2003:

You are required to calculate Liquidity and Capital Structure ratios.

3. Activity Ratios:

The activity ratios are applied to evaluate the efficiency of management in utilizing the assets to generate sales and profits. These ratios are also known as turnover ratios because they indicate the speed with which assets are being turned-over or converted into sales. In this sense, activity ratios involve a relationship between sales and assets. These ratios are derived from both income statements and Balance Sheet.

Problem 3:

You are required to show the activity ratios of X Ltd. and comment on them.

4. Profitability Ratios:

A company should earn sufficient profits for its survival and growth. It is an established fact that “sufficient profit must be earned by a business unit and sustain the operations of the business, to be able to obtain funds from investors for expansion and growth and to contribute towards the social overheads for the welfare of the society”.—Drucker P.F.

The profitability ratios are calculated to measure the operating efficiency of the company. Moreover, management, creditors and owners are equally interested in the profitability of the firm.

Creditors like to receive interest and repayment of principal regularly. Shareholders want to get a reasonable return on their investments and management wants to satisfy all interested parties thereby to create goodwill for the organisation. All these are possible when the company earns substantial profits.

There are generally two types of profitability ratios:

1. Profitability in relation to sales.

2. Profitability in relation to investment.

1. Profitability in relation to Sales:

(a) Gross Profit Margin:

Gross Profit/Sales x 100

The gross profit margin reflects the efficiency with which the management produces each unit of product. It measures also the efficiency of both purchase and sales departments. The efficiency of these two departments reduces the cost of goods sold and thereby increases the efficiency of competitiveness in a competitive and global markets.

Obviously, a high gross profit margin is a sign of good management.

A gross profit margin ratio may be higher due to any of the following factors:

(i) Higher sale price, cost of goods sold remaining constant;

(ii) Lower cost of goods sold, sales prices remaining constant;

(iii) A combination of variations in sales prices and costs; and

(iv) An increase in the proportionate volume of higher margin items.

(b) Net Profit Margin = x 100

The net profit margin establishes relationship between net profit and sales and points out management’s efficiency in manufacturing, administration and selling its products.

The high net profit margin enables a company to survive in a situation of adverse economic conditions. A firm with high net profit margin can make better use of favourable market and economic conditions such as rising sales prices, falling cost of production or increasing demand for the product. Such a firm has the ability to accelerate its profits at a faster rate.

Net profit margin for evaluating operating performance may be computed in the following manner:

Net Profit Margin = x 100

(c) Operating Expense Ratio:

(i) Operating Expenses = Cost of goods sold + office and administrative expenses + selling expenses. Interest is not considered.

This ratio is a yardstick of operating efficiency. A higher operating expense ratio is unfavourable since it will leave a small amount of operating income to meet interest and dividends.

Interpretation:

The operating expense ratio is used for measuring the operating efficiency. It is advisable to use this ratio very cautiously since it is affected by a number of factors, such as external uncontrollable factors, internal factors.

Taxes are not controllable by a firm, and also one may not know the marginal corporate tax rate while analysing the published data, it is more appropriate to use the following measures of ROI for comparing the operating efficiency of firm.

2. Profitability in relation to investment:

Since taxes are not controllable by management and since opportunities for availing tax incentives differ from firm to firm, it is more prudent to use before tax measure of Return on Investment. The term investment may refer to total assets or net assets. Net assets mean capital employed.

(iii) Earning per Share (EPS):

The earning per share is calculated by dividing the profit after taxes by the total number of Equity shares. Therefore, EPS is equal to

Eps =

EPS calculations made over the years indicate the trend of profitability of the firm. This trend can easily guide the investors in taking investment decisions. But, it fails to reflect how much is paid as dividend and how much is retained in the business.

(iv) Dividend per Share (DPS):

The net profits after taxes belong to shareholders. But the income which they actually receive is the amount of earnings distributed as cash dividend (including interim dividend, if any).

Dps=

(v) Dividend Payout Ratio:

Pay out Ratio =

(vi) Price Earning Ratio:

Price Earning Ratio: or MV/EPS

This ratio indicates investor’s judgement or expectations about the firm’s performance. Management is also interested in this market appraisal of the firm’s performance and will like to identity the causes of weak performance if the P/E ratio declines.