Accounting Ratios Analysis/Financial Ratios Analysis:

There are many special measurements that may be developed from financial statements and supplementary financial data. Such measurements may be divided into: Those that analyze balance sheet position, and Those that analyze operating results.

Some of these measurements have special significance to particular groups, while others may be of general interest to all groups. Creditors, for example, are concerned with the ability of a company to pay its current obligations and seek information about the relationship of current assets to current liabilities. Shareholders are concerned with dividends and seek information relating the earnings per share that will form the basis for dividend declarations. Management is concerned with the liquidity of stock of goods and seek information relating to the number of times stock have turned over during the period. All parties are vitally interested in the profitability of operations and wish to be informed about the relationship of earnings to both creditors and shareholders. A number of measurements developed from financial statements will be explained effectively through using accounting ratios. It is fact that ratio analysis is one of the tools of the financial analysis. It is used to diagnose the financial health of an enterprise. 1. Meanings, Nature and Usefulness of Ratios Analysis: What is meant by the term "accounting ratios"? What is the nature of ratios analysis? why is ratios analysis useful? Find answers of these questions in this article. Click here to read. 2. Interpretation of Ratios: What is interpretation of accounting ratios? This article tells you how accounting ratios are interpreted. Click here to read. 3. Important Factors for Understanding Ratios Analysis: The reliability of ratios is linked with the quality of financial statements. Financial statements which have been prepared by faithful adherence to generally accepted accounting principles (GAAP). Generally accepted accounting principles are likely to contain reliable data. Calculation of ratios from such financial statements is bound to be more useful and trustworthy. Continue reading. 4. Significance and Usefulness Ratios Analysis: Ratios as a tool of financial analysis provide symptoms with the help of which any analyst is in a position to diagnose the financial health of the unit. Financial analysis may be compared with biopsy conducted by the doctor on the patient in order to diagnose the causes of illness so that treatment may be prescribed to the patient to help him recover.Click here to continue reading.

5. Classification of Ratios: Neither the number of ratios is limited nor the purpose of analysis is uniform. Therefore set of ratios required will depend upon the purpose of analysis; type of data available analyst etc. Click here to continue reading. 6. Analysis of Short Term Financial Position or Test of Liquidity: Trade creditors; creditors for expenses; commercial banks; short-terms lenders are concerned with the short-term financial position or liquidity of the unit. Click here to continue reading. 7. Current Ratio: Current ratio is also known as working capital ratio or 2 : 1 ratio. It is the ratio of total current assets to total current liabilities. Click here to continue reading 8. Quick/Acid Test/Liquid Ratio: Quick ratio also known as liquid ratio or acid test ratio. Current ratio provides a rough idea of the liquidity of a firm so subsequently a second testing device was developed named as acid test ratio or quick ratio. Click here to continue reading. 9. Absolute Liquid Ratio: Absolute liquid ratio extends the logic further and eliminates accounts receivable (sundry debtors and bills receivables) also. Though receivables are more liquid as comparable to inventory but still there may be doubts considering their time and amount of realization.Click here to continue reading. 10. Inventory/Stock Turnover Ratio: Inventory turnover ratio or Stock turnover ratio indicates the velocity with which stock of finished goods is sold i.e. replaced. Generally it is expressed as number of times the average stock has been "turned over" or rotate of during the year. Click here to continue reading 11. Debtors / Receivable Turnover Ratio: Ratio of net credit sales to average trade debtors is called debtors turnover ratio. It is also known as receivables turnover ratio. This ratio is expressed in times. Click here to continue reading. 12. Creditors / Payables Turnover Ratio: It is a ratio of net credit purchases to average trade creditors. Creditors turnover ratio is also know as payables turnover ratio. Click here to continue reading. 13. Working Capital Turnover Ratio: Working capital turnover ratio establishes relationship between cost of sales and net working capital. As working capital has direct and close relationship with cost of goods sold, therefore, the ratio provides useful idea of how efficiently or actively

working capital is being used. Click here to continue reading. 14. Profitability Ratios: The main object of a business concern is to earn profits. In general terms, efficiency in business is measured by profitability. Click here to continue reading. 15. Gross Profit Ratio (GP Ratio): Gross profit ratio is the ratio of gross profit to net sales i.e. sales less sales returns. The ratio thus reflects the margin of profit that a concern is able to earn on its trading and manufacturing activity. Click here to continue reading. 16. Operating Profit Ratio: Operating net profit ratio is calculated by dividing the operating net profit by sales. This ratio helps in determining the ability of the management in running the business. Click here to continue reading. 17. Net profit ratio (NP ratio): Net profit ratio (NP ratio) expresses the relationship between net profit after taxes and sales. This ratio is a measure of the overall profitability net profit is arrived at after taking into account both the operating and non-operating items of incomes and expenses. Click here to continue reading. 18. Operating ratio: The operating ratio is determined by comparing the cost of the goods sold and other operating expenses with net sales. Click here to continue reading.

19. Expense ratio: Expense ratios are calculated to ascertain the relationship that exists between operating expenses and volume of sales. Click here to continue reading. 20. Solvency ratios - Test of Long Term Solvency: The long-term financial soundness of any business can be judged by its long-term creditors by testing its ability to pay interest charges regularly and its ability to repay the principal as per schedule. Click here to continue reading. 21. Debt-equity Ratio: The relationship between borrowed funds and internal owner's funds is measured by Debt-Equity ratio. This ratio is also known as debt to net worth ratio. Click here to continue reading. 22. Debt Service Ratio or Interest Coverage Ratio: The ratio measures debts servicing capacity of a business so far as interest on longterm loans is concerned. This ratio shows how many times the interest charges are

covered by the earnings. Debt service ratios is also know as interest coverage ratio. Click here to continue reading. 23. Fixed Assets Ratio: This ratio establishes the relationship between long term funds (equity plus longterm loans) and fixed assets. Click here to continue reading. 24. Debts to Total Funds or Solvency Ratio: Solvency is the term which is used to describe the financial position of any business which is capable to meet outside obligations in full out of its own assets. Click here to continue reading. 25. Reserves to Capital Ratio: This ratio establishes relationship between reserves and capital. Click here to continue reading. 26. Capital Gearing Ratio: It is the ratio between the capital plus reserves i.e. equity and fixed cost bearing securities. Fixed cost bearing securities include debentures, long term mortgage loans etc.Click here to continue reading. 27. Proprietary Ratio: Proprietary ratio (also known as Equity Ratio or Net worth to total assets or shareholder equity to total equity). Establishes relationship between proprietor's funds to total resources of the unit. Click here to continue reading. 28. Accounting Ratios Formulas: Collection of formulas of all of the above accounting ratios Click here. 29. Limitations of Ratios Analysis: Ratio analysis is a widely used and useful technique to evaluate the financial position and performance of any business unit but it suffers from a number of limitations. These limitations must be kept in mind by the analyst while using this technique. Click here to read full article.

Inventory / Stock Turnover Ratio: Definition and Explanation: Inventory turnover ratio or Stock turnover ratio indicates the velocity with which stock of finished goods is sold i.e. replaced. Generally it is expressed as number of times the average stock has been "turned over" or rotate of during the year. A slow inventory movement has the following disadvantages: 1. Blocking of scarce funds which could be gainfully employed elsewhere; 2. Requiring more strong space resulting in higher maintenance and handling costs; 3. Chances of product being outdated or out of fashion especially in case of consumer goods; 4. During storage for excessive period quality may deteriorate due to inherent factors like rusting

loss of potency etc. Similarly insufficient level of inventory is also dangerous because it may be responsible for the loss of business opportunity. Thus for each item of stock minimum average and maximum levels should be fixed carefully. Formula: Cost of goods sold / Average inventory at cost Where Cost of goods sold = Sales - Gross profit or + Gross loss or Opening stock + Net purchases + Direct Expenses Closing stock and Average inventory = (Opening stock + Closing stock) / 2 However in the absence of required information any one of the following formula may be substituted. Inventory turnover ratio = Net sales / Average inventory at cost

or Net sales / Average inventory at selling price or net sales / Inventory Interpretation: High turnover suggests efficient inventory control, sound sales policies, trading in quality goods, reputation in the market, better competitive capacity and so on. Low turnover suggests the possibility of stock comprising of obsolete items, slow moving products, poor selling policy, over investment in stock etc. Inventory Conversion Period: For better understanding it is of interest to know that on an average how many days were taken to dispose off average inventory? It is known as inventory conversion period and is calculated as: Inventory conversion period = Days in the year/Inventory turnover ratio or No of days in the year x Average inventory at

cost/Cost of goods sold Example: From the following particulars calculate (1) Inventory turnover ratio and (2) Inventory conversion period.
$ Cost of goods sold Opening stock Closing stock 4,50,000 1,25,000 1,75,000

Solution: (1) Inventory turnover ratio = Cost of goods sold / Average inventory = 4,50,000 / 1,50,000* = 3 times *(1,25,000 + 1,75,000) / 2 (2) Inventory conversion period = No. of days in the year/Inventory turnover ratio = 365 / 3 = 121.66 days (say) 122 days. Alternatively: = 365 Average inventory / Cost of goods sold

= 365 1,50,000*/4,50,000 = 121.66 days (Approx.) 122 days. *(1,25,000 + 1,75,000)/2 Relevant Articles:

Debtors Turnover Ratio or Receivable Turnover Ratio: Definition and Explanation: Ratio of net credit sales to average trade debtors is called debtors turnover ratio. It is also known as receivables turnover ratio. This ratio is expressed in times. Accounts receivables is the term which includes trade debtors and bills receivables. It is a component of current assets and as such has direct influence on working capital position (liquidity) of the business.

Perhaps, no business can afford to make cash sales only thus extending credit to the customers is a necessary evil. But care must be taken to collect book debts quickly and within the period of credit allowed. Otherwise chances of debts becoming bad and unrealizable will increase. How effective or efficient is the credit collection? To provide answer debtors turnover ratio or receivable turnover ratio is calculated. Formula: Following formula is used to calculate debtors turnover ratio: Receivables turnover ratio = Annual net credit sales / Average accounts receivables Where accounts receivables = Trade debtors + Bills receivables Figure of trade debtors for this purpose should be gross i.e. provision for bad and doubtful debts should not be deducted from the amount of debtors. Receivables collection period (also known as average collection period) is calculated and supplemented with the receivables turnover ratio to help better understanding and communication. Interpretation:

Normally higher the debtors turnover ratio better it is. Higher turnover signifies speedy and effective collection. Lower turnover indicates sluggish and inefficient collection leading to the doubts that receivables might contain significant doubtful debts. Receivables collection period is expressed in number of days. It should be compared with the period of credit allowed by the management to the customers as a matter of policy. Such comparison will help to decide whether receivables collection management is efficient or inefficient. Example: From the following particular calculate Receivables turnover ratio and average collection period
$ Annual total sales Cash sales (included in above) Sales returns Opening balance of receivables (net) Closing balance of receivables (net) Provision for bad and doubtful debts (opening) Provision for bad and doubtful debts (closing) 49,50,000 6,25,000 75,000 3,60,000 4,00,000 40,000 50,000

Solution: Working:

Annual credit sales (net) Total sales Less: Cash sales Less: Sales returns 6,25,000 75,000

$ 49,50,000

7,00,000

42,50,000

Average receivables: Opening receivables (net) Add: Provision opening Add: Closing receivables (net) Add Provision closing 3,60,000 40,000 4,00,000 50,000

8,50,000

Average (i.e. 8,50,000 / 2)

$4,25,000

Receivables turnover ratio = Annual credit sales (net) / Average accounts receivables = 42,50,000 / 4,25,000 10 times Receivables collection period = No. of days in the year / Receivable turnover ratio

= 365 / 10 = 36.5 approx. or 37 days. Relevant Articles:

Creditors Turnover Ratio or Payables Turnover Ratio: Definition and Explanation: It is a ratio of net credit purchases to average trade creditors. Creditors turnover ratio is also know as payables turnover ratio. It is on the pattern of debtors turnover ratio. It indicates the speed with which the payments are made to the trade creditors. It establishes relationship between net credit annual purchases and average accounts payables. Accounts payables include trade

creditors and bills payables. Average means opening plus closing balance divided by two. In this case also accounts payables' figure should be considered at gross value i.e. before deducting provision for discount on creditors (if any). Payable turnover ratio = Annual net credit purchases / Average accounts payable Accounts payable = Trade creditors + Bills payable The above ratio is usually complemented with average payment period which may be calculated as follows: Average accounts payable / Average daily credit purchases Where average daily credit purchases = Net annual credit purchases / No. of days in the year Alternatively average payment period can also be calculated with the following formulae. (Average accounts payable x No. of days in the year) / Annual net credit purchases or No. of days in the year / Payable turnover ratio Interpretation: Shorter average payment period or higher payable

turnover ratio may indicate less period of credit enjoyed by the business it may be due to the fact that either business has better liquidity position; believe in availing cash discount and consequently enjoys better credit standing in the market or business credit rating among suppliers is not good and therefore they do not allow reasonable period of credit. The above two alternative conclusions are contradictory of each other therefore the ratio should be interpreted with caution. Example. From the following figures calculate average age of creditors and creditor turn over ratio:
$ Creditor (closing) Bills payable (closing) Total purchases Cash purchases Purchases returns Days of year 54200 5800 338000 28500 9500 365

SOLUTION: Average age of creditors = Average account payable x Days of year / Net credit purchases

= 60,000 x 365 / 300,000 = 73 days Creditors turn over ratio = Net credit purchase / Average accounts payable = 300,000 / 60,000 = 5 times Working: As opening creditors are not given so average creditors will be considered as ending creditors + Ending bills payable i.e., = 54200 + 5800 = $60,000 No. of days in a year = 365 Net Credit Purchases:
Total purchases Less:Cash purchases Less: Return outwards 28500 9500 38,000 $3,38,000

3,00,000

Relevant Articles:

Working Capital Turnover Ratio: Definition and Explanation: Working capital turnover ratio establishes relationship between cost of sales and net working capital. As working capital has direct and close relationship with cost of goods sold, therefore, the ratio provides useful idea of how efficiently or actively working capital is being used. Interpretation of this ratio should be done when interfirm or inter-period comparison is being done. Increasing ratio indicates that working capital is more active; it is supporting, comparatively, higher level of production and sales; it is being used more intensively. Formula: Working capital turnover ratio = Cost of sales /

Average net working capital Where, cost of sales = Opening stock + Net purchases + Direct expends - Closing stock Net working capital = Current assets - Current liabilities Average of networking capital is calculated, as usual, opening + closing dividing by 2. However, if the information regarding cost of sales and opening balance of networking capital is not available then the formulae should be substituted as: Net sales / Net working capital Example: From the summarized balance sheet given below of a company calculate working capital turnover ratio.
2000 $ Equity Long term loans Current liabilities 1,24,000 1,10,000 74,000 2001 $ 1,22,000 80,000 1,38,000

3,08,000

3,40,000

Fixed assets Current assets

2,08,000 1,00,000

1,98,000 1,42,000

3,08,000

3,40,000

Your are informed that sales (net) during 2000 and 2001 amounted to $6,00,000 and $5,00,000 respectively and Gross profit for the two years was $80,400 and $60,801 respectively. Working Notes:
Ascertaining cost of sales: 2000 $ 6,00,000 Loss gross profit Cost of sales 5,19,600 4,39,200 80,4000 2001 $ 5,500,000 60,8000

Ascertaining networking capital:

2000 $ 1,00,000

2001 $ 1,42,000 1,42,000

Current assets

1,00,000

Less current liabilities

74,000

1,38,000

Net working capital

26,000

4,000

Average networking capital cannot be calculated for the year 2000 because opening figure is not available. Hence we shall use closing balance. Average networking capital for the year (2001) (Opening + Closing) / 2 = (26,000 + 4,000) / 2 = 30,000 / 2 = $15,000 Working capital turnover ratio (2000) = Cost of sales / Net working capital = 5,19,000 / 26,000 20 times (app.) Working capital turnover ratio (2001) = Cost of sales / Average networking capital = 4,39,200 / 15,000 = 29 times (approx.)

Relevant Articles:

Profitability Ratio: The main object of a business concern is to earn profits. In general terms, efficiency in business is measured by profitability. A low profitability may arise due to lack of control over the expenses. Bankers financial institutions and other creditors look at the profitability ratios as an indicator whether or not the firm earns substantially more than it pays interest for the use of borrowed funds and whether the ultimate repayment of their debt appears reasonably certain. Owners are also interested to know the profitability as

it indicates the return which they can get on their investments. Following are some of the most important profitability ratios: (1) Gross Profit Ratio: Gross profit ratio is the ratio of gross profit to net sales i.e. sales less sales returns. (2) Operating Profit Ratio: Operating net profit ratio is calculated by dividing the operating net profit by sales. (3) Net Profit Ratio: Net profit ratio expresses the relationship between net profit after taxes and sale. (4) Operating Ratio: This ratio is determined by comparing the cost of the goods sold and other operating expenses with net sales (5) Expense Ratios: Expense ratios are calculated to ascertain the relationship that exists between operating expenses and volume of sales: Expense ratios are calculated by dividing each item of expense or group of expenses

with the net sales so analyse the cause of variation of the operating ratio. Relevant Articles:

Gross Profit Ratio (GP Ratio): Definition and Explanation: Gross profit ratio is the ratio of gross profit to net sales i.e. sales less sales returns. The ratio thus reflects the margin of profit that a concern is able to earn on its trading and manufacturing activity. It is the most commonly calculated ratio. It is employed for inter-firm and inter-firm comparison of trading results. Formula: Following formula is used to calculated gross profit

ratio (GP Ratio): Gross profit / (Net sales 100) Where Gross profit = Net sales - Cost of goods sold Cost of goods sold = Opening stock + Net purchases + Direct expenses - Closing stock Net sales = Sales - Returns inwards Gross profit is what is revealed by the trading account. It results from the difference between net sales and cost of goods sold without taking into account expenses generally charged to the profit and loss account. The larger the gap, the greater is the scope for absorbing various expenses on administration, maintenance, arranging finance, selling and distribution and yet leaving net profit for the proprietors or shareholders. In case, there is increase in the percentage of gross profit as compared to the previous year, it is indicator of one or more of the following factors.

The selling price of the goods has gone up without corresponding increase in the cost of goods sold. The cost of goods sold has gone down without corresponding decrease in the selling price of the goods.

Purchases might have been omitted or sales figures might have been inflated. The valuation of the opening stock is lower than what it should be or the valuation of the closing stock is higher than what it should be. In case, there a decrease in the rate of gross profit, it may be due to one or more of the following reasons. There may be decrease in the selling rate of the goods sold without corresponding decrease in the cost of goods sold. There may be increase in the cost of goods sold without corresponding increase in the selling price of the goods sold. There may be omission of sales. Stock at the end may have been under-valued or opening stock may have been over-valued.

Example: Calculate gross profit ratio from the following particulars.

$ 1,55,000 5,000 40,000 $ 80,000 10,000 10,000

particulars Sales Sales returns Opening stock

particulars Purchases Purchases returns Closing stock

Solution:

Cost of goods sold = Opening stock + Net purchases Closing stock = 40,000 + 70,000 - 10,000 = 1,00,000 Net sales = 1,55,000 - 5,000 = 150,000 Gross profit = 1,50,000 - 1,00,000 = 50,000 Gross profit ratio = (50,000 / 1,50,000) x 100 = 33.33 % Relevant Articles:

Operating Profit Ratio: Operating net profit ratio is calculated by dividing the operating net profit by sales. This ratio helps in determining the ability of the management in running the business. Formula: Operating profit / (Net sales 100) Operating profit = Gross profit - Operating Exp. OR Operating profit = Net sales - Operating cost OR = Net sales - (Cost of goods sold + Administrative and office expenses + Selling and distribution exp.) OR (Net profit + Non-operating expenses) - (Non-operating incomes) Higher the ratio, better it is Example:
Particulars Sales less returns Gross profit $ 4,00,000 1,40,000 Particulars Selling expenses Income from $ 25,000 1,000

investment Administration expenses 35,000 Loss on account of fire 2,000

Solution: Operating profit = Gross profit - Administration and selling expenses = 1,40,000 - (35,000 + 25,000) = 1,40,000 - 60,000 = $80,000 Operating profit ratio = 80, 000 / (4,00,000 100) = 20 % Relevant Articles:

Net Profit Ratio (NP Ratio): Net profit ratio (NP ratio) expresses the relationship between net profit after taxes and sales. This ratio is a measure of the overall profitability net profit is arrived at after taking into account both the operating and non-operating items of incomes and expenses. The ratio indicates what portion of the net sales is left for the owners after all expenses have been met. Formula: Following formula is used to calculate net profit ratio: Net profit ratio = (Net profit after tax / Net sales) 100 It is expressed in percentage. Higher the net profit ratio, higher is the profitability of the business. Example: From the following information calculate net profit ratio (NP ratio) Total sales = $520,000; Sales returns = $ 20,000; Net profit $40,000 Net sales = (520,000 20,000) = 500,000 Net Profit Ratio = [(40,000 / 500,000) 100] = 8%

Significance: Net profit ratio is used to measure the overall profitability and hence it is very useful to proprietors. The ratio is very useful as if the net profit is not sufficient, the firm shall not be able to achieve a satisfactory return on its investment. This ratio also indicates the firm's capacity to face adverse economic conditions such as price competition, low demand, etc. Obviously, higher the ratio the better is the profitability. But while interpreting the ratio it should be kept in mind that the performance of profits also be seen in relation to investments or capital of the firm and not only in relation to sales. Relevant Articles:

Operating Ratio: The operating ratio is determined by comparing the cost of the goods sold and other operating expenses with net sales. Formula: Following formula is used to calculate operating ratio: [(Cost of goods sold + Operating expenses / Net sates)] 100 Here cost of goods sold = Operating stock + Net purchases + Manufacturing expenses - Closing stock OR = Net sales - Gross profit Operating expenses = Office and administrative expenses + Selling and distribution expenses Interpretation: This ratio is a test of the efficiency of the management in their business operation. It is a means of operating efficiency. In normal conditions, the operating ratio should be low enough so as to leave portion of the sales sufficient to give a fair return to the investors. Operating ratio plus operating profit ratio is 100. The two ratios are obviously interrelated. For example, if

the operating profit ratio is 20%, it means that the operating ratio is 80%. A rise in the operating ratio indicates a decline in the efficiency. Lower the operating ratio, the better is the position because greater is the profitability and management efficiency of the concern. The higher the ratio, the less favorable is the situation, because there will be smaller margin of profit available for the purpose of payment of dividend and creation of reserves. Example: From the following details, calculate the operating ratio:
Cost of goods sold Operating Expenses Sales Sales returns 6,00,000 40,000 8,20,000 20,000

Solution: Operating ratio = [(Cost of goods sold + Operating expenses) / Net Sales] 100 = (6,00,000 + 40,000) / (8,20,000 - 20,000) 100 = 640,000 / 800,000 = 80 %

Relevant Articles:

Expense Ratios: Definition and Explanation: Expense ratios are calculated to ascertain the relationship that exists between operating expenses and volume of sales. Expense ratios are calculated by dividing each item of expense or group of expenses with the net sales so analyse the cause of variation of the operating ratio. It indicates the portion of sales which is consumed by various operating expenses.

Formula:

Ratio of material used to sales: (Direct material cost / Net sales) 100 Ratio of labour to sales: (Direct labour cost / Net sales) 100 Ratio of factory overheads to sales: (Factory expenses / Net sales) 100 Ratio of office and administration expenses to sales: (Office and administration expenses / Net sales) 100 Ratio of selling and distribution expenses to sales: (Selling and distribution expenses / Net sales) 100

These ratios are expressed in terms of percentage. The total of the above ratios will be equal to the operating ratio. The total revenue expenditure may be sub-divided into two categories with fixed and variable. In the case of a fixed expense, the ratio will fall with increase in sales and for a variable expense, the ratio in proportion to sales shall nearly remain the same. Example: The following is the trading and profit and loss account of a Private Ltd. company for the year ended June 30, 1998.

Details Stock in hand Purchases Carriage and freight Wages Gross profit c/d

$ 76,250 3,15,250 2,000 5,000 2,00,000

Details Sales Stock in hand

$ 5,00,000 98,000

5,98,500

5,98,500

Administrative expenses Finance expenses Selling and distribution expenses Non-operating expenses:

1,01,000 7,000 12,000

Gross profit b/d Non-operating incomes: Interest on securities Dividend on shares Profit on sale of shares 1,500

2,00,000

3,750

loss on sale of securities Provision for legal suit

350 1,650 2,000

750

6,000

Net profit

84,000

2,06,000

2,06,000

You are required to calculate:

Administration express ratio

Finance expenses ratio Selling and distribution expenses ratio Non-operating expenses ratio

Solution:

Administration express ratio = (Administration express / Net sales) 100 = (1,01,000 / 5,00,000) 100 = 20.2 % Finance expenses ratio = (Finance express / Net sales) 100 = (7,000 / 5,00,000) 100 = 1.4 % Selling and distribution expenses ratio = (Selling and distribution express / Net sales) 100 = (12,000 / 5,00,000) 100 = 2.4 %

Non-operating expenses ratio = (Non-operating ratio / Net sales) 100 = (2,000 / 5,00,000) 100 = 0.4 %

Relevant Articles:

Solvency Ratios - Test of Long Term Solvency: The long-term financial soundness of any business can be judged by its long-term creditors by testing its ability to pay interest charges regularly and its ability to repay the principal as per schedule. Thus long-term financial soundness (or solvency) of any business is examined by calculating ratios popularly, known as leverage of capital structure ratios. These ratios help us the interpreting repay long-term debt as per installments stipulated in the contract. Following are the most important solvency ratios: 1. Debt-Equity ratio: (also known as debt to net worth ratio). The relationship between borrowed funds and internal owner's funds is measured by Debt-Equity ratio. 2. Debt Service or Interest Coverage Ratio: The ratio

measures debts servicing capacity of a business so far as interest on long-term loans is concerned. The ratio is calculated with formula. 3. Debts to Total Funds or Solvency Ratio: Solvency is the term which is used to describe the financial position of any business which is capable to meet outside obligations in full out of its own assets. So this ratio establishes relationship between total liabilities and total assets. 4. Reserves to Capital Ratio: This ratio establishes relationship between reserves and capital. 5. Capital Gearing Ratio: It is the ratio between the capital plus reserves i.e. equity and fixed cost bearing securities. Fixed cost bearing securities include debentures, long-term mortgage loans etc. 6. Proprietary Ratio: Proprietary ratio (also known as Equity Ratio or Net worth to total assets or shareholder equity to total equity). Relevant Articles:

Debt-Equity Ratio: Definition: The relationship between borrowed funds and internal owner's funds is measured by Debt-Equity ratio. This ratio is also known as debt to net worth ratio. Formula: The following formulas are used to calculate debt equity ratio:

Debt Equity Ratio = Total long term debts / shareholder' funds

Where total long-term debts excludes current liabilities. Shareholder's funds include (i) Ordinary share capital, (ii) Credit balance of profit and loss account and free reserves etc., but deduction should be made for fictitious assets if any in the balance sheet. Shareholders funds or net worth = Owner's equity Fictitious assets Debt-equity ratio with above concept is also known as Debt to Net worth ratio.

Another version of Debt-Equity ratio (known as external-internal equity ratio) is where relationship is established between borrowed

funds and owner's equity. Debt-equity ratio = External equity ratio / Internal Equity ratio or Total debs / Shareholders equity Where Total debts = (Short-term debts + Long-term debts). The difference between this and the first approach is m respect of current liabilities. In the first approach current liabilities are excluded where as in the second approach the same are included.

Still another version of Debt-Equity ratio known as debts vs. funds ratio is when long-term loans are related to total long-term funds.

Debt-Equity ratio = Long term loans / Total long term funds where long-term funds = Long-term loans + Equity Examples: From the following calculate the Debt-equity ratio.
$ 10,000 Equity shares @ $10 each. General reserve Accumulated profit 1,00,000 45,000 30,000

Debentures Sundry trade creditors Outstanding expenses

75,000 40,000 10,000

Solution: Debt-Equity Ratio = Total long term debts / Shareholders funds = 75,000 / 1,00,000 + 45,000 + 30,000 = 3 : 7

Every three dollars of long-term debts are being backed by an investment of seven dollars by the owners. Thus the safety margin for creditors is more than double. Debt-Equity ratio = External equity / Internal equity

Debentures + Sundry trade creditors + Outstanding expenses / Equity capital + General reserve + Accumulated profits = 75,000 + 40,000 + 10,000 / 1,00,000 + 45,000 + 30,000 = 1,25,000 / 1,75,000 =5:7 Outsider's investment of $5 is matched well by owner's investment of $7.

Debt-Equity ratio = Total long term loans / Total long term funds

= Debenture / Equity capital + Gen. reserve + Profits + Debentures = 75,000 / 1,00,000 + 45,000 + 30,000 + 75,000 = 75,000 / 2,50,000 = 3 : 10 Every ten dollars of long-term funds include seven dollars of owners and three dollars of the outsiders. Note: Because of different versions of this ratio it is advised that the student should state in his solution as to which version he has made use of. Relevant Articles:

Debt Service Ratio or Interest Coverage Ratio: Definition: The ratio measures debts servicing capacity of a business so far as interest on long-term loans is concerned. This ratio shows how many times the interest charges are covered by the earnings. Debt service ratios is also know as interest coverage ratio. Formula: The ratio is calculated with following formula: Debt service ratio = Earnings before interest and taxes (EBIT) / Fixed interest charges Example: From the following, calculate interest coverage ratio.
$ 9% Mortgage loan 7.5% Debentures Net profit (after tax) Income tax rate 10,00,000 12,00,000 9,72,000 50 %

Solution: Interest coverage ratio = Earnings before interest and tax / Fixed interest charges

= 21,24,000* / 1,80,000** 11.8 times Working: (i) Calculation of Interest Payable: (l0,00,000 9 / 100 ) + (12,00,00 15 / 2 1 / 100) 90,000 + 90,000 = $1,80,000** (ii) Calculation of Tax Liability: Tax rate = 50% Profit after tax = 972,000 Tax amount = [9,72,000 / (100 - 50)] x 50 = 9,72,000 (iii) Profit before Interests and Tax: = Profit after tax + Tax + Interest = 9,72,000 + 9,72,000 + 1,80,000 = 21,24,000* Comments: Net profits available for payment of interest are approximately 12 times. It implies that even if earnings decline to 1/11th of the current figure long-term

creditors interest repayments is safe. Relevant Articles:

Fixed Assets Ratio: Definition: This ratio establishes the relationship between long term funds (equity plus long-term loans) and fixed assets. Since financial management advocates that fixed assets should be purchased out of long term funds only. Formula: Following formula or equation is used to calculate

fixed assets ratio: Fixed Assets ratio = Net fixed assets / Long term funds Relevant Articles:

Debts to Total Funds or Solvency Ratio: Solvency is the term which is used to describe the financial position of any business which is capable to meet outside obligations in full out of its own assets. So this ratio establishes relationship between total liabilities and total assets. Formula: Debts to Total Funds or Solvency Ratio = Total liabilities / Total assets

Relevant Articles:

Reserves to Capital Ratio: This ratio establishes relationship between reserves and capital. Higher proportion of reserves shows financial soundness because:

Unit shall be able to meet future losses as and when suffered. Unit can grow, expand, diversify as it may desire.

Formula: The ratio is calculated with the help of following formula: Reserves to capital ratio = Reserves Capital / Capital

Capital Gearing Ratio: Definition and Explanation: It is the ratio between the capital plus reserves i.e. equity and fixed cost bearing securities. Fixed cost bearing securities include debentures, long term mortgage loans etc. In a company form of organization, real risk is borne by equity shareholders because they are entitled to whatever residue is left after all others have been paid at the contracted rate. This ratio measures the extent of capitalization by the funds raised by the issue of fixed cost securities. This ratio is interpreted by the use of two terms. Highly geared mean lower proportion of equity. Low geared means high proportion of equity as compared

to fixed cost bearing capital. Formula: The formula/equation for the calculation of capital gearing ratio is as follows: Capital gearing ratio = Equity / Fixed cost bearings securities Where, Equity = Equity share capital + Free reserves + Profits and loss account credit balance Fixed cost bearing securities = Debentures + Long term loans Significance: Capital gearing must be carefully planned. Financial management gives us a concept of "Trading on Equity". It means as long as rate of earnings of business is higher than cost of fixed interest/dividend bearings securities the equity shareholders gain on the strength of their equity. Reverse follows in alternative situations. Relevant Articles:

Proprietary Ratio: Definition and Explanation: Proprietary ratio (also known as Equity Ratio or Net worth to total assets or shareholder equity to total equity). Establishes relationship between proprietor's funds to total resources of the unit. Where proprietor's funds refer to Equity share capital and Reserves, surpluses and Tot resources refer to total assets. Formula: Following formula is used to calculate proprietary ratio: Proprietary ratio = Proprietor's funds / Total assets This relationship highlights the fact as to what is the proportion of Proprietors and outsiders in financing the total business. Suppose, in a business total assets amount of $4,00,000 and Proprietors equity is

$3,00,000 then Proprietary ratio = 3,00,000 / 4,00,000 = 0.75 times. or 75% meaning hereby that 25% of the funds have been supplied by the outside creditors. Example: From the balance sheet given below calculate the proprietary ratio. Balance Sheet
Liabilities Equity share capital Reserves & surplus Debentures Creditors $ 3,00,000 50,000 1,00,000 50,000 Assets Fixed assets Current assets Good will Investment $ 2,00,000 1,00,000 50,000 1,50,000

5,00,000

5,00,000

Solution: Proprietary ratio = Proprietor's funds / Total assets Where, proprietor's funds = Share capital + Reserves and surplus

i.e., 3,00,000 + 50,000 = 3,50,000 and total assets are 5,00,000 Hence the ratio is = 3,50,000 / 5,00,000 = 7 : 10 Note: Some accountants exclude intangible assets from the term total assets. If so, then assets are (5,00,000 - goodwill) = 4,50,600 in that case. Proprietary = 3,50,000 / 4,50,000 =7:9 Relevant Articles:

Accounting Ratios Formulas: 1. Gross profit ratio = (Gross profit / Net sales) x 100 2. Net profit ratio = (Net profit / Net sales) x l00 3. Operating profit ratio = (Operating profit / Net sales) x 100 4. Expense ratios = (Individual expenses / Net sates) x 100 5. Operating (cost) ratio = (Operating cost / Net sales) x 100 6. Net profit to net worth ratio = (Net profit after interest and tax / Net worth) x 100 7. Return on capital employed (ROI) = (Net profit before interest, tax / Capital employed) x 100 8. Earning per share = net profit available for equity shareholders / Number of equity shares 9. Dividends per share = Dividend amount / Number of equity shares 10. Capital employed turnover ratio = Cost of sales / Capital employed 11. Fixed assets turnover ratio = Cost of sales or sales / Fixed assets 12. Working capital turnover ratio = Cost of sales or Net sales / Net working capital 13. Inventory turnover ratio = Cost of goods sold / Average inventory 14. Debtors (receivables) turnover ratio = Annual net credit sales / Average accounts receivable 15. Debtors (receivables) collection period = Accounts receivables / Net credit sales per day 16. Creditors turnover ratio = Net credit

purchases / Average creditors 17. Average credit period = Average account payables / Net credit purchases per day 18. Current ratio = Current assets / Current liabilities 19. Quick ratio/Acid test ratio = Quick assets / Current liabilities 20. Debt Equity Ratio = Total long term debts / shareholder' funds 21. Debt to net worth = Total long term debt / Shareholder's funds 22. External-internal equity = External equity / Internal equity 23. Debt vs. funds = total long term debts / Total long term funds 24. Debt service ratio = Earnings before interest and taxes / Fixed interest charges 25. Fixed assets ratio =Net fixed assets / Longterm funds 26. Solvency (debt to total funds) ratio = Total liabilities / Total assets 27. Reserves to capital ratio = Reserves / Capital 28. Capital gearing ratio =Equity / Fixed interest hearing securities 29. Proprietary ratio = Proprietor's funds / Total assets