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Accounting Ratios

Accounting Ratios

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Accounting Ratios
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Activity Ratios
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Dividend Payout and Price/Earnings Ratio
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Earnings per Share and Book Value per Share
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Financial Statement Analysis
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Liquidity Ratios
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Profitability Ratios
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Return on Capital Employed
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Solvency Ratios
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Types of Ratios
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Learning Objectives

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Learning Objectives

  • Explain the meaning, objectives, and limitations of accounting ratios.
  • Identify the various types of ratios commonly used.
  • Calculate various ratios to assess solvency, liquidity, efficiency, and profitability of the firm.
  • Interpret the various ratios calculated for intra-firm and inter-firm comparisons.

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Revision Notes & Summary

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Accounting Ratios

1. Meaning of Accounting Ratios

  • Accounting ratios are mathematical numbers calculated to express the relationship between two or more accounting numbers. They can be expressed as a fraction, proportion, percentage, or a number of times.

2. Objectives of Accounting Ratios

  • Assess solvency, efficiency, and profitability of enterprises.

3. Advantages of Ratio Analysis

  1. Helps to understand efficacy of decisions: Indicates the effectiveness of operating, investing, and financing decisions.
  2. Simplifies complex figures: Summarizes financial information effectively and assesses managerial efficiency.
  3. Helpful in comparative analysis: Enables trend analysis over multiple years.
  4. Identification of problem areas: Highlights areas needing attention and those performing well.
  5. Enables SWOT analysis: Assists in understanding current threats and opportunities.
  6. Various comparisons: Allows comparisons with benchmarks, other enterprises, and industry standards.

4. Limitations of Ratio Analysis

  • Ratios are means to an end, not the end itself.
  • Lack of standardized definitions and universally accepted standard levels.
  • Ratios based on unrelated figures can be meaningless.

5. Types of Ratios

  • Liquidity Ratios: Current Ratio, Liquid Ratio.
  • Solvency Ratios: Debt Equity Ratio, Interest Coverage Ratio.
  • Activity Ratios: Inventory Turnover, Trade Receivables Turnover.
  • Profitability Ratios: Gross Profit Ratio, Net Profit Ratio, Return on Investment (ROI).

6. Key Ratios and Their Formulas

Ratio TypeFormulaDescription
Current RatioCurrent Assets / Current LiabilitiesMeasures short-term solvency
Liquid Ratio(Current Assets - Inventory) / Current LiabilitiesMeasures immediate liquidity
Debt Equity RatioTotal Debts / Shareholders' FundsMeasures financial leverage
Interest Coverage RatioNet Profit before Interest and Tax / Interest on Long-term DebtsMeasures ability to cover interest payments
Gross Profit RatioGross Profit / Revenue from OperationsMeasures profitability from sales
Return on Investment (ROI)Net Profit / Total InvestmentMeasures efficiency of investment

7. Example Calculations

  • Current Ratio Calculation:
    • Current Assets = Inventories + Trade Receivables + Cash = Rs. 1,34,000
    • Current Liabilities = Trade Payables + Short-term Borrowings = Rs. 1,04,000
    • Current Ratio = Rs. 1,34,000 / Rs. 1,04,000 = 1.29:1
  • Interest Coverage Ratio Calculation:
    • Net Profit before Tax = Net Profit after Tax / (1 - Tax Rate) = Rs. 1,00,000
    • Interest on Long-term Debt = 15% of Rs. 10,00,000 = Rs. 1,50,000
    • Interest Coverage Ratio = Rs. 2,50,000 / Rs. 1,50,000 = 1.67 times

8. Conclusion

  • Ratio analysis is a vital tool for assessing the financial health of a business, providing insights into various aspects of its performance.
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Practice Test – MCQs, True/False

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Multiple Choice Questions

A.

EPS = Profit available for equity shareholders / Number of Equity Shares

B.

EPS = Total Revenue / Number of Equity Shares

C.

EPS = Net Profit / Total Assets

D.

EPS = Gross Profit / Net Revenue
Correct Answer: A

Solution:

Earnings per Share (EPS) is calculated as the profit available for equity shareholders divided by the number of equity shares.

Chapter Concept:

Earnings per Share and Book Value per Share

A.

Current Ratio

B.

Debt to Equity Ratio

C.

Inventory Turnover Ratio

D.

Gross Profit Ratio
Correct Answer: C

Solution:

The Inventory Turnover Ratio measures how efficiently a company converts its inventory into sales, reflecting operational efficiency.

Chapter Concept:

Types of Ratios

A.

Increase

B.

Decrease

C.

Remain unchanged

D.

Cannot be determined
Correct Answer: B

Solution:

Issuing additional equity shares increases the equity component, thereby decreasing the debt-equity ratio.

Chapter Concept:

Solvency Ratios

A.

$25,000

B.

$50,000

C.

$75,000

D.

$100,000
Correct Answer: A

Solution:

The current assets are 100,000(2×100,000 (2 \times 50,000) and the quick assets are 75,000(1.5×75,000 (1.5 \times 50,000). The inventories are the difference between current assets and quick assets, which is 100,000−100,000 - 75,000 = $25,000.

Chapter Concept:

Financial Statement Analysis

A.

The company has a high amount of cash.

B.

The company has significant inventories.

C.

The company has low trade receivables.

D.

The company has high short-term borrowings.
Correct Answer: B

Solution:

The difference between the current ratio and the quick ratio indicates the presence of significant inventories, as inventories are excluded from quick assets.

Chapter Concept:

Accounting Ratios

A.

15%

B.

20%

C.

25%

D.

30%
Correct Answer: B

Solution:

Net profit ratio is calculated as (Net Profit / Revenue from Operations) * 100 = (300,000/300,000 / 1,500,000) * 100 = 20%.

Chapter Concept:

Accounting Ratios

A.

Current Assets / Current Liabilities

B.

Current Liabilities / Current Assets

C.

Quick Assets / Current Liabilities

D.

Current Assets - Current Liabilities
Correct Answer: A

Solution:

The current ratio is calculated as Current Assets divided by Current Liabilities.

Chapter Concept:

Liquidity Ratios

A.

8

B.

10

C.

12

D.

15
Correct Answer: B

Solution:

The P/E ratio is calculated as the market price per share divided by the earnings per share (EPS). Here, P/E ratio = 50/50 / 5 = 10.

Chapter Concept:

Dividend Payout and Price/Earnings Ratio

A.

Solvency Ratio

B.

Liquidity Ratio

C.

Profitability Ratio

D.

Activity Ratio
Correct Answer: B

Solution:

Liquidity ratios are used to measure a company's ability to pay off its short-term liabilities with its short-term assets.

Chapter Concept:

Types of Ratios

A.

It provides a precise and final figure of profit.

B.

It ignores price-level changes.

C.

It includes qualitative factors.

D.

It is based on standardized accounting practices.
Correct Answer: B

Solution:

Ratio analysis ignores price-level changes, which can affect the comparability of financial statements over time.

Chapter Concept:

Accounting Ratios

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Accounting Ratios

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True or False

Correct Answer: True

Solution:

ROCE is a financial ratio that indicates the efficiency and profitability of a company's capital investments. It is calculated by dividing profit before interest and tax by capital employed, highlighting the overall utilization of funds.

Chapter Concept :

Return on Capital Employed

Correct Answer: True

Solution:

The dividend payout ratio indicates the proportion of earnings distributed to shareholders, thereby reflecting the company's dividend policy and potential growth in owner's equity.

Chapter Concept :

Dividend Payout and Price/Earnings Ratio

Correct Answer: True

Solution:

Profitability ratios assess the earning capacity of a business by examining how effectively resources are utilized, as indicated by the various profitability ratios such as Gross Profit Ratio, Net Profit Ratio, and Return on Investment.

Chapter Concept :

Types of Ratios

Correct Answer: True

Solution:

Activity ratios are specifically designed to assess how effectively a company utilizes its assets to generate revenue. High turnover ratios indicate efficient use of assets.

Chapter Concept :

Activity Ratios

Correct Answer: True

Solution:

The quick ratio excludes inventories and other non-liquid current assets, making it a more stringent measure of a firm's ability to meet short-term obligations.

Chapter Concept :

Liquidity Ratios

Correct Answer: True

Solution:

Earnings per Share (EPS) is indeed calculated by dividing the profit available for equity shareholders by the number of equity shares, as specified in the text.

Chapter Concept :

Earnings per Share and Book Value per Share

Correct Answer: True

Solution:

Financial statement analysis is crucial for understanding the financial health of a business and involves techniques such as comparative statements, common size statements, trend analysis, accounting ratios, and cash flow analysis.

Chapter Concept :

Financial Statement Analysis

Correct Answer: True

Solution:

The Price/Earnings ratio reflects investors' expectations about the growth in the firm's earnings. A high P/E ratio suggests that investors anticipate higher future earnings growth.

Chapter Concept :

Dividend Payout and Price/Earnings Ratio

Correct Answer: True

Solution:

Earnings per Share (EPS) is indeed calculated by dividing the profit available for equity shareholders by the number of equity shares, as it provides a measure of the profitability attributed to each share of common stock.

Chapter Concept :

Earnings per Share and Book Value per Share

Correct Answer: False

Solution:

Accounting ratios must be calculated using numbers that are meaningfully correlated. Using unrelated figures would result in a meaningless ratio.

Chapter Concept :

Accounting Ratios

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