Accounting Ratios

Accounting ratios are used to define the relationship of one accounting ratio to another. Accounting ratios give us full comparisons of accounting results. Accounting ratios are used to determine the profitability and financial position of a firm. Accounting ratios provides the basis for fundamental analysis. Accounting ratio is used to measure the weaknesses and strength of a firm. It also gives sufficient information to an investor to make future investment decisions about a firm.

There are many types of accounting ratios used in accounting but there are three major accounting ratios that are mainly used. These are as under

 

  • Profitability Ratio
  • Liquidity Ratio
  • Turnover Ratio

The Profitability ratios are used to calculate the profit of a firm. The main objective of every business is to earn profits which are essential for the development and growth of a firm. The profitability ratios provide information of the concern operating performance and efficiency of a project. The profitability ratio is further classified into sub ratios these are

  • Gross profit ratio
  • Net profit ratio
  • Return on investment ratio
  • Debt equity ratio

The gross profit ratio represents the margin of profit that is earned on the sales. A high gross profit ratio shows a satisfactory position of a company. It shows that the price if sold goods is low. It shows the tend to which a firm can reduce the purchase price of goods without any loss. The formula of gross profit ratio is

Gross profit ratio = (gross profit \ net sales)* 100

Where net sales = total sales – sale returns

Gross profit = net sales – cost of goods sold

Let us consider an example.

Example:

Total sales = $520,000; Sales returns = $ 20,000; Cost of goods sold $400,000

Required: Calculate gross profit ratio.

Calculation:

Gross profit = [(520,000 – 20,000) – 400,000]

= 100,000

Gross Profit Ratio = (100,000 / 500,000) × 100

= 20%

Net profit ratio which is also called net profit margin gives the profit of project related to its sales. It is represented in percentage form. The main objective of net profit ratio is to measure the profitability due to various factors such as operational efficiency. It gives the extent to which a management can reduce operational expenditure. The formula of net profit ratio is given by

Net Profit Ratio = (Net profit / Net sales) × 100

Let us consider an example of net profit ratio

Example:

Total sales = $520,000; Sales returns = $ 20,000; Net profit $40,000

Calculate net profit ratio.

Calculation:

Net sales = (520,000 – 20,000) = 500,000

Net Profit Ratio = [(40,000 / 500,000) × 100]

= 8%

Return on investment ratio is another basic profitability ratio. It gives the relationship between the profit and the investment made. This ratio measures the productivity of investments. Here the word investment is referring as long term funds invested in a project. The formula used for the return on investment ratio is

Return on Investment Ratio = net profits before tax / shareholders equity.

The debt equityratio is another important profitability ratio. It is the calculation of fixed interest funds with the shareholders’ funds invested in a firm or project. The main purpose of calculating the debt equity ratio is to measure the proportion of relative debt and equity in financing a firm. A low debt equity ratios shows more equity used than debt. The formula used for debt equity ratio is as under

Debt Equity Ratio = External Equities / Internal Equities

Or

Outsider’s funds / Shareholders funds

As a long term financial ratio it may be calculated as follows:

Total Long Term Debts / Total Long Term Funds

Or

Total Long Term Debts / Shareholders Funds

Let us consider an example.

Example:

From the following figures calculate debt to equity ratio:

Equity share capital
Capital reserve
Profit and loss account
6% debentures
Sundry creditors
Bills payable
Provision for taxation
Outstanding creditors
1,100,000
500,000
200,000
500,000
240,000
120,000
180,000
160,000

Required: Calculate debt to equity ratio.

Calculation:

External Equities / Internal Equities

= 1,200,000 / 18,000,000

= 0.66 or 4: 6

The second major accounting ratio is liquidity ratio. Liquidity ratio is used to measure the financial position of a firm. It tells us about the liquidity of the firm. Liquidity ratio is the measure of ability of a firm to provide enough cash to cover it short term obligations. The most common types of liquidity ratio are

  • Current  ratios
  • Quick ratios

Current ratio shows the relation between the current assets and the current liabilities. Both these figures can be obtained from the balance sheet of a company. Current assets include cash and other short term liabilities that can be converted into cash. Current liabilities on the other hand are money owned by a company. The formula of current ratio is

Current Ratio =          Current Assets \Current Liabilities

Quick ratio is similar to current ratio. But in quick ratio measures the ability of a firm to pay its short term debt without relying on the sale of its inventory. The formula of calculating quick ratio is as under

Quick Ratio    = (Current Assets – Inventories) \Current Liabilities

Let us consider the following data for the calculation of quick ratio and current ratio

 

ASSETS: LIABILITIES:
Current Assets: Current Liabilities:
Cash $ 2,550 Accounts Payable $ 9,500
Marketable securities $ 2,000 Short-term Bank Loan $11,375
Account Receivable (Net) $16,675 Total Current Liabilities $20,875
Inventories $26,470
Total Current Assets $47,695

 

Current Ratio = Current Assets
Current Liabilities
= $47,695
$20,875
= 2.28
Quick Ratio = Current Assets – Inventories
Current Liabilities
= $47,695 – $26,470
$20,875
= 1.02

 

The third major type of accounting ratio is INVENTORY TURNOVER RATIO. The inventory turnover ratio shows the relationship between cost of goods sale and average inventory. It is an efficient ratio and it measures that how many times a business sells and replaces its inventory per period. The formula for the calculation of inventory turnover ratio is as under

Inventory Turnover = Cost of Goods Sold\Average Inventory

Let us consider an example of inventory turnover ratio

Example: During the year ended December 31, 2010 Loud Corporation sold goods costing $324,000. Its average stock of goods during the same period was $23,432. Calculate the company’s inventory turnover ratio.

Solution
Inventory Turnover Ratio = $324,000 / $23,432 = 13.83

The other types of accounting ratios are as under

  • Gearing Ratio

 

Debt to Assets Ratio = Total Liabilities / Total Assets

 

  • Capital Marketing Ratio

Dividend Cover = Earnings Available for Common Shareholders / Dividends Paid

Dividend Yield = Annual Dividends per Common Share / Market Price Per Common Share

Historic Price Earnings (HPE) Ratio = Current Market Price of Common Share / Last Published Earnings per Share

Market to Book Ratio = Market Price per Common Share / Book Value of Equity Per Common Share

Price Earnings (PE) Ratio = Market Price of Common Share / Earnings per Share

 

 

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One Response to Accounting Ratios

  1. kingman says:

    great understandable work

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