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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