Accounting ratios express the mathematical relationship between two related accounting figures drawn from financial statements. They condense vast financial data into a form that enables quick assessment of liquidity, solvency, profitability, and activity.
Classification of Ratios
1. Liquidity Ratios (Short-term Solvency)
Measure a firm's ability to meet short-term obligations.
- a. Current Ratio
- Current Ratio = Current Assets / Current Liabilities
- Ideal ratio: 2:1 (higher generally better, but too high may indicate idle assets).
- Current Assets: stock, debtors, cash, short-term investments, prepaid expenses.
- Current Liabilities: creditors, bills payable, bank overdraft, outstanding expenses, short-term provisions.
b. Quick Ratio (Acid-test Ratio / Liquid Ratio)
Quick Ratio = Quick Assets / Current Liabilities
Quick Assets = Current Assets - Inventories - Prepaid Expenses
- Ideal ratio: 1:1.
- Removes less liquid assets (stock, prepaid) to give a stricter test of liquidity.
2. Solvency Ratios (Long-term Solvency)
Measure ability to meet long-term obligations.
- a. Debt-to-Equity Ratio
- Debt-to-Equity Ratio = Long-term Debt / Shareholders Funds (Equity)
- Long-term Debt = Debentures + Long-term Loans.
- Ideal: 2:1 for most companies. Lower is safer for creditors.
b. Total Assets to Debt Ratio
Total Assets to Debt Ratio = Total Assets / Long-term Debt
- Higher ratio = more secure creditors.
c. Proprietary Ratio
Proprietary Ratio = Shareholders Funds / Total Assets
- Shows proportion of total assets financed by owners. Higher = lower reliance on external debt.
d. Interest Coverage Ratio
Interest Coverage Ratio = Net Profit Before Interest and Tax (EBIT) / Interest on Long-term Debt
- Shows how many times interest can be paid from profits. Higher = safer for lenders.
3. Activity Ratios (Efficiency / Turnover Ratios)
Measure how efficiently assets are used to generate sales.
a. Inventory Turnover Ratio
Inventory Turnover = Cost of Revenue from Operations / Average Inventory
Average Inventory = (Opening Stock + Closing Stock) / 2
b. Debtor Turnover Ratio (Trade Receivables Turnover)
Debtor Turnover = Net Credit Sales / Average Trade Receivables
c. Creditor Turnover Ratio (Trade Payables Turnover)
Creditor Turnover = Net Credit Purchases / Average Trade Payables
d. Working Capital Turnover Ratio
Working Capital Turnover = Revenue from Operations / Working Capital
Working Capital = Current Assets - Current Liabilities
4. Profitability Ratios
Measure a firm's ability to generate profit relative to sales, assets, or equity.
a. Gross Profit Ratio
Gross Profit Ratio = (Gross Profit / Revenue from Operations) x 100
Gross Profit = Revenue from Operations - Cost of Revenue from Operations
b. Net Profit Ratio
Net Profit Ratio = (Net Profit After Tax / Revenue from Operations) x 100
c. Operating Ratio
Operating Ratio = (Operating Cost / Revenue from Operations) x 100
Operating Cost = Cost of Revenue from Operations + Operating Expenses (excluding finance costs and tax)
d. Return on Investment (Return on Capital Employed — ROCE)
ROCE = (Net Profit Before Interest and Tax / Capital Employed) x 100
Capital Employed = Shareholders Funds + Long-term Debt = Total Assets - Current Liabilities
e. Return on Net Worth (RONW)
RONW = (Net Profit After Tax / Shareholders Funds) x 100
Worked Example 1: Current Ratio
Current Assets = Rs. 4,00,000; Current Liabilities = Rs. 2,00,000.
Current Ratio = 4,00,000 / 2,00,000 = 2:1. This meets the ideal benchmark.
Worked Example 2: Quick Ratio
Current Assets = Rs. 4,00,000; Stock = Rs. 1,20,000; Prepaid Expenses = Rs. 30,000; Current Liabilities = Rs. 2,00,000.
Quick Assets = 4,00,000 - 1,20,000 - 30,000 = Rs. 2,50,000.
Quick Ratio = 2,50,000 / 2,00,000 = 1.25:1. This is above the ideal of 1:1 — a healthy position.
Worked Example 3: Debt-to-Equity Ratio
Long-term Debt = Rs. 6,00,000; Shareholders Funds = Rs. 4,00,000.
Debt-Equity Ratio = 6,00,000 / 4,00,000 = 1.5:1. This indicates moderate leverage.
Worked Example 4: Inventory Turnover
Cost of Revenue = Rs. 12,00,000; Opening Stock = Rs. 1,50,000; Closing Stock = Rs. 2,50,000.
Average Inventory = (1,50,000 + 2,50,000) / 2 = Rs. 2,00,000.
Inventory Turnover = 12,00,000 / 2,00,000 = 6 times. Stock turns over 6 times a year.
Worked Example 5: Gross Profit Ratio
Revenue from Operations = Rs. 15,00,000; Cost of Revenue = Rs. 10,50,000.
Gross Profit = Rs. 4,50,000.
GP Ratio = (4,50,000 / 15,00,000) x 100 = 30%.
Worked Example 6: Return on Capital Employed
EBIT = Rs. 3,00,000; Shareholders Funds = Rs. 8,00,000; Long-term Debt = Rs. 4,00,000.
Capital Employed = Rs. 12,00,000.
ROCE = (3,00,000 / 12,00,000) x 100 = 25%.
Worked Example 7: Interest Coverage Ratio
EBIT = Rs. 5,40,000; Annual interest on debentures = Rs. 60,000.
Interest Coverage = 5,40,000 / 60,000 = 9 times. Highly comfortable for lenders.
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Common mistakes
- Including bank overdraft in long-term debt — bank overdraft is a current liability, not long-term debt.
- Using "Gross Revenue" instead of "Net Revenue from Operations" in profitability ratios.
- Forgetting to exclude prepaid expenses from Quick Assets.
- Using total debt (current + non-current) instead of only long-term debt for Debt-Equity Ratio.
- Confusing Operating Ratio with Net Profit Ratio — Operating Ratio uses operating cost (excludes interest and tax); Net Profit Ratio uses PAT.
Summary
Ratios fall into four groups: liquidity (current, quick), solvency (debt-equity, interest coverage), activity (inventory, debtors, creditors, working capital turnover), and profitability (GP, NP, operating, ROCE, RONW). Each ratio benchmarks a specific dimension of financial health. Always use the correct numerator, denominator, and definition. Ratios must be interpreted in context — against industry norms, historical trends, and comparative data.