Accounting Ratio Analysis

Introduction 

Accounting ratios are an important tool for analysing financial statements. It is a comparison of two or more financial data that is used to analyse a company’s financial statements. These depict a connection between two or more accounting numbers obtained from financial statements. It is a useful tool for shareholders, creditors, and other stakeholders to understand a company’s profitability, strength, and financial health. This is also known as financial ratios, which are used to track corporate performance and make key business choices.

“Accounting Ratios are ratios used to analyze a company's business and current financial standing and it is also used to spot and analyze companies in potential financial distress.”

All of these sorts of ratios are used to track business performance and compare results to those of competitors. Additionally, such ratios can be stated as a fraction, percentage, proportion, or number of times. The financial statements determine the correctness and efficiency of accounting ratios as a financial statement analysis tool. This is because the two or more accounting statistics used to calculate a financial ratio are obtained from such statements. As a result, if the financial statements contain incorrect data, the ratios will also portray an inaccurate analysis of the company’s financial results.

Financial Statement Analysis Tools

1. Ratio Analysis
2. Cash Flow Statement
3. Fund Flow Statement
4. Common Size Statement
5. Comparative Financial Statement

Accounting Ratio

Ratio analysis is a study of relationship among various financial factors in a business. It is technique of financial statement analysis. It is widely used tool to interpret quantitative relationship between two variables of financial statements.

1. Ration – Arithmetical expression of relationship between two interdependent items.
2. According Ratios – Ratios when calculated on the basis of accounting information (according Variables)

Accounting ratios when calculated on the basis of accounting equation or accounting variables. Accounting ratios indicate the company’s performance by comparing various figures from financial statements and the results or performance of the company over the last period, suggesting the relationship between two accounting items where financial statements analysis using liquidity, solvency, activity and profitability ratios.

Ratios Accounting are also known as Financial Ratios as these ratios help in determining the financial performance of the business.

Objectives of Accounting Ratio Analysis

All stakeholders in a business must be able to interpret financial statements and other financial data. As a result, ratio analysis becomes an important tool for financial analysis and management. The following are the objectives of performing financial ratio analysis of an organization:

1. Measure the Profitability and Growth - Every company’s ultimate goal is to make money. So, if I tell you that ABC Company made a profit of 5 lakhs last year, how would you know whether it is a good or terrible figure? To quantify profitability, context is essential, which is provided by ratio analysis. Gross Profit Ratios, Net Profit Ratios, and Expense Ratios, among others, provide a gauge of a company’s profitability. Such ratios can be used by management to identify and improve problem areas.
2. Evaluate Operational Efficiency of an Organization - Certain ratios reflect a company’s level of efficiency in managing its assets and other resources. To avoid excessive expenditures, it is critical that assets and financial resources be allocated and used wisely. Turnover and efficiency ratios will highlight any asset mismanagement.
3. Liquidity - Every company must ensure that part of its assets is liquid in case it needs money right now. As a result, ratios like the current ratio and the quick ratio are used to assess a company’s liquidity. These aid a company’s ability to sustain the necessary degree of short-term solvency.
4. Financial Strength - Some ratios can be used to determine a company’s long-term solvency. They can tell if a company’s assets are being strained or if the company is over-leveraged. To avoid liquidation in the future, management will need to immediately correct the situation. Debt-Equity Ratios, Leverage Ratios, and other similar ratios are examples.
5. Comparison with Industry Standards and Competitors - To acquire a better picture of the organization’s financial health and fiscal situation, the ratios must be compared to industry standards. If the company fails to meet market criteria, the management can take corrective measures. The ratios can also be compared to past years’ ratios to evaluate how far the company has progressed. Trend analysis is the term for this.

Liquidity Ratio 

A firm has assets and liabilities to its name. Some are fixed in nature and then there are current assets and current liabilities. These are short-term in nature and easily convertible into cash. The liquidity ratios deal with the relationship between such current assets and current liabilities.

Liquidity ratios evaluate the firm’s ability to pay its short-term liabilities, i.e., current liabilities. It shows the liquidity levels, i.e., how many of their assets can be quickly converted to cash to pay of their obligations when they become due. It is not only a measure of how much cash there is but also how easily current assets can be converted to cash or marketable securities.

Liquidity Ratios (concerned with short-term assets and liquidity position) in simple term Those ratios which are computed to evaluate the capability of the entity to meet its short-term liabilities

Current Ratios

Current ratio gives the relationship between current assets and current liabilities. It objective is computed to assess the short-term financial position of the enterprise. Current ratio is an indicator of the enterprise ability to meet its short-term financial obligations. Ideal ratio is 2: 1, current assets should be twice the current liability.

Current Assets

Current Liabilities

Current Assets are the assets that are either in the form of cash or cash equivalent or can be converted into cash or cash equivalent in short time i.e., within 12 months from the date of balance sheet or within the period of operating cycle. It Includes: §  Current investment, § Inventories excluding loose tools and store and spares § Trade receivable, bills receivable and sundry debtors less provision for doubtful debt §  Cash and cash equivalents, cash in hand, cash at bank, cheques or drafts in hand etc. §  Short term loans and advances and § Other current assets such as prepaid expenses, interest receivable etc.

Current liabilities are the liabilities repayable in a short time, i.e., within 12 months from the date of balance sheet or within the period of operating cycle It Includes: §  Short terms borrowings § Trade payables such as bills payable and sundry creditors § Other current liabilities such as current maturities of long-term debts, interest accrued but not due on borrowing interest accrued and due on borrowing, outstanding expenses unclaimed dividend, call in advance etc. §  Short term provisions

Illustration: from the following compute current ratio

Trade Receivables (Sundry Debtors)	1,00,000	Bills payable	20,000
Prepaid Expense	10,000	Sundry Creditors	40,000
Cash & Cash Equivalents	30,000	Debentures	2,00,000
Short Terms Investments	20,000	Inventories	40,000
Machinery	7,000	Expense payable	40,000

Solution 

• Current Assets = Sundry Debtor (1,00,000) + Prepaid expense (10,000) + Cash (30,000) + short term investment (20,000) + Inventories (40,000) = 2,00,000.
• Current Liabilities = Bills payable (20,000) + Sundry creditor (40,000) + Bills payables (40,000) = 1,00,000
• Current Ratio = Current Assets ÷ Current Liabilities
• 2,00,000 ÷ 1,00,000 = 2: 1

Illustration: calculates current ratio from the following, working capital 15,000; total liabilities (other than shareholders funds) 32,500; long term debts 25,000.

Solution 

• Current liabilities = Total liabilities (other than shareholders’ funds) – long term debts 
• = 32,500 – 25,000 – 7,500
• Working Capital = Current assets – current liabilities
• Current assets = working capital + current liabilities
• =15,000 + 7,500 + 22,500
• Current Ratio = Current Assets ÷ Current Liabilities
• 22,500 ÷ 7,500 = 3:1

Liquid Ratio or Quick Ratio or Acid test ratio

It gives a relationship of liquid assets with current liabilities. It is computed to assess the short-term liquidity such as debt paying capacity of the enterprises. Thus, it is a better indicator of liquidity. Liquid assets are the assets which are either in form of cash & cash equivalent or can be converted into cash within a very short period this, it does not include inventories and prepaid expense. Ideal quick ratio = 1:1.

Basis	Current Ratio	Liquid or Quick Ratio
Relationship	It establishes relationship between current assets and current liabilities.	It establishes relationship between liquid assets and current liabilities.
Assessment	It assesses the ability to meet current liabilities within 12 months from the date of balance sheet or within the period of operating cycle.	It assesses the ability to meet current liabilities immediately.
Ideal Ratio	2:1 is considered to be an ideal ratio.	1:1 is considered to be an ideal ratio.
Measure	It is not considered to be better than liquid or quick ratio to measure short term financial position.	It is considered to be better than current ratio to measure short term financial position.

Illustration: Calculate liquid ratio from the following information

Current liabilities	50,000	Prepaid expense	5,000
Current Assets	80,000	Trade Receivables	30,000
Inventories	25,000

Solution 

• Liquid Assets = Current assets – Inventories – Prepaid expense
• =80,000 – 25,000 – 5,000 = Rs. 50,000.
• Liquid Ratio = Liquid Assets ÷ Current liabilities
• 50,000 ÷ 50,000 = 1:1

Illustration. Inventories are 80,000; working capital 2,40,000; current assets 4,00,000; calculate liquid or quick ratio.

Solution 

• Quick Ratio = Liquid or Quick Assets ÷ Current Liabilities
• Working Capital = Current Assets – Current Liabilities
• Current Liabilities = Current Assets – Working Capital
• =4,00,000 – 2,40,000 = Rs. 1,60,000.
• Liquid or Quick Assets = Current Assets – Inventories 
• = 4,00,000 – 80,000 = 3,20,000

As per Quick Ratio Formula above 

3,20,000 ÷ 1,60,000 = 2:1

Profitability ratio

The management of a company cannot wait for the year to end to analyze their financial performance and their profits. This must be done year-round. These profitability ratios help the management determine an entity’s ability to use its assets and create earnings. The most useful comparisons for these ratios are to the performance of the previous years.

Profitability ratios are both revenue statement ratios and balance sheet ratios. They compare the revenue of a firm to different types of expense accounts within the Profit and Loss Statement. And then some profitability ratios also compare revenue to aspects of the balance sheet such as assets and equity.

There are a variety of profitability ratios calculated with the help of the Income Statement and the Balance Sheet. Here we will be focusing on the most important ones that are used regularly to analyze the profitability of various entities.

Profitability ratio is generally used to determine how well the business is generating profits from its operations. Profit is the balance of income earned after deducting all related expenses. 

Note - Profitability Ratios (concerned with gross, operating and net profits) and Profitability measures the efficiency in business. Accounting ratio measuring the profitability are known profitability ratio.

Gross profit ratio

It establishes the relationship of gross profit and revenue from operations i.e. Net Sales of an enterprises.

Trading Accounts
Cost of goods of Sold	Revenue from operation (Sales)
Gross profit
Total	Total

Gross profit Ratio = {Gross profit ÷ Revenue from operations (i.e. Net Sales)} × 100.

Here, Gross profit = revenue from operations – cost of revenue from operations.

Cost of revenue from operations or cost of goods sold = Opening inventory (excluding spare parts and loose tools) + purchase + direct expense – closing inventories (excluding spare parts and loose tools)

Objective and significance of Gross profit ratio

1. To determine the efficiency with which production or purchase operation and selling operations are carried on. 
2. Gross profit should be adequate to cover expense, dividend building up of reserve. Higher Gross profit ratio is better as it leaves high margin to meet operating expense and certation of reserve.
3. The ratio may be compared with ratio of earlier years of other firms to compare and assess the efficiency of the business of other firms.

Net Profit Ratio

It establishes the relationship between net profit and revenue from operations i.e. Net Sales. It shows the percentage net profit earned on revenue from operation.

Trading Accounts
Cost of goods of Sold	Revenue from operation (Sales)
Gross profit
Total	Total

Profit and loss Accounts
Operating & non-operating expense	Gross profit
Net profit	Non-Operating income
Total	Total

1. Net profit ratio = {Net profit after tax ÷ revenue from operation i.e. Net sales} × 100
2. Net profit = Revenue from operation – cost of revenue from operations – operating expense – non operating expense + non-operating income + tax.

Objective and significance of Net Profit Ratio

1. Net profit ratio is an indicator of overall efficiency of the business. 
2. Higher the net profit ratio is better for business.
3. An increase in ratio over the previous period shows improvement in the operational efficiency and decline means otherwise. 
4. A comparison with industry standard is also an indicator the efficiency of the business.

Operating Profit Ratio

It measures the relationship between operating profit and reverses from operation. i.e. net Sales.

Profit and loss Accounts
Other operating expense	Gross profit
Operating profit	Other Operating income
Total	Total

• Operating profit ratio = {operating profit ÷ revenue from operating profit (Net Sales)} ×100.

• Operating profit = gross profit + other operating income
• Operating profit = net profit (before tax) + non-operating expense or losses – non operating incomes
  

Objective and significant of Operating Profit Ratio

1. To determine operational efficiency of the business.
2. An increase in the ratio over the previous period shows improvement in operational efficiency of the business

Operating Cost Ratio

It establishes the relationship between operating costs a revenue from operating i.e., Net Sales. Operating costs are those costs which are associated with operating activities of the business. For example, employee benefits expenses and other expenses. 

It shows the proportion of cost of revenue from operations cost of goods sold and operating expense to revenue from operation i.e., Net Sales.

• Operating Cost = cost of goods sold + operating expenses
• Operating ratio = {(cost of revenue from operations + operating expense) ÷ revenue from operations (net sales)} × 100
• Cost revenue from operations = opening inventory (excluding spare and loose tools) + Net Purchase + Direct Expense – Closing Inventory (excluding spare parts and loose tools)
• Revenue from operations – Gross Profit 
• Cost of materials consumed + purchase of stock in trade + change in inventories of finished goods, work in progress and stock in trade + direct expense
• Operating expense = employee benefits expense, depreciation and amortisation expense and other expense (other than non-operating expense)
• Operating expense = office expense, administrative expense, selling and distribution expense, employee benefits expense, depreciation and amortisation expense.

Objective and significance of Operating Cost Ratio

To assess the operational efficiency of the business. It shows the percentage of revenue from operation i.e., that is absorbed by the cost of goods sold or cost of revenue from operations and operating expense. Lower operating ratio is better because it leaves higher margin to meet interest, dividend etc. A rise in the operating ratio indicates declines in efficiency.

Important note

1. Operating profit ration and operating ratio a complementary to each other. Thus, if one of the two ratio is deducted from 100, another ratio is obtained.
2. Operating ratio + Operating Profit ratio = 100

Return on investment or return on capital employed ratio

It shows the relationship of profit before interest and tax with capital employed. The sources i.e., fund used in the business to earn this profit and loss are proprietor’s or shareholder fund and loan. 

Return on Investment = {net profit before interest, tax and dividend ÷ capital employed} × 100 = …%

Balance sheet
Share holders’ fund	Non-Current Assets
Equity share capital	Fixed Assets
Preference share capital	Current Assets
Reserve & Surplus	Current investment
Non-current liabilities	Cash & Cash Equivalent
Debenture	Other current Assets
Long term loan
Current Liabilities
Trade payables
Total	Total

Capital employed is computed following either liabilities approach or Asset’s approach.

1. When liability approach is followed capital employed is computed by adding 
• Shareholder’s fund (i.e., share capital, reserve and surplus)
• Noncurrent liabilities (long-term borrowing and long-term provisions) 
2. When asset approach is followed. Capital employed is computed by adding 
• Non current assets – fixed assets (noncurrent investment, long term loans and advance)

Objective and significance of Return on investment

1. It assesses the overall performance of the enterprise.
2. It measures how efficiently the resources of business are used.
3. ROCE is a fair measure of the profitability of any concern with responds that the performance of different industries may be compared.
4. An enterprise should have a satisfactory ratio
5. To assess whether the ratio is satisfactory or not, it should be compared with its own ratios of the past years or with the ratio of similar enterprise in industry or with the industry storage.

Leverage or Solvency Ratio

Solvency ratios also known as leverage ratios determine an entity’s ability to service its debt. So, these ratios calculate if the company can meet its long-term debt. It is important since the investors would like to know about the solvency of the firm to meet their interest payments and to ensure that their investments are safe. Hence solvency ratios compare the levels of debt with equity, fixed assets, earnings of the company etc.

One thing to make note of is the difference between solvency ratios and liquidity ratios. These two are often confused for the other. Liquidity ratios compare current assets with current liabilities, i.e., short-term debt. Whereas solvency ratios analyze the ability to pay long-term debt.

Leverage ratio measures the utilization of borrowed money by the business. It helps to identify the financial stability of the business by analyzing the total debt of the company.

Note - Solvency Ratios (concerned with long-term debt and solvency) and Solvency ratio is ratio which show ability of the enterprise to meet its long-term liabilities.

Debt to Equity Ratio

It is calculated to assess the long-term financial soundness of the enterprise. The ratio expresses the relationship between external equities, i.e., external debt and internal equities i.e., shareholder’s fund of the enterprise.

External equities or external debts: it is the liabilities to the outsider. For example, long-term borrowing and long-term provisions. Shown noncurrent liabilities in liabilities part of balance sheet.

• Debt to equity ratio = debt ÷ equity (shareholder’s funds)
• Debt = long term borrowing + long term provisions
• Debt = total debt – current liabilities
• Equity or shareholder funds = share capital + reserve and surplus
• Equity or shareholder funds = non-current assets {(tangible assets) + intangible asset + non-current trade investment+ long term loans and advance} + working capital – noncurrent liabilities (long term borrowing + long term provisions)
• Equity or shareholder funds = Total assets – total debt
• Working capital = current assets – current liabilities

It also indicate the extent to which the enterprise depends on external funds for its business. Debt to equity ratio shows the relative proportion of shareholder’s funds and debt. i.e. capital contributed by long term lenders and shareholders used to finance company's operation. Debt to equity ratio of 2:1 is considered as an appropriate ratio.

1. High debt to equity ratio means – enterprise depending more on borrowing or debts as compared to shareholder’s fund. In effect external equity are at higher risk.
2. Low debt to equity ratio means – enterprise funding more on shareholder’s fund than external equities. In effect, external equities are at lower risk and have higher safety.

Illustration – from the following information calculate debt to equity ratio.

Share capital 10,000 @ 10 each	1,00,000	Debenture	75,000
General reserve	45,000	Long term provisions	25,000
Surplus i.e., balance in statement of P&L	30,000	Outstanding expense	10,000

Solution 

• Equity = share capital + general reserve + surplus i.e., Balance in statement of profit and loss 
•  = 1,00,000+45,000+30,000 = 1,75,000
• Debt = debenture + long term provisions = 75,000 +25,000 = 1,00,000
• Debt to equity ratio = debt ÷ equity (shareholders’ funds) 
• = 1,00,000 ÷ 1,75,000 = 0.57 :1 

Note – equity means fund belonging to all the shareholders whether equity or preference.

Total Assets to debts Ratio

It establishes relationship between total assets and total long-term debts of the enterprise.

Total assets to debt ratio = total assets ÷ debt

Total assets	Debt
It includes §  Non-current assets – fixed asset (tangible and intangible asset) + non-current investment + long term loans and advances) §  Current assets (current investment + inventories including spare parts and loose tools) +trade receivable + cash and cash equivalents + short term loans and advance + other current assets)	It includes §  Long term borrowing §  Long term provisions

Objective and significance of total assets to debts ratio

It measures the extent to which debt is covered by the assets. 

1. High ratio means – higher safety for lender to the business
2. Low ratio means – lower safety for lenders as the business depends largely on outside loan for its existence. Investment by the proprietor is low.

Illustration – shareholders’ funds 14,00,000, total debts 18,00,000, current liabilities 2,00,000. Calculates total assets to debt ratios.

Solutions 

Total assets to debt ratio = total assets ÷ debt = 32,00,000 ÷ 16,00,000 =2:1

• Long term debts = total debts – current liabilities
• 18,00,000 – 2,00,00 = 16,00,000
• Total assets = shareholder’s fund + long term debts + current liabilities
• 14,00,000 +16,00,000 +2,00,000 = 32,00,000

Proprietary ratio

It establishes the relationship between proprietor funds and total assets.

Proprietary ratio = proprietor’s funds or shareholder’s funds ÷ total assets.

1. Liabilities approach = share capital + reserve and surplus
2. Asset’s approach = non-current assets (tangible assets + intangible assets + non-current investment + long term loans and advance) + working capital – noncurrent liabilities (long term borrowing + long term provisions)

Significance and objective of Proprietary ratio

To measure the proportion of total assets financed by proprietor’s funds. The ratio is important for creditors as they can ascertain the portion of shareholder’s fund in the total assets employed in the firm. It shows financial strength of the enterprise.

1. High ratio means adequate safety for creditors - A very high ratio means improper mix of proprietor’s fund and loan funds, which results in lower return on investment.
2. A low ratio means lower or inadequate safety for the creditors. It may lead to unwillingness of creditors to extend credit to the enterprise.

Illustration. From the following information calculate Proprietary ratio.

Share holders’ fund		Non-Current Assets
Equity share capital	1,00,000	Fixed Assets (tangible)	1,25,000
Preference share capital	50,000	Current Assets
Reserve & Surplus	25,000	Current investment	75,000
Non-current liabilities		Cash & Cash Equivalent	40,000
Debenture	60,000	Other current Assets	10,000
Current Liabilities
Trade payables	15,000
	2,50,000		2,50,000

Solution 

Proprietary ratio = shareholder’s fund ÷ total assets 

• 1,75,000 ÷2,50,000 = 0.7

Note – calculation of shareholder’s fund or equity or proprietors’ funds

Liabilities Approach	Amount	Assets Approach	Amount
Equity share capital	1,00,000	Fixed assets	1,25,000
Add: Reserves and surplus	25,000	Add: Working capital	1,10,000
Equity shareholders’ funds	1,25,000		2,35,000
Add: preference share capital	50,000	Less: long term borrowing (debenture)	60,000
Shareholders Fund’s	1,75,000	Shareholders Fund’s	1,75,000

Working capital = current (current investment + cash and cash equivalents + others current assets) – current liabilities (trade payable)

= 75,000 + 40,000 +10,000 – 15,000 = 1,10,000

Interest coverage ratio 

The ratio establishes the relationship between net profit before interest and tax and interest on long term debts.

Interest coverage ratio = {profit before interest and tax ÷ interest on long term debt} = … times.

Objective and significance of Interest coverage ratio

To ascertain the amount of profit available to cover interest on long term debt. A high ratio is considered better for the lenders as it means higher safety margin.

For instance -

Let’s say company has the flowing for the year 

• Earnings before interest and taxes (EBIT) = 5,00,000

• Interest expense = 1,00,000

• Interest coverage ratio = 5,00,000 ÷ 1,00,000 = 5:1 

Interpretation - the company earns 5 times than its annual interest expense. A ratio above 1 means the company can cover its interest. Higher is better it indicates stronger health and lower risk of default.

Activity Ratio / Efficiency Ratio / Performance Ratio / Turnover Ratio

These ratios basically measure the efficiency with which assets are being utilized or managed. This is why they are also known as productivity ratio, efficiency ratio or more famously as turnover ratios. These ratios show the relationship between sales and any given asset. It will indicate the ratio between how much a company has invested in one particular type of group of assets and the revenue such asset is producing for the company. This ratio helps the business to identify effective utilization of the assets and thereby facilitates efficient management:

Activity Ratios (concerned with turnover and accounts receivable/payable) It measures how well the resource been used by enterprise. It measures the effectiveness with the enterprise available resource. Higher turnover ratio means better use of capital which in turn means better profitability ratio.

Inventory or stock turnover ratio

It measures how many times an enterprise sells and replaces its inventory, i.e. how many times the inventory was converted into sales during the period. It establishes the relationship between cost of revenue from operation, i.e. cost of goods sold and average inventory carried during that period.

Inventory or stock turnover ratio = {cost of revenue from operations or cost of goods sold ÷ average inventory or stock} = … times

• Cost of revenue from operations or cost of goods sold = revenue from operation – gross profit
• Cost of revenue from operations or cost of goods sold = revenue from operations + gross loss
• Cost of revenue from operations or cost of goods sold = opening inventory + net purchase + direct expense – closing inventory
• Cost of revenue from operations or cost of goods sold = cost of materials consumed + purchase of stock in trade + change in inventories of finished goods, work in progress and stock in trade + direct expense

Objectives and significance of activity Ratio

1. To ascertain the efficiency of inventory management
2. To determine whether the investment in stock has been judicious or not.
3. A very high inventory ratio shows overtrading and it may result in working capital shortage.
4. Low inventory turnover ratio means inefficient use of investment over investment in stock, accruing of stock at the end of the period in anticipation of higher price or unsatisfiable goods etc.
5. Thus, only an optimum inventory or stock turnover ratio ensures adequate working capital and also enables the enterprise to earn reasonable margin of profits. 

Illustration – from the following information, calculate inventory turnover ratio

Cost of revenue from operation or cost of goods sold	4,50,000
Inventories in the beginning of the year	1,00,000
Inventories at the end of the year	1,25,000

Solution 

• Average inventory = (opening inventory + closing inventory) ÷ 2 
• (1,00,000 + 1,25,000) ÷ 2 = Rs. 1,12,500
• Inventory or stock turnover ratio = cost of revenue from operations or cost of goods sold ÷ average inventory.
• 4,50,000 ÷ 1,12,500 = 4 times

Trade receivables or debtor’s turnover ratio

Debtor turnover ratio establishes the relationship between credit revenue from operation. i.e. net credit sales and average trade receivable debtors and bill receivable of year.

Trade receivables or debtor’s turnover ratio = credit revenue from operation i.e. net credit sales ÷ average trade receivables.

Notes 

1. Credit revenue from operations = credit sales – sales return
2. Credit revenue from operations = revenue from operations – cash revenue from operation
3. Average trade receivable = {opening debtors + opening bill receivable + closing debtors +closing bill receivable) ÷ 2 
4. Average trade receivable = {opening trade receivable + closing trade receivable) ÷ 2

Objective and significance of debtor’s turnover ratio

1. It shows, how quickly receivables are converted into cash and cash equivalent and thus shows thus efficient collection of amounts due from debtors
2. A high ratio is better since it indicates that debt a collected more promptly
3. A lower ratio shows inefficiency in collection and investment in debtors than required

Debt collection period or average collection period

It provides an approximation on the average time that I take to collect debt. It is computed by diving 365 on by the trade receivable or debtor turnover ratio.

• Debt collection period = {365 ÷ trade receivable or debtors’ turnover ratio} = numbers of days 
• Debt collection period = (12 ÷ trade receivables or debtors’ turnover ratio} = numbers of months

Illustration - calculate trade receivable or debtor’s turnover ratio and average collection period. Credit revenue from operation (nets credit sales) for the year is 6,00,000; debtor 50,000; bills receivable 50,000.

Solution 

• Trade receivables or debtor’s turnover ratio = credit revenue from operation (net credit sale) ÷ average trade receivables (debtors + bills receivables)
• = 6,00,000 ÷ (50,000 + 50,000) = 6,00,000 ÷ 1,00,000 = 6 times 
• Average collection period (months) = (12 ÷ trade receivables or debtors’ turnover ratio} 
• = 12 ÷ 6 = 2 months
• Average collection period (days) = no of days in a year ÷ trade receivable or debtors’ turnover ratio
• 365 ÷ 6 = 60.83 or 61 days

Trade payable or Creditors turnover ratio

It shows the relationship between net credit purchases and total payables or average payables. Average payment period or creditor velocity shows the credit period enjoyed but the enterprise in paying creditors.

1. High turnover ratio or shorter payment period shows the availability of less credit or early payment. It also indicates that the enterprise not availing credit period this boost up the credit worthiness of the firm.
2. Low turnover ratio or longer payment period indicates that creditor is not paid in time or increased credit period.

Trade payable or creditor turnover ratio = net credit purchase ÷ average trade payables = … times.

1. Average trade payables = {opening trade payables + closing trade payables} ÷ 2
2. Average trade payables = {opening creditors + opening bill payable + closing creditor +closing bills payable} ÷ 2
3. Average payment period or average age of payables = {average trade payables ÷ net credit purchase} × number of months or days in a year.
4. Average payment period or average age of payables = months or days in a year ÷ trade payables or creditors turnover ratio.

Illustration – from the following particulars taken from the books of XYZ ltd. Calculate trade payables or creditors turnover ratio and average payable period in days.

Total purchase	8,50,000	Creditors at the end of the year	1,60,000
Cash purchase	80,0000	Creditors in the beginning	1,20,000
Purchase return	40,000

Solution 

• Trade payables or creditor turnover ratio = net credit purchase ÷ average trade payables
• = 7,30,000 ÷ 1,40,000 = 5.21 times.
• Average payable period = {average trade payables ÷ net credit purchase} × 365 
• {1,40,000 ÷ 7,30,000} × 365 = 70 days
• Alternatively, average payable period = 365 ÷ trade payable ratio
• 365 ÷ 5.21 = 70 days

Notes 

• Net credit purchase = total purchase – cash purchase – purchase return 
• 8,50,000 – 80,000 – 40,000 = 7,30,000
• Average trade payables = {opening trade payables + closing trade payables} ÷ 2
• {1,20,000 + 1,60,000} ÷ 2 = 1,40,000

Working capital turnover ratio

It shows the relationship between working capital and revenue from operations or net sales. It shows the number of times a unit of rupee invested in working capital produce sales. To ascertain whether or not working capital has been effectively used in making sales.

• Higher the ratio netter it is, but a very high ratio indicates overtrading the working capital being inadequate for the sale off operations.
• Working capital turnover ratio = revenue from operation (net sales) ÷ working capital = … times
• Working capital turnover ratio = cost if revenue from operations of cost of goods sold ÷ working capital

Note: working capital = current assets – current liabilities

Illustration – current assets 12,00,000; current liabilities 2,40,000; sales credit 24,00,000 and cash 5,20,000; sales return 40,000; calculate working capital turnover ratio from the above information.

Solutions

• Working capital turnover ratio = revenue from operation i.e. net sale ÷ working capital
• 28,80,000 ÷ 9,60,00 = 3 times 
• Revenue from operation i.e. Net Sales = Cash Sales + Credit Sales – Sales return 
• 5,20,000 + 24,00,000 – 40,000 = 28,80,000
• Working capital = current assets – current liabilities 
• 12,00,000 – 2,40,000 = 9,60,000

Advantage of ratio analysis 

Ratio analysis will assist in validating or disproving the firm’s finance, investment, and operational decisions. They convert the financial statement into comparison statistics, allowing management to assess and evaluate the firm’s financial status and the outcomes of their decisions.

1. Complex accounting statements and financial data are reduced to simple ratios of operating efficiency, financial efficiency, solvency, long-term positions, and so on.
2. Ratio analysis assists in identifying issue areas and drawing management’s attention to them. Some information is lost in the complicated accounting statements, and ratios will aid in identifying these issues.
3. Allows the company to compare itself to other companies, industry standards, and intra-firm comparisons, among other things. This will assist the firm in gaining a better understanding of its financial situation in the economy.

Limitation of ratio analysis

1. The data utilised in the analysis is based on the company’s own published prior results. As a result, ratio analysis indicators are not always indicative of future firm performance.
2. Because financial statements are released on a regular basis, there are time gaps between them. Real prices are not represented in the financial accounts if inflation has occurred between periods. As a result, until the figures are corrected for inflation, they are not comparable across time periods.
3. If the company’s accounting standards and practices have changed, this could have a significant impact on financial reporting. The key financial indicators used in ratio analysis are changed in this scenario, and the financial outcomes reported after the change are not comparable to those recorded before the change. It is the analyst’s responsibility to keep up with changes in accounting policies. The notes to the financial statements section usually contain the changes made.
4. A company’s operational structure, from its supply chain strategy to the product it sells, may undergo major changes. When a firm undergoes significant operational changes, comparing financial measures before and after the change might lead to inaccurate inferences about the company’s success and future prospects.
5. Seasonal influences should be considered by analysts because they can lead to ratio analysis constraints. Due to the inability to alter the ratio analysis for seasonality effects, the results of the analysis may be misinterpreted.
6. The information given by the corporation in its financial accounts is the basis for ratio analysis. This data could be modified by the company’s management to show a greater performance than it actually has. As a result, ratio analysis may not adequately reflect the underlying nature of the firm, because information misrepresentation is not detectable by basic analysis. It is critical for an analyst to be aware of these potential manipulations and to conduct thorough due diligence before drawing any conclusions.

FAQ's

Why do we use Accounting Ratios?

We use accounting ratios: 

1. to make comparisons between different accounting periods of the same company, 
2. when we compare one company with the average within its industry, 
3. when making a comparison between different companies, as well as 
4. to compare one industry with another. 

A ratio is only useful if we benchmark it against something else, like another company or past performance.

Why is Accounting Ratio Analysis being important?

Accounting ratios provide a full picture of the financial health of a company. Instead of studying your cash flow statements and other financial statements, it makes more sense to look at ratios instead and get a clearer picture with a smaller data set. Financial ratios help a business plan its future by telling the management how the company is doing across all its fronts - operational, market, liabilities and equity. It helps optimize resource allocation, business development and planning, M&A, etc. A detailed analysis of accounting ratios lays a business bare in front of lenders and creditors, which is why it is important to keep a close eye on the numbers your company is creating. Additionally, these ratios make it possible for a business to form relevant strategies for the immediate and the far future so that it is able to prosper from what it is creating.

How Analysts and External Stakeholders use Financial Ratios

External stakeholders use financial ratios to: 

• Carry out competitor analysis 
• Determine whether to finance a company in the form of debt 
• Assess how profitable a company is 
• Determine whether to provide equity financing or buy shares in the company 
• Calculate tax liabilities 
• Measure a company’s market value 
• Calculate return on shareholders’ equity 
• Perform market analysis

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