- What is an Accounting Ratios?
- Objectives of Accounting Ratios Analysis
- Advantages of Accounting Ratio Analysis
- Limitations of Accounting Ratios Analysis
- 1. Limitations of Accounting Data
- 2. Ignores Price- position Changes
- 3. Ignore Qualitative or Non-monetary Aspects
- 4. Variations in Accounting Practices
- 5. Vaticinating
- Types of Accounting Ratios
- I. Liquidity Ratios
- II. Solvency Ratios
- III. Exertion (or Development) Ratios
- IV. Profitability Ratios
- I.Liquidity Ratios
- II. Activity (or Turnover) Ratio
What is an Accounting Ratios?
As stated before, Accounting ratios are a pivotal tool of financial statements analysis. Accounting ratios are the fine number calculated as a reference to the relationship of two or further figures and may be expressed as a bit, proportion, chance, and a number of times. When the number is calculated by pertaining to two account figures deduced from the fiscal statements, it’s nominated as a counting rate.
For illustration, if the. gross profit of the business is Rs.10,000 and thus the‘ Profit from Operations is Rs.1,00,000, it is frequently said that the gross profit periphery is 10%, 10,000/1,00,000 x 100 of the ‘ Profit from Operations’. This rate is nominated as the gross profit periphery rate. Also, the force development rate is perhaps 6 which means that force turns into ‘ Profit from Operations six-fold during a time.
It needs to be observed that counting rates parade a relationship if any, between account figures uprooted from fiscal statements. Rates are basically deduced figures and their efficacity depends on an excellent deal upon the introductory figures from which they’re calculated.
Hence, if the fiscal statements. contain some crimes, the deduced figures in terms of rate analysis would also. present an incorrect script. Further, a rate must be calculated using. figures that are meaningfully identified. A rate calculated by using two unconnected figures would hardly serve any purpose. For illustration, the cabinetwork of the business is Rs. 1,00,000 and Purchases are Rs. 3,00,000. The rate of purchases to cabinetwork is 3 (3,00,000/1,00,000) but it hardly has any applicability.
Objectives of Accounting Ratios Analysis
Accounting ratios analysis is necessary as a part of the interpretation of results revealed by the financial statements. It provides druggies with pivotal fiscal information and points out the areas which bear disquisition. Rate analysis is a fashion that involves regrouping of knowledge by operation of arithmetical connections, though its interpretation is a complex matter. It requires a fine understanding of the way and the rules used for preparing fiscal statements. Formerly done effectively, it provides tons of data which helps the critic.
1. to understand the areas of the business which bear further attention;
2. to understand the implicit areas which may be bettered with the trouble in the asked direction;
3. to provide a deeper analysis of the profitableness, liquidity, solvency. and effectiveness situations in the business;
4. to supply information for creating cross-sectional analysis by comparing the performance with the simplest assiduity norms.
5. to supply information deduced from fiscal statements useful for making protrusions and estimates for the future.
Advantages of Accounting Ratio Analysis
The accounting ratios analysis if duly done improves the stoner’s understanding of the effectiveness with which the business is being conducted. The numerical connections throw light on numerous idle aspects of the business. If duly analyzed, the rates make us understand colorful problem areas as well as the bright spots of the business.
The knowledge of problem areas helps operations take care of them in the future. The knowledge of areas that are working more helps you ameliorate the situation further. It must be emphasized that rates are means to an end rather than the top in themselves. Their part is basically reflective and that of a whoosh cracker. There are numerous advantages deduced from Rate analysis. These are summarised as follows:
1. Helps to understand the efficacy of decisions
The rate analysis helps you to understand whether the business establishment has taken the right kind of operating, investing, and financing opinions. It indicates how far they’ve helped in perfecting the performance.
2. Simplify complex numbers and establish connections
Accounting ratios help in simplifying the complex account numbers and bringing out their connections. they help summarise the fiscal information effectively and assess the directorial effectiveness, establishment’s creditworthiness, earning capacity, etc.
3. Helpful in relative analysis
The rates are not be calculated for one time only. When numerous time numbers are kept side by side, they help an excellent deal in exploring the trends visible within the business. The knowledge of trends helps in making protrusions about the business which may be a truly useful point.
4. Relating of problem areas
Accounting ratios help businesses in relating the matter areas also because of the bright areas of the business. Problem areas would wish further attention and bright areas will need polishing to retain still better results.
5. Enables Geek analysis
Accounting ratios help an excellent deal in explaining the changes being within the business. the knowledge of change helps the operation an excellent deal in understanding the present pitfalls and openings and allows the business to try its own Geek (StrengthWeakness- Occasion- Trouble) analysis.
6. Colorful comparisons
Accounting ratios help comparisons with certain marks to assess whether an establishment’s performance is voguish or else. For this thing, the profitability, liquidity, solvency, etc., of a business, perhaps compared (i) over a variety of counting ages with itself (Intra-firm Comparison/ Time Series Analysis), (ii) with other business. enterprises (Inter-firm Comparison/Cross-sectional Analysis) and (iii) with morals set for that establishment/ assiduity (comparison with a typical (or assiduity prospects).
Limitations of Accounting Ratios Analysis
Since the rates are deduced from the fiscal statements, any weakness within the original fiscal statements also will sneak in the deduced analysis within the form rate analysis. Therefore, the restrictions of financial statements also form the. limitations of the rate analysis. Hence, to interpret the rates, the stoner should remember the principles followed within the medication of financial statements and also their nature and limitations. The limitations of accounting ratios analysis which arises primarily from the character of financial statements are as under:
1. Limitations of Accounting Data
Data give an unwarranted print of perfection and futurity. In fact, data “ reflect an admixture of recorded data, counting conventions and private judgments which affect them materially. For illustration, the profit of the business isn’t a precise and final figure. It’s simply an opinion of the accountant grounded on the operation of counting programs. The soundness of the judgment inescapably depends on the capability and integrity of these who make them and on their adherence to Generally Accepted Accounting Principles and Conventions”. Therefore, the financial statements might not reveal the verity state of affairs of the enterprises also the rates also won’t give a verity picture.
2. Ignores Price- position Changes
The fiscal account is grounded on a stable plutocrat dimension principle. It implicitly assumes that price position changes are moreover missing or minimum. But the verity is else. We’re typically living in inflationary husbandry where the installation of cash declines constantly. A change in the price position makes analysis of the financial statements of different account times pointless because account records ignore changes in the value of plutocrat.
3. Ignore Qualitative or Non-monetary Aspects
An account provides information about quantitative (or financial) aspects of the business. Hence, the rates also reflect only the financial aspects, ignoring fully the non-monetary (qualitative) factors.
4. Variations in Accounting Practices
There are differing counting programs for valuation of force, computation of deprecation, treatment of intangibles Means the description of certain fiscal variables., available for colorful aspects of business deals. These variations leave an enormous interrogation point on the cross-sectional analysis. As there are variations in account practices followed by different business enterprises, a valid comparison of their financial statements isn’t possible.
Vaticinating unborn trends grounded only on literal analysis isn’t doable. Proper soothsaying requires consideration of non-financial factors also.
Now let us talk about the limitations of the rates. The colorful limitations are
1. Means and not the End: Rates are means to an end rather than the end by themselves.
2. Lack of capability to resolve problems: Their part is basically reflective of whistleblowing and not furnishing a result to the problem.
3. Lack of standardized delineations: There’s a lack of standardized delineations of colorful generalities used in rate analysis. For illustration, there’s no standard description of liquid arrears. Typically, it includes all current arrears, but occasionally it refers to current arrears less bank overdraft.
4. Lack of widely accepted standard situations: There’s no universal mark that specifies the position of ideal rates. There’s no standard list of the situations widely respectable, and, in India, the assiduity pars are also not available.
5. Rates grounded on unconnected numbers: A rate calculated for unconnected numbers would basically be a pointless exercise. For illustration, creditors ofRs. and cabinetwork ofRs. represent a rate of 11. But it has no applicability to assessing the effectiveness of solvency.
Types of Accounting Ratios
There’s a two-way bracket of rates
(1) traditional bracket, and
(2) functional bracket.
The traditional bracket has been on the basis of financial statements to which the determinants of rates belong. On this base, the rates are classified as follows
1. Statement of Profit and Loss Ratios
A rate of two variables from the statement of profit and loss is known as a statement of profit and loss rate. For illustration, the rate of gross profit to profit from operations is. known as the gross profit rate. It’s calculated using both numbers from the statement of profit and loss.
2. Balance Distance Ratios
In case both variables are from the balance distance, it’s classified as balance distance rates. For illustration, the rate of current means to current arrears is known as the current rate. It is calculated using both numbers from balance distance.
3. Composite Ratios
If a rate is reckoned with one variable from the statement of profit and loss and another variable from the balance sheet.
Although counting rates are calculated by taking data from fiscal statements bracket of rates on the base of fiscal statements is infrequently used in practice. It must be recalled that the introductory purpose of the account is to throw light on the fiscal performance (profitability) and fiscal position (it’s capacity to raise plutocrat and invest them wisely) as well as changes being in fiscal position ( possible explanation of changes in the exertion position). As similar, the indispensable bracket ( functional bracket) grounded on the purpose for which a rate is reckoned, is the most generally used bracket which is as follows:
I. Liquidity Ratios
To meet its commitments, the business needs liquid. finances. The capability of the business to pay the quantum due to stakeholders as and when it’s due is known as liquidity, and the rates calculated to measure it are known as liquidity Rates’. These are basically short-term in nature.
II. Solvency Ratios
The solvency of a business is determined by its capability to meet its contractual scores towards stakeholders, particularly. towards external stakeholders, and the rates calculated to measure solvency position are known solvency Ratios’. These are basically long-term in nature.
III. Exertion (or Development) Ratios
This refers to the rates that are calculated for measuring the effectiveness of operations of business grounded
on effective utilization of coffers. Hence, these are also known as ‘ Effectiveness Rates’.
IV. Profitability Ratios
It refers to the analysis of gains in relation to profit from operations or finances (or means) employed in the business and the rates calculated to meet this ideal are known as profitability Rates’.
Liquidity rates are calculated to measure the short-term solvency of the business, i.e. the establishment’s capability to meet its current scores. These are analyzed by looking at the quantities of current means and current arrears in the balance distance. The two rates included in this order are the current rate and liquidity rate.
i) Current Ratio
The current ratio is the proportion of current assets to current liabilities. It is expressed as follows:
Current Ratio = Current Assets: Current Liabilities or
Current Assets/Current Liabilities
Current Means include current investments, supplies, trade receivables. (debtors and bills receivables), cash and cash coequals, short-term loans and. advances and other current means like reimbursed charges, advance duty and. accrued income, etc.
Current Arrears include short-term borrowings, trade payables (creditors and bills payables), other current arrears, and short-term vittles.
ii) Quick Ratio
It is the ratio of quick (or liquid) assets to current liabilities. It is expressed as
Quick ratio = Quick Assets: Current Liabilities or
Quick Assets/Current Liabilities
Quick Means are defined as those means which are snappily convertible into cash. While calculating quick means we count the supplies at the end and other current means similar as reimbursed charges, advance duty, etc., from the current means. Because of the rejection of non-liquid current means, it’s considered better than the current rate as a measure of the liquidity position of the business. It’s calculated to serve as a supplementary check on the liquidity position of the business and is, thus, also known as acid- Test Ratio’.
II) Solvency Ratios
The persons who have advanced plutocrat to the business on a long-term base are interested in the safety of their periodic payment of interest as well as the prepayment of the top quantum at the end of the loan period. Solvency rates are calculated to determine the capability of the business to service its debt in the long run. The following rates are typically reckoned for assessing the solvency of the business.
a. Debt-Equity Ratio;
b. Debt to Capital Employed Ratio;
c. Proprietary Ratio;
d. Total Assets to Debt Ratio;
e. Interest Coverage Ratio.
a) Debt-Equity Ratio
Debt-Equity Ratio measures the connection between long-term debt and equity. If the debt component of the entire long-term funds employed is little, outsiders feel safer. From a security point of view, a capital structure with less debt and more equity is taken into account favorable because it reduces the chances of bankruptcy. Normally, it’s considered to be safe if the debt-equity ratio is 2: 1. However, it’s going to vary from industry to industry.
b) Debt to Capital Employed Ratio
The Debt to capital employed rate refers to the rate of long-term debt to the aggregate of external and internal finances ( capital employed or net means). It’s reckoned as follows
Debt to Capital Employed Rate = Long-term Debt/ Capital Employed (or Net Means)
Capital employed is acceptable to the long-term debt shareholders’ finances.
Alternately, it’s going to be taken as net means which are acceptable to the entire means – current arrears.
Significance Like the debt-equity rate, it shows the proportion of long-term debts capital employed. A low rate provides security to lenders and a high rate helps operations in trading on equity. In the below case, the debt to Capital Employed. rate is a lower quantum than half which indicates reasonable backing by debt and acceptable security of debt.
It may be noted that Debt to Capital Employed Rate also can be reckoned in relation to total means. In that case, it always refers to the rate of total debts. long- term debts current arrears) to total means, i.e., the aggregate of non-current. and current means (or shareholders’, finances long- term debts current arrears),. and is expressed as
Debt to Capital Employed Ratio=Total Debts /Total Assets
A personal rate expresses the relationship of owner’s (shareholders) finances to net means and is calculated as follows
Personal Rate = Shareholders’, Finances/ Capital employed (or net means)
d) Total Assets to Debt Ratio
This rate measures the extent of the content of long-term debts by means. It is calculated as
Total means to Debt Rate = Total means/ Long- term debts
The advanced rate indicates that means have been substantially financed by possessors Finances and the long-term loans are adequately covered by means. It’s better to take the net means ( capital employed) rather than the total means for calculating this rate also. It’s observed that in that case, the rate is the complementary of the debt to capital employed rate.
e)Interest Coverage Ratio
It’s a rate that deals with the servicing of interest on loans. It’s a measure of security of interest outstanding on long-term debts. It expresses the relationship between gains available for payment of interest and the quantum of interest outstanding. It’s calculated as follows
Interest Coverage Ratio=Net Profit before Interest and Tax/Interest on long-term debts
II. Activity (or Turnover) Ratio
These rates indicate the speed at which, the conditioning of the business is being performed. The exertion rates express the number of times means employed, or, for that matter, any element of means is turned into deals during an accounting period. An advanced development rate means the better application of means and signifies Bettered effectiveness and profitability, and as similar is known as effectiveness rates. The important exertion rates calculated under this order are
1. Inventory Turnover
2. Trade receivable Turnover
3. Trade outstanding Turnover
4. Investment (Net means) Turnover
5. Fixed assets Turnover
6. Working capital Turnover
1. Inventory Turnover
It determines the number of times force is converted into profit from operations during the accounting period under consideration. It expresses the relationship between the cost of profit from operations and the average force. The formula for its calculation is as follows
Inventory Turnover Ratio = Cost of Revenue from Operations / Average Inventory
Where average force refers to computation normal of opening and ending force, and the cost of profit from operations means to profit from operations less gross profit
2. Trade receivable Turnover
It expresses the relationship between credit profit from operations and trade receivable. It’s calculated as follows
Trade Receivable Development rate = Net Credit Revenue from Operations/ Average
Where Average Trade Receivable = ( Opening Debtors and Bills Receivable Ending Debtors and Bills Receivable)/ 2
It needs to be noted that debtors should be taken before making any provision for doubtful debts.
3. Trade outstanding Turnover
Trade payables development rate indicates the pattern of payment of trade outstanding. As trade outstanding arise on account of credit purchases, it expresses a relationship between credit purchases and trade outstanding. It’s calculated as follows:
Trade Payables Turnover ratio = Net Credit purchases/Average trade payable
Where Average Trade Payable= (Opening Creditors and Bills Payable +Closing Creditors and Bills Payable)/2
Average Payment Period=No. of days/month in a year/Trade Payables Turnover Ratio
4. Investment (Net means) Turnover
It reflects the relationship between the profit from operations and net means ( capital employed) in the business. Advanced development means better exertion and profitability. It’s calculated as follows
Net Assets or Capital Employed Turnover ratio =Revenue from Operation/Capital Employed
5. Fixed assets Turnover
Capital employed turnover ratio which studies turnover of capital employed (or Net Assets) is analyzed further by following two turnovers of accounting ratios :
a) Fixed Assets Turnover Ratio: It is computed as follows:
Fixed asset turnover ratio =Net Revenue from Operation/Net Fixed Assets
(b) Working Capital Turnover Ratio: It is calculated as follows :
Working Capital Turnover Ratio =Net Revenue from Operation/Working Capital