Link: http://www.accountingnotes.net/cost-accounting/ratio-analysis/list-of-ratio-analysis-formulasand-explanations-accounting/17121List of Ratio Analysis Formulas andExplanations | AccountingArticle shared by : List of Ratio Analysis Formulas and Explanations!Profitability Ratios:Profit making is the main objective of business. Aim of everybusiness concern is to earn maximum profits in absoluteterms and also in relative terms i.e., profit is to be maximumin terms of risk undertaken and capital employed. Ability tomake maximum profit from optimum utilisation of resourcesby a business concern is termed as “profitability”. Profit is anabsolute measure of earning capacity.Profitability depends on sales, costs and utilisation ofresources. Profitability analysis consists of different elementsi.e., study of sales, cost of goods sold, analysis of gross marginon sales, analysis of operating expenses, operating profit andanalysis of profit in relation to capital employed.The following are various ratios used to analyseprofitability:1. Return on Investment (or) Overall Profitability Ratio:This ratio is called ‘Return on Investment’ (R.O.I) or ‘Returnon capital employed’. It measures the sufficiency or otherwiseof profit in relation to capital employed.Return on capital employed is calculated by using thefollowing formula:Formula:The term operating profit means profit before interest andtax.Link: http://www.accountingnotes.net/cost-accounting/ratio-analysis/list-of-ratio-analysis-formulasand-explanations-accounting/17121The term capital employed has been interpreted in differentways by different accountants and authors.Some of the different meanings of capital employedare given below:(1) Total of all assets i.e., fixed as well as current assets.(2) Total of fixed assets.(3) Total of long-term funds employed in the business.i.e., (Share capital + Reserves and Surplus + Long-termloans)-(Non business assets + Fictitious assets)(4) Net working capital + Fixed assets.Return on investment is used to measure the operational andmanagerial efficiency. A comparison of ROI with that ofsimilar firms, with that of industry and with past ratio will behelpful in determining how efficiently the long-term funds ofowners and creditors being put into use. Higher the ratio, themore efficient is the use of the capital employed.Return on investment can be computed for measuring thereturn for various purposes.Some of the purposes for which the ratios arecalculated are explained below:(a) Return on Shareholders’ Funds:This ratio determines the profitability from the shareholder’spoint of view.Formula:Link: http://www.accountingnotes.net/cost-accounting/ratio-analysis/list-of-ratio-analysis-formulasand-explanations-accounting/17121The net profit here is net income after payment of interestand tax and it includes net non- operating income also, (i.e.,Non-operating income minus non- operating expenses).The term shareholders’ funds includes equity share capital,preference share capital and all reserves and profits belongingto shareholders.(b) Return on Equity Shareholders Funds (or)Return on Equity (or) Return on Net Worth:This ratio signifies the return on equity shareholders’ funds.The profit considered for computing the ratio is taken afterpayment of preference dividend.The ratio of return on equity shareholders’ funds iscalculated as given below:Formula:The term equity shareholders’ funds (or) Equity (or) Networth refers to equity share capital + Reserves + Profits –Accumulated losses(c) Return on Total Assets:This ratio is calculated to measure the productivity of totalassets. There are-two ways of calculating this ratio.Formula:Link: http://www.accountingnotes.net/cost-accounting/ratio-analysis/list-of-ratio-analysis-formulasand-explanations-accounting/17121The term fictitious assets refer to preliminary expenses, debitbalance of Profit and Loss Account and other similar lossesshown on Balance Sheet asset side.2. Gross Profit Ratio:This ratio is also known as Gross margin or trading marginratio. Gross profit ratio indicates the difference between salesand direct costs. Gross profit ratio explains the relationshipbetween gross profit and net sales.Formula:A higher ratio is preferable, indicating higher profitability.A higher ratio will be due to the result of one or moreof the following factors:(1) Increase in selling price without change in the cost ofgoods sold.(2) Decrease in cost of goods sold, with selling priceremaining constant.(3) Increase in selling price and decrease in cost of goodssold.(4) Increase in the sales mix, the proportion of products withhigher gross profit margins.A lower gross profit margin may be due to thefollowing factors:(1) Increase in cost of goods sold.(2) Decrease in selling price.Link: http://www.accountingnotes.net/cost-accounting/ratio-analysis/list-of-ratio-analysis-formulasand-explanations-accounting/17121(3) A combined effect of increase to costs and decrease, inselling price.(4) Higher proportion of low margin products in the salesmix.The gross profit ratio is expected to be adequate to coveroperating expenses, fixed interest charges, dividends andtransfer to reserves.3. Operating Ratio:This ratio indicates the relationship between total operatingexpenses and sales.Formula:Total operating expenses here include cost of goods soldadministrative expenses and Selling and distributionexpenses. Generally finance expenses like interest are notincluded under operating expenses.Net sales mean total sales minus sales returns.Operating ratio measures the amount of expenditure incurredin production sales and distribution of output. It indicatesoperational efficiency of the concern. Lower the ratio more isthe efficiency. The ratio should be low enough to provide fairreturn to the shareholders and other investors.4. Operating Profit Ratio:It is the ratio of profit made from operating sources to thesales. Usually shown as a percentage. It shows the operationalefficiency of the firm and is a measure of the management’sefficiency in running the routine operations of the firm.Formula:Link: http://www.accountingnotes.net/cost-accounting/ratio-analysis/list-of-ratio-analysis-formulasand-explanations-accounting/17121Operating expenses include administration, selling anddistribution expenses. Finance expenses are generallyexcluded.5. Expenses Ratios:These ratios are also known as supporting ratios to operatingratio. They indicate the efficiency with which business as awhole functions. It is better for the concern to know how it isable to save of waste over expenditure in respect of differentitems of expenses. Therefore each aspect of cost of sales andoperating expenses are analysed.The formulas for some of the expanses are givenbelow:Formula:Note:Similar ratio also can be calculated for each item of cost, viz.,direct material expense ratio, direct wage cost and factoryoverhead, where each item of cost is the numerator and netsales is the denominator.Link: http://www.accountingnotes.net/cost-accounting/ratio-analysis/list-of-ratio-analysis-formulasand-explanations-accounting/171216. Net Profit Ratio:This ratio is also called net profit to sales ratio. It is a measureof management’s efficiency in operating the businesssuccessfully from the owner’s point of view. It indicates thereturn on shareholders’ investments. Higher the ratio betteris the operational efficiency of the business concern.Formula:Net profit includes non-operating incomes and profits.Similarly net profit is the profit after reducing non-operatingexpenses. Provision for tax is also subtracted whiledetermining net profit.7. Earnings per Share (EPS):This ratio highlights the overall success of the concern fromowners’, point of view and it is helpful in determining marketprice of equity shares. It reflects upon the capacity of theconcern to pay divided to its equity shareholders. The ratio iscalculated by dividing the net profit after tax and preferencedividend by number of equity shares.Formula:Generally, investors are accustomed to judge companies inthe context of the share market, with the help of ‘Earnings pershare’.8. Price Earnings Ratio (P.E.R):This ratio indicates earnings per share reflected by the marketprice.Formula:Link: http://www.accountingnotes.net/cost-accounting/ratio-analysis/list-of-ratio-analysis-formulasand-explanations-accounting/17121This ratio is of use to prospective investors to decide whetherto invest in the equity shares of a company at a particularmarket price or not.9. (a) Pay Out Ratio:This ratio also indirectly throws light on the financial policyof the management in ploughing back.Formula:(b) Retained Earnings Ratio:This ratio shows the proportion of profits retained in thebusiness out of the current year’s profits. In fact the total ofthe payout ratio and retained earnings ratio should be equalto 100.Retained earnings are essential for growth and expansion ofbusiness. In fact retaining at least 20% of the net profit beforedeclaring any dividend is a statutory requirement.10. Interest Cover or Fixed Charges Cover:This ratio establishes the relationship between profit beforeinterest and tax and fixed interest charges.Link: http://www.accountingnotes.net/cost-accounting/ratio-analysis/list-of-ratio-analysis-formulasand-explanations-accounting/17121This ratio is meaningful to debenture-holders and lenders oflong-term loans. It highlights the ability of the concern tomeet interest commitments and its capacity to raiseadditional funds in future. Higher the ratio better is theposition of long-term creditors and the company’s risk islesser.11. Dividend Yield Ratio:In this ratio the dividend is related to the market value ofshares. The result is known as dividend yield.The ratio is very significant from the view point of thoseinvestors who are interested in dividend income.Turnover Ratios or Activity Ratios:These ratios are also called performance ratios. Activity ratioshighlight the operational efficiency of the business concern.The term operational efficiency refers to effective, profitableand rational use of resources available to the concern. Inorder to examine the judicious utilisation of resources as wellas the wisdom and farsightedness in observing the financialpolicies laid down in this regard, certain ratios are computedand they are collectively called turnover or activity orperformance ratios.The ratios comprising this category are calculated withreference to sales or cost of sales and expressed in number oftimes, i.e., rate of turning over or rotation. The activity ratiosindicate the briskness with which the business is beingcarried on. Therefore they are also called ‘velocities’.Link: http://www.accountingnotes.net/cost-accounting/ratio-analysis/list-of-ratio-analysis-formulasand-explanations-accounting/17121Following are various activity ratios.1. (a) Inventory or Stock Turnover Ratio:This ratio is also called stock velocity ratio. It is calculated toascertain the efficiency of inventory management in terms ofcapital investment. It shows the relationship between the costof goods sold and the amount of average inventory. Stockturnover ratio is obtained by dividing the cost of sales byaverage stock.The rationale behind establishing the relationship betweencost of sales and average stock is that stock is at the cost price.This ratio is helpful in evaluating and review of inventorypolicy. It indicates the number of times the inventory isturned over during a particular accounting period.There are different ways of calculating stockturnover ratio as mentioned below:The first and the third are mostly in use. The second formulacan be used when cost of goods sold is not available. Fourthformula is used to eliminate the effect of changing prices.Cost of goods sold can be ascertained as mentionedbelow:(1) In Case of Trading Concerns:Link: http://www.accountingnotes.net/cost-accounting/ratio-analysis/list-of-ratio-analysis-formulasand-explanations-accounting/17121Cost of goods sold = (Opening stock + Purchases + Directexpenses) – Closing stockIn case of manufacturing concerns:Cost of goods sold = (Total cost of production + Openingstock of finished goods) —Closing stock of finished goodsTotal cost of production = Cost of material consumed +Labour cost + Production overheadsIn all situations where gross profit is known:Cost of goods sold = Sales – Gross profitAverage stock may be taken as the average of stocks at thebeginning and end of the accounting period.Stock turnover ratio indicates whether the investment ininventory is optimum. The quantity of stock should beenough to meet the requirements of the business but it shouldnot be too excessive which locks up too much capital and mayalso lead to different types of stock losses.To judge the efficiency of stock turnover ratio it should becompared over a period of time.A high inventory ratio indicates efficient inventorymanagement and efficiency of business operations.(b) Stock Turnover Period (or) Inventory TurnoverPeriod (or) Stock Velocity:Inventory turnover ratio or stock turnover ratio can be relatedto ‘time’. The ratio can be expressed in terms of days ormonths.Link: http://www.accountingnotes.net/cost-accounting/ratio-analysis/list-of-ratio-analysis-formulasand-explanations-accounting/17121The stock velocity of 73 days or 2.4 months conveys that onaverage every item of stock remains in the store for 73 days or2.4 months before it is sold or used.The general objective is to increase the stock velocity as muchas possible or in effect decrease the days or months for whichitems remain in stock.2. Debtors Turnover Ratio:Debtors Turnover ratio is also called as receivables turnoverratio or debtors velocity. A business concern generally adoptsdifferent methods of sales. One of them is selling on credit.Goods are sold on credit based on credit policy adopted by thefirm. The customers who purchase on credit are called tradedebtors or book debts. Debtors and bills receivables togetherare called ‘Accounts receivables’. Some of the customers maybe prepared to accept bills for goods purchased on credit.Bills or hundies are termed as bills receivables.Debtors turnover ratio measures the number of times thereceivables are rotated in a year in terms of sales. This ratioalso indicates the efficiency of credit collection and efficiencyof credit policy. The ratio is helpful in determining theoperational efficiency of a business concern and theeffectiveness of its credit policy. It is important to maintain areasonable quantitative relationship between receivables andsales.Debtors turnover ratio can be calculated as follows:Link: http://www.accountingnotes.net/cost-accounting/ratio-analysis/list-of-ratio-analysis-formulasand-explanations-accounting/17121The objective of this ratio is to measure the liquidity ofreceivables or obtaining the average period over whichreceivables are uncollected.If information relating to credit sales and average debtors isnot available, the alternative is to calculate the debtorsturnover in terms of the relationship between total sales andclosing balance of debtors.Thus:It is to be noted that the first approach to the computation ofthe debtors turnover is superior. In case of the secondapproach the effect is that debtors turnover ratio is inflated.Another approach for measuring the liquidity of a firm’sdebtors is the average collection period. This ratio isinterrelated to and depends on the debtors turnover ratio.It can be calculated by any of the following formulae:The higher the turnover ratio and shorter the averagecollection period, better is the liquidity of debtors. In otherLink: http://www.accountingnotes.net/cost-accounting/ratio-analysis/list-of-ratio-analysis-formulasand-explanations-accounting/17121words high turnover ratio and short collection period conveyquick payment on the part of debtors. If the turnover ratio islow and the collection period is long, it implies that paymentsby debtors are delayed.3. Creditors Turnover Ratio (or) Accounts PayableTurnover:This ratio is also known as accounts payable or creditorsvelocity. A business concern usually purchases raw materials,services and goods on credit. The quantum of payables of abusiness concern depends upon its purchase policy, thequantity of purchases and suppliers’ credit policy. Longer theperiod of payables outstanding lesser is the problem ofworking capital of the firm. But if the firm does not pay off itscreditors within time, it will adversely affect goodwill of thebusiness.Creditors turnover ratio indicates the number of times thepayables rotate in a year. The term accounts payable includessundry creditors and bills payable.Payables turnover indicates the relationship between netpurchases for the whole year and total payables.A higher ratio indicates that creditors are not paid in time. Alower ratio indicates payment of creditors promptly.Link: http://www.accountingnotes.net/cost-accounting/ratio-analysis/list-of-ratio-analysis-formulasand-explanations-accounting/17121Depending on the liquidity position of the firm, the kind ofpayables turnover desirable can be planned.4. Working Capital Turnover Ratio:Working capital ratio measures the effective utilisation ofworking capital. It also measures the smooth running ofbusiness or otherwise. The ratio establishes relationshipbetween cost of sales and working capital. Working capitalturnover ratio is calculated with the help of the followingformula.Higher sales in comparison to working capital indicateovertrading and a lower sale in comparison to working capitalindicates under trading. A higher ratio is the indication oflower investment of working capital and more profit.5. Fixed Assets Turnover Ratio:This ratio determines efficiency of utilisation of fixed assetsand profitability of a business concern. Higher the ratio, moreis the efficiency in utilisation of fixed assets. A lower ratio isthe indication of under utilisation of fixed assets.The former formula which relates the fixed assets to the costof sales is more popular and preferable.6. Capital Turnover Ratio:Link: http://www.accountingnotes.net/cost-accounting/ratio-analysis/list-of-ratio-analysis-formulasand-explanations-accounting/17121Managerial efficiency is also calculated by establishing therelationship between cost of sales or sales with the amount ofcapital invested in the business.Capital turnover ratio is calculated with the help ofthe following formula:Higher ratio indicates higher efficiency and lower ratioindicates ineffective usage of capital.Solvency or Financial Ratios:Solvency or Financial ratios include all ratios which expressfinancial position of the concern. Financial ratios arecalculated on the basis of items of the Balance Sheet.Therefore, they are also called Balance Sheet ratios. Financialposition may mean differently to different, persons interestedin the business concern. Creditors, banks, management,investors and auditors have different views about financialposition.The term financial position generally refers to short-term andlong-term solvency of the business concern, indicating safetyof different interested parties. Financial ratios are alsoanalysed to find judicious use of funds. The significantLink: http://www.accountingnotes.net/cost-accounting/ratio-analysis/list-of-ratio-analysis-formulasand-explanations-accounting/17121financial ratios are classified as short-term solvency ratiosand long-term solvency ratios.Therefore financial ratios are as under:(1) Overall solvency(2) Short-term solvency (or) Liquidity ratios(i) Current ratio(ii) Liquid ratio(iii) Cash position ratio(3) Long-term solvency ratios-(i) Fixed assets ratio(ii) Debt equity ratio(iii) Proprietary ratio, and(iv) Capital gearing ratio.1. Overall Solvency (or) Total Debt (or) Debt Ratio:It is a ratio which relates the total tangible assets with thetotal borrowed funds. In a sense, it is the ‘other side of thecoin’ for proprietary ratio.In this ratio, total debt includes both short-term and longterm borrowings. It shows the proportion of assets needed torepay the debts. A higher ratio indicates greater risk andlower safety to the owners. A higher ratio also makes the firmvulnerable’ to business cycles and its solvency becomesLink: http://www.accountingnotes.net/cost-accounting/ratio-analysis/list-of-ratio-analysis-formulasand-explanations-accounting/17121suspect. Further borrowing becomes difficult for firms with ahigh total debt ratio. Such firms are called ‘Highly geared’.2. Short-Term Solvency Ratios:(i) Current Ratio:The ratio of current assets to current liabilities is called‘current ratio’. In order to measure the short-term liquidity orsolvency of a concern, comparison of current assets andcurrent liabilities is inevitable. Current ratio indicates theability of a concern to meet its current obligations as andwhen they are due for payment.The term current assets includes debtors, stock, billsreceivables, bank and cash balances, prepaid expenses,income due and short-term investments.The term current liabilities includes creditors, bank overdraft,bills payable, outstanding expenses, income received inadvance, etc.Standard Expected Current Ratio:Internationally accepted current ratio is 2 :1 i.e., currentassets shall be 2 times to current liabilities.The business concern will be able to meet its currentobligations easily with such a ratio between its current assetsand liabilities. The ability of the concern also depends oncomposition of current assets. If current assets have more ofstock, debtors, other than cash and bank, it may be difficult tomeet current obligations. But at the same time most of thecurrent assets consist of bank and cash, it is easier to meet theobligations.Link: http://www.accountingnotes.net/cost-accounting/ratio-analysis/list-of-ratio-analysis-formulasand-explanations-accounting/17121A very high current ratio also does not indicate efficiencysince it means less efficient use of funds. A high current ratioalso indicates dependence on long-term sources of raisingfunds. Long-term funds are more expensive than currentliabilities. A ratio of less than 2 indicates inadequate currentassets to meet current liabilities. Ideal ratio of ‘2’ is insistedbecause even if current assets are reduced to half i.e., ‘1’instead of ‘2’, creditors will be able to get their dues in full.The difference between the current assets and currentliabilities acts as ‘cushion’ and provides flexibility forpayments.(ii) Liquid Ratio:This ratio is also called ‘Quick’ or ‘Acid test’ ratio. It iscalculated by comparing the quick assets with currentliabilities.Quick or liquid assets refer to assets which are quicklyconvertible into cash. Current assets other than stock andprepaid expenses are considered as quick assets.The ideal liquid ratio or the generally accepted ‘norm’ forliquid ratio is ‘1’.Comparison of quick ratio with current ratio indicates theinventory hold ups.(iii) Cash Position Ratio:This ratio is also called ‘Absolute Liquidity ratio’ or ‘superquick ratio’. This is a variation of quick ratio. This ratio iscalculated when liquidity is highly restricted in terms of cashLink: http://www.accountingnotes.net/cost-accounting/ratio-analysis/list-of-ratio-analysis-formulasand-explanations-accounting/17121and cash equivalents. This ratio measures liquidity in termsof cash and near cash items and short-term current liabilities.Cash position ratio is calculated with the help of the followingformula-3. Long-Term Solvency Ratios:(1) Fixed Assets Ratio:The ratio establishes the relationship between fixed assetsand long-term funds. The objective of calculating this ratio isto ascertain the proportion of long-term funds invested infixed assets.The ratio is calculated as given below:The ratio should not generally be more than ‘1’. If the ratio isless than one it indicates that a portion of working capital hasbeen financed by long-term funds. It is desirable in that partof working capital is core working capital and it is more orless a fixed item.An ideal fixed assets ratio is 0.67.Fixed assets ratio of more than ‘1’ implies that fixed assets arepurchased with short-term funds, which is not a prudentpolicy.Fixed assets here mean = Fixed assets – DepreciationLink: http://www.accountingnotes.net/cost-accounting/ratio-analysis/list-of-ratio-analysis-formulasand-explanations-accounting/17121Long-term funds = Share capital + Reserves and surplus +Long-term loans – Fictitious assets(2) Debt Equity Ratio:This ratio is ascertained to determine long-term solvencyposition of a company. Debt equity ratio is also called‘external-internal equity ratio’.The third formula which shows the long-term borrowings as aproportion of owners’ funds is the most popular one.(3) Proprietary Ratio:This ratio compares the shareholders’ funds or owner’s fundsand total tangible assets. In other words this ratio expressesthe relationship between the proprietor’s funds and the totaltangible assets.Link: http://www.accountingnotes.net/cost-accounting/ratio-analysis/list-of-ratio-analysis-formulasand-explanations-accounting/17121This ratio shows the general soundness of the company. It isof particular interest to the creditors of the company as ithelps them to ascertain the shareholders’ funds in the totalassets of the business. A high ratio indicates safety to thecreditors and a low ratio shows greater risk to the creditors.A ratio below 5 is alarming for the creditors since they have tolose heavily in the event of company’s liquidation as itindicates more of creditors funds and less of shareholders’funds in the total assets of the company.(4) Capital Gearing Ratio:This ratio is also known as capitalisation or leverage ratio. Itis also one of the long-term solvency ratios. It is used toanalyse the capital structure of the company. The ratioestablishes relationship between fixed interest and dividendbearing funds and equity shareholders’ funds.The capital gearing ratio is calculated with the help of thefollowing formulaCapital gearing ratio shows the proportion of various items oflong-term finance employed in the business. Its mainemphasis is on indication of the proportion between owners’funds and non-owners’ funds. This proportion is calledleverage. If the ratio is high, the capital gearing is said to behigh and if the ratio is low the capital gearing is said to below. The implication is that high gearing is ‘Trading on ThinEquity’ and low gearing is ‘Trading on Thick Equity.’Further, highly geared capital structure is the indication forunder capitalisation which means that amount of capital isdisproportionate to the needs measured by the volume ofLink: http://www.accountingnotes.net/cost-accounting/ratio-analysis/list-of-ratio-analysis-formulasand-explanations-accounting/17121activity. A low gearing ratio indicates over capitalisation. Theaim should be to avoid both high gearing and low gearing andachieve ‘Fair capitalisation’.
