Types and Calculation of Accounting Ratios
Liquidity Ratios
Liquidity ratios measure a company's ability to meet its short-term obligations using its short-term assets. These ratios are crucial for assessing the company's short-term financial health and its capacity to convert assets into cash to settle current liabilities.
Current Ratio
The Current Ratio is a widely used liquidity ratio that measures a company's ability to pay off its short-term liabilities with its short-term assets. It compares current assets to current liabilities.
Formula:
$ \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} $
Components:
- Current Assets: Assets that are expected to be realised in, or are intended for sale or consumption in, the company's normal operating cycle, or expected to be realised within twelve months after the reporting date, or cash and cash equivalents. Examples include Inventories, Trade Receivables, Cash and Cash Equivalents, Short-term Loans and Advances, Other Current Assets (like prepaid expenses, accrued income), and Current Investments.
- Current Liabilities: Liabilities that are expected to be settled in the company's normal operating cycle, or are held primarily for the purpose of being traded, or are due to be settled within twelve months after the reporting date, or for which the company does not have an unconditional right to defer settlement for at least twelve months. Examples include Short-term Borrowings, Trade Payables, Other Current Liabilities (like outstanding expenses, income received in advance), and Short-term Provisions, and Current maturities of long-term borrowings.
Interpretation:
A higher Current Ratio indicates better short-term solvency and liquidity. A ratio of 2:1 is often considered satisfactory, meaning the company has ₹2 of current assets for every ₹1 of current liability. However, the ideal ratio varies significantly across industries. A very high ratio might suggest inefficient use of funds (e.g., excessive inventory or idle cash).
Quick Or Liquid Ratio (Acid Test Ratio)
The Quick Ratio is a more stringent test of liquidity than the Current Ratio. It measures the company's ability to meet its short-term obligations using only its quick assets (assets that can be quickly converted into cash). It excludes inventories and prepaid expenses from current assets, as these are generally less liquid than other current assets.
Formula:
$ \text{Quick Ratio} = \frac{\text{Quick Assets}}{\text{Current Liabilities}} $
Or,
$ \text{Quick Ratio} = \frac{\text{Current Assets} - \text{Inventories} - \text{Prepaid Expenses}}{\text{Current Liabilities}} $
Components:
- Quick Assets: Current Assets excluding Inventories, Prepaid Expenses, and sometimes other items that are not readily convertible into cash (e.g., loans to employees). Includes Trade Receivables, Cash and Cash Equivalents, Current Investments, etc.
- Current Liabilities: Same as defined for Current Ratio.
Interpretation:
A higher Quick Ratio indicates a better ability to pay off current liabilities immediately. A ratio of 1:1 is often considered satisfactory, meaning the company has ₹1 of quick assets for every ₹1 of current liability. Like the Current Ratio, the ideal benchmark varies by industry.
Solvency Ratios
Solvency ratios measure a company's ability to meet its long-term obligations, including interest payments and repayment of principal. These ratios provide insights into the company's financial structure, debt levels, and long-term financial stability.
Debt-Equity Ratio
The Debt-Equity Ratio measures the relationship between long-term debt and shareholders' funds. It indicates the proportion of funds contributed by lenders relative to the funds contributed by owners.
Formula:
$ \text{Debt-Equity Ratio} = \frac{\text{Non-current Liabilities (Long-term Debt)}}{\text{Shareholders' Funds (Equity)}} $
Components:
- Non-current Liabilities (Long-term Debt): Long-term Borrowings (like debentures, term loans) and Long-term Provisions (like long-term employee benefits provision).
- Shareholders' Funds (Equity): Share Capital (Equity and Preference) + Reserves and Surplus + Money received against share warrants.
Interpretation:
A lower Debt-Equity Ratio generally indicates lower financial risk, as the company is less reliant on borrowed funds. A higher ratio suggests higher leverage, which can increase potential returns for shareholders in good times but also increases the risk of bankruptcy during downturns. A common benchmark is 2:1, but this is highly industry-dependent.
Debt To Capital Employed Ratio
This ratio measures the proportion of long-term debt in the total capital employed in the business. It is another way to look at the company's capital structure.
Formula:
$ \text{Debt to Capital Employed Ratio} = \frac{\text{Non-current Liabilities (Long-term Debt)}}{\text{Capital Employed}} $
Components:
- Non-current Liabilities (Long-term Debt): Same as defined for Debt-Equity Ratio.
- Capital Employed: Sum of Shareholders' Funds and Non-current Liabilities. Alternatively, Total Assets minus Current Liabilities. Capital Employed represents the total long-term funds invested in the business.
Interpretation:
Similar to the Debt-Equity Ratio, a lower ratio indicates less reliance on long-term debt for funding the business's operations. A higher ratio suggests a more leveraged capital structure.
Proprietary Ratio
The Proprietary Ratio expresses the relationship between shareholders' funds and total assets. It shows the extent to which the total assets of the company are financed by the owners' funds.
Formula:
$ \text{Proprietary Ratio} = \frac{\text{Shareholders' Funds}}{\text{Total Assets}} $
Components:
- Shareholders' Funds: Same as defined for Debt-Equity Ratio.
- Total Assets: Sum of all Non-current Assets and Current Assets. (This is equal to Total Equity and Liabilities).
Interpretation:
A higher Proprietary Ratio indicates a larger proportion of assets financed by owners, implying a stronger financial position and better long-term solvency from the shareholders' perspective. A low ratio means a greater reliance on debt.
Total Assets To Debt Ratio
This ratio measures the relationship between the total assets of the company and its long-term debt. It indicates the extent to which assets are available to cover long-term debt. It is the inverse of the Debt to Total Assets ratio (if equity is zero, which is not applicable for a company).
Formula:
$ \text{Total Assets to Debt Ratio} = \frac{\text{Total Assets}}{\text{Non-current Liabilities (Long-term Debt)}} $
Components:
- Total Assets: Same as defined for Proprietary Ratio.
- Non-current Liabilities (Long-term Debt): Same as defined for Debt-Equity Ratio.
Interpretation:
A higher ratio signifies that the company has a larger asset base to secure its long-term debt, which provides a greater margin of safety for lenders. From the company's perspective, it indicates its ability to use its assets to cover its long-term borrowings.
Interest Coverage Ratio
The Interest Coverage Ratio measures a company's ability to meet its interest obligations on borrowed funds out of its earnings. It shows how many times the earnings before interest and tax can cover the interest expense.
Formula:
$ \text{Interest Coverage Ratio} = \frac{\text{Profit before Interest and Tax (PBIT)}}{\text{Finance Costs (Interest Expense)}} $
Components:
- Profit before Interest and Tax (PBIT): Net Profit (or Loss) before deducting Finance Costs (Interest) and Tax Expense. It is calculated by adding back Interest Expense and Tax Expense to Net Profit After Tax.
$ \text{PBIT} = \text{Net Profit after Tax} + \text{Tax Expense} + \text{Finance Costs (Interest)} $
- Finance Costs (Interest Expense): All interest paid or payable on borrowings (debentures, loans, etc.) during the period.
Interpretation:
A higher Interest Coverage Ratio indicates a greater ability to service debt interest payments. Lenders prefer a high ratio (e.g., 6-7 times or more) as it suggests that the company has sufficient earnings to cover its interest obligations comfortably. A low ratio (especially below 1.5-2) is a warning sign of potential difficulty in meeting interest payments.
Activity (Or Turnover) Ratio
Activity ratios measure how efficiently a company is utilising its assets to generate sales or revenue. They are also known as efficiency ratios or turnover ratios.
Inventory Turnover Ratio
The Inventory Turnover Ratio measures how many times a company's inventory is sold and replaced over a period. It indicates the efficiency of inventory management.
Formula:
$ \text{Inventory Turnover Ratio} = \frac{\text{Cost of Revenue from Operations (Cost of Goods Sold)}}{\text{Average Inventory}} $
Components:
- Cost of Revenue from Operations (Cost of Goods Sold - COGS): For a trading concern: Opening Stock-in-Trade + Purchases + Direct Expenses - Closing Stock-in-Trade. For a manufacturing concern: Cost of Materials Consumed + Purchases of Stock-in-Trade + Changes in Inventories of Finished Goods, WIP & Stock-in-Trade + Direct Expenses. Alternatively, Revenue from Operations - Gross Profit.
- Average Inventory: $ \frac{\text{Opening Inventory} + \text{Closing Inventory}}{2} $. Inventory includes Raw Materials, WIP, Finished Goods, Stock-in-Trade, Stores & Spares. If opening inventory is not available, closing inventory may be used, but average is preferred.
Interpretation:
A higher Inventory Turnover Ratio generally indicates efficient inventory management and strong sales. A low ratio suggests slow-moving or excess inventory, which can lead to storage costs and obsolescence. Very high might indicate insufficient stock leading to lost sales.
This ratio can also be expressed as the Average Age of Inventory or Inventory Holding Period:
$ \text{Average Age of Inventory} = \frac{\text{Days/Months in a year}}{\text{Inventory Turnover Ratio}} $
This shows the average number of days inventory is held before being sold.
Trade Receivables Turnover Ratio (Debtors Turnover Ratio)
The Trade Receivables Turnover Ratio measures how many times a company collects its average trade receivables during a period. It indicates the efficiency of the company's credit sales and collection efforts.
Formula:
$ \text{Trade Receivables Turnover Ratio} = \frac{\text{Revenue from Operations (Net Credit Sales)}}{\text{Average Trade Receivables}} $
Components:
- Revenue from Operations (Net Credit Sales): Ideally, this should be net credit sales. If credit sales figures are not available separately, total net sales (Revenue from Operations) can be used, assuming credit sales constitute a major portion. Net Sales = Gross Sales - Sales Returns.
- Average Trade Receivables: $ \frac{\text{Opening Trade Receivables} + \text{Closing Trade Receivables}}{2} $. Trade Receivables include Trade Debtors and Bills Receivable. If opening figures are not available, closing Trade Receivables can be used.
Interpretation:
A higher Trade Receivables Turnover Ratio indicates faster collection of credit sales, suggesting efficient credit management and prompt collection. A low ratio might indicate poor credit policies, inefficient collection procedures, or potential bad debts.
This ratio is often supplemented by the Average Collection Period or Debtors Collection Period:
$ \text{Average Collection Period} = \frac{\text{Days/Months in a year}}{\text{Trade Receivables Turnover Ratio}} $
This shows the average number of days it takes for the company to collect cash from its debtors.
Trade Payable Turnover Ratio (Creditors Turnover Ratio)
The Trade Payable Turnover Ratio measures how many times a company pays its average trade payables during a period. It indicates the speed at which the company pays its suppliers.
Formula:
$ \text{Trade Payable Turnover Ratio} = \frac{\text{Net Purchases (Net Credit Purchases)}}{\text{Average Trade Payables}} $
Components:
- Net Purchases (Net Credit Purchases): Ideally, this should be net credit purchases. If credit purchases figures are not available, total net purchases (Purchases - Purchase Returns) can be used, assuming credit purchases constitute a major portion.
- Average Trade Payables: $ \frac{\text{Opening Trade Payables} + \text{Closing Trade Payables}}{2} $. Trade Payables include Trade Creditors and Bills Payable. If opening figures are not available, closing Trade Payables can be used.
Interpretation:
A higher Trade Payable Turnover Ratio indicates faster payment to suppliers. A lower ratio suggests the company is taking longer to pay its suppliers, which might be a result of a deliberate credit policy (availing longer credit periods) or could indicate financial distress if the delays are involuntary.
This ratio is often supplemented by the Average Payment Period or Creditors Payment Period:
$ \text{Average Payment Period} = \frac{\text{Days/Months in a year}}{\text{Trade Payable Turnover Ratio}} $
This shows the average number of days the company takes to pay its suppliers.
Net Assets Or Capital Employed Turnover Ratio
This ratio measures the efficiency with which the company uses its total long-term funds (capital employed or net assets) to generate sales. It relates the revenue generated to the capital invested.
Formula:
$ \text{Capital Employed Turnover Ratio} = \frac{\text{Revenue from Operations}}{\text{Capital Employed}} $
Or,
$ \text{Net Assets Turnover Ratio} = \frac{\text{Revenue from Operations}}{\text{Net Assets}} $
(Note: Capital Employed and Net Assets generally refer to the same figure when Capital Employed = Shareholders' Funds + Non-current Liabilities, or Total Assets - Current Liabilities).
Components:
- Revenue from Operations: Net Sales.
- Capital Employed (or Net Assets): Shareholders' Funds + Non-current Liabilities. Alternatively, Total Assets minus Current Liabilities. Average Capital Employed $ \frac{\text{Opening Capital Employed} + \text{Closing Capital Employed}}{2} $ is preferred if data is available.
Interpretation:
A higher ratio indicates more efficient utilisation of the long-term capital in generating revenue. A low ratio might suggest underutilisation of long-term assets or inefficient management of overall funds.
Profitability Ratios
Profitability ratios measure the company's ability to generate profits from its sales and/or the capital invested in the business. These ratios are crucial for assessing the company's operational efficiency and overall financial performance.
Gross Profit Ratio
The Gross Profit Ratio measures the relationship between Gross Profit and Revenue from Operations. It indicates the profitability of goods sold, reflecting pricing strategy and production/purchase costs efficiency.
Formula:
$ \text{Gross Profit Ratio} = \frac{\text{Gross Profit}}{\text{Revenue from Operations}} \times 100 $
Components:
- Gross Profit: Revenue from Operations - Cost of Revenue from Operations.
- Revenue from Operations: Net Sales.
Interpretation:
A higher Gross Profit Ratio indicates a larger margin on sales after covering the direct cost of goods. This suggests effective pricing, efficient production/procurement, or control over cost of goods sold. A declining trend might signal increasing costs or pressure on selling prices.
Operating Ratio
The Operating Ratio measures the relationship between operating costs (cost of revenue from operations plus operating expenses) and revenue from operations. It indicates the operational efficiency of the business in terms of cost management.
Formula:
$ \text{Operating Ratio} = \frac{\text{Cost of Revenue from Operations} + \text{Operating Expenses}}{\text{Revenue from Operations}} \times 100 $
Components:
- Cost of Revenue from Operations: Same as defined for Inventory Turnover Ratio/Gross Profit Ratio.
- Operating Expenses: Expenses incurred in the normal course of business operations other than the cost of goods sold. Typically includes Employee Benefits Expense, Depreciation and Amortisation Expense, Other Expenses (excluding non-operating expenses like finance costs, loss on sale of assets, etc.). Selling, distribution, and administrative expenses are usually included here.
- Revenue from Operations: Net Sales.
Interpretation:
A lower Operating Ratio indicates higher operational efficiency, as a smaller proportion of revenue is consumed by operating costs. This leaves a larger margin for covering financing costs, tax, and generating net profit. The Operating Ratio is complementary to the Operating Profit Ratio (Operating Ratio + Operating Profit Ratio = 100%).
Operating Profit Ratio
The Operating Profit Ratio measures the relationship between Operating Profit and Revenue from Operations. It shows the profitability of the core business operations before accounting for finance costs and tax.
Formula:
$ \text{Operating Profit Ratio} = \frac{\text{Operating Profit}}{\text{Revenue from Operations}} \times 100 $
Components:
- Operating Profit: Revenue from Operations - (Cost of Revenue from Operations + Operating Expenses). Alternatively, Net Profit before Interest and Tax (PBIT) adjusted for non-operating income/expenses.
$ \text{Operating Profit} = \text{Gross Profit} - \text{Operating Expenses} $
$ \text{Operating Profit} = \text{Net Profit before Tax} + \text{Finance Costs} - \text{Non-operating Income} + \text{Non-operating Expenses} $
- Revenue from Operations: Net Sales.
Interpretation:
A higher Operating Profit Ratio indicates greater profitability from the main business activities, suggesting efficient operations and cost control. It is a key indicator of the company's core earning power.
Net Profit Ratio
The Net Profit Ratio measures the relationship between Net Profit (after all expenses, interest, and tax) and Revenue from Operations. It represents the overall profitability and the company's ability to generate a net return on sales.
Formula:
$ \text{Net Profit Ratio} = \frac{\text{Net Profit (after tax)}}{\text{Revenue from Operations}} \times 100 $
Components:
- Net Profit (after tax): Profit for the period as shown in the Statement of Profit and Loss, after deducting all expenses, finance costs, and tax.
- Revenue from Operations: Net Sales.
Interpretation:
A higher Net Profit Ratio indicates better overall profitability. It reflects the combined effect of operational efficiency, financing decisions, and tax management. It is the ultimate measure of profitability for the owners.
Return On Capital Employed Or Investment (ROCE or ROI)
Return on Capital Employed (ROCE) measures the profitability of the total long-term funds (capital employed) invested in the business. It assesses the efficiency with which the company uses its capital to generate returns before accounting for financing costs and tax.
Formula:
$ \text{ROCE} = \frac{\text{Profit before Interest and Tax (PBIT)}}{\text{Capital Employed}} \times 100 $
Components:
- Profit before Interest and Tax (PBIT): Same as defined for Interest Coverage Ratio. It represents the total earnings available to both debenture holders (interest) and shareholders (profit).
- Capital Employed: Shareholders' Funds + Non-current Liabilities. Alternatively, Total Assets - Current Liabilities. Average Capital Employed is preferred for a more accurate representation of capital used during the period.
$ \text{Average Capital Employed} = \frac{\text{Opening Capital Employed} + \text{Closing Capital Employed}}{2} $
Interpretation:
A higher ROCE indicates greater efficiency in using the total long-term funds to generate profits. It allows comparison of profitability across companies with different capital structures. It should be compared with the cost of capital to assess if the business is creating value.
Return On Shareholders’ Funds (ROF) or Return On Equity (ROE)
Return on Shareholders' Funds (or Return on Equity) measures the profitability of the owners' investment (shareholders' funds) in the business. It indicates how effectively the company is using the equity capital to generate profits available to shareholders.
Formula:
$ \text{ROE} = \frac{\text{Net Profit (after tax and preference dividend)}}{\text{Shareholders' Funds}} \times 100 $
Components:
- Net Profit (after tax and preference dividend): Profit after deducting all expenses, finance costs, tax, and preference dividend (if any). This is the profit available to equity shareholders.
- Shareholders' Funds (Equity): Share Capital (Equity and Preference) + Reserves and Surplus - Accumulated Losses (if any). Often, only funds attributable to equity shareholders are considered, i.e., Shareholders' Funds less Preference Share Capital and reserves attributable to preference shares. Average Shareholders' Funds is preferred if data is available.
$ \text{Average Shareholders' Funds} = \frac{\text{Opening Shareholders' Funds} + \text{Closing Shareholders' Funds}}{2} $
Interpretation:
A higher ROE indicates that the company is generating higher returns for its shareholders. It is a key metric for investors to evaluate the profitability of their investment. It is influenced by the company's net profit margin, asset turnover, and financial leverage.
Earnings Per Share (EPS)
Earnings Per Share (EPS) is the portion of a company's profit allocated to each outstanding share of common stock (equity shares). It is an important indicator of a company's profitability from an equity shareholder's perspective.
Formula:
$ \text{Earnings Per Share (EPS)} = \frac{\text{Net Profit (after tax and preference dividend)}}{\text{Number of Equity Shares Outstanding}} $
Components:
- Net Profit (after tax and preference dividend): Same as defined for ROE.
- Number of Equity Shares Outstanding: The weighted average number of equity shares outstanding during the period is ideally used, especially if there have been issues or buybacks of shares during the year. If the number of shares remains constant, the simple number of shares outstanding at the end of the period can be used.
Interpretation:
A higher EPS indicates greater earnings available per equity share. It is a widely used measure to assess a company's performance and compare it with other companies or its own past performance. EPS is used in the calculation of other ratios like P/E Ratio and Dividend Payout Ratio.
Book Value Per Share
Book Value Per Share represents the net assets (based on accounting values) available to each equity share. It indicates the asset backing for each share as per the company's books.
Formula:
$ \text{Book Value Per Share} = \frac{\text{Shareholders' Funds (attributable to Equity)}}{\text{Number of Equity Shares Outstanding}} $
Components:
- Shareholders' Funds (attributable to Equity): Total Shareholders' Funds minus any Preference Share Capital and reserves attributable to preference shares. It includes Equity Share Capital + Reserves and Surplus (excluding any portion related to preference shares).
- Number of Equity Shares Outstanding: Number of equity shares at the balance sheet date.
Interpretation:
It shows the net asset value per share based on historical costs and accounting policies. Comparing book value per share with the market price per share can provide some perspective, although market price is influenced by many factors beyond book value, including future prospects and market sentiment.
Dividend Payout Ratio
The Dividend Payout Ratio measures the proportion of the profit available to equity shareholders that is distributed to them as dividends. It indicates the company's dividend policy.
Formula:
$ \text{Dividend Payout Ratio} = \frac{\text{Total Equity Dividend Paid/Proposed}}{\text{Net Profit (after tax and preference dividend)}} \times 100 $
Or, using per share values:
$ \text{Dividend Payout Ratio} = \frac{\text{Dividend Per Share (DPS)}}{\text{Earnings Per Share (EPS)}} \times 100 $
Components:
- Total Equity Dividend Paid/Proposed: Total amount of dividend paid or proposed (recommended) for equity shareholders during the period.
- Net Profit (after tax and preference dividend): Same as defined for EPS and ROE.
Interpretation:
A high Dividend Payout Ratio means the company is distributing a large portion of its profits as dividends and retaining less for reinvestment in the business. This might be preferred by investors seeking regular income. A low ratio suggests the company is retaining more profits for growth and expansion, which might appeal to growth-oriented investors.
Price / Earnings Ratio (P/E Ratio)
The Price/Earnings (P/E) Ratio is a market-based ratio that relates the market price of a share to its earnings per share. It indicates how much investors are willing to pay for each rupee of current earnings.
Formula:
$ \text{Price / Earnings Ratio (P/E Ratio)} = \frac{\text{Market Price Per Equity Share}}{\text{Earnings Per Share (EPS)}} $
Components:
- Market Price Per Equity Share: The prevailing market price of the company's share on the stock exchange at a given date.
- Earnings Per Share (EPS): Same as calculated above.
Interpretation:
A higher P/E Ratio generally suggests that investors have high expectations for the company's future earnings growth. They are willing to pay a premium for the current earnings. A low P/E ratio might suggest that the company is undervalued, has poor growth prospects, or is facing significant risks. P/E ratios vary significantly by industry and economic conditions.