International financial and management accounting lesson 05

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International Financial and
Management Accounting

LESSON

5
RATIO ANALYSIS
CONTENTS
5.0
5.1
5.2
5.3
5.4

5.5
5.6
5.7
5.8
5.9
5.10
5.11

Aims and Objectives
Introduction
Purposes of the Ratio Analysis
Utility of the Ratio Analysis
Classification of Ratios
5.4.1 On the Basis of Financial Statements
5.4.2 On the Basis of Functions
5.4.3 Short-term Solvency Ratios

5.4.4 Leverage Ratios/Capital Structure Ratios
5.4.5 Debt -Equity Ratio
5.4.6 Proprietary Ratio
5.4.7 Fixed Assets Ratio
5.4.8 Coverage Ratios
5.4.9 Interest Coverage Ratio
5.4.10 Return on Assets
5.4.11 Turnover Ratio
Limitations of the Ratio Analysis
Dupont Analysis
Let us Sum up
Lesson End Activity
Keywords
Questions for Discussion
Suggested Readings

5.0 AIMS AND OBJECTIVES
In this lesson we shall discuss about various types of ratio analysis. After going through
this lesson you will be able to:
Apply the accounting ratios to extract the financial performance of the firm from
the financial statements
Study not only the quantitative results of the firm but also qualitative factors viz
solvency, liquidity and so on

5.1 INTRODUCTION
The ratio analysis is one of the important tools of financial statement analysis to study
the financial stature of the business fleeces, corporate houses and so on.


How the ratios are able to facilitate to study the financial status of the enterprise?

What is meant by ratio?
The ratio illustrates the relationship in between the two related variables.
What is meant by the accounting ratio?
The accounting ratios are computed on the basis available accounting information
extracted from the financial statements which are not in a position to reveal the status of
the enterprise.
The accounting ratios are applied to study the relationship in between the quantitative
information available and to take decision on the financial performance of the firm.
Definition
According to J. Betty, “The term accounting is used to describe relationships significantly
which exist in between figures shown in a balance sheet, Profit & Loss A/c,
Trading A/c, Budgetary control system or in any part of the accounting organization.”
According to Myers “Study of relationship among the various financial factors of the
enterprise.”
How the Accounting Ratios are expressed?
To understand the methodology of expressing the ratios, the expression of ratios should
highlighted in the following discussion:
Expression

Quotient

Current Ratio
/Leverage Ratio

Percentage

Net Profit Ratio

Time

Stock Turnover Ratio

Fraction

Fixed assets to capital
employed

Figure 5.1: Methodology of Expressing the Ratios

5.2 PURPOSES OF THE RATIO ANALYSIS
To study the short-term solvency of the firm - liquidity of the firm
To study the long-term solvency of the firm - leverage position of the firm
To interpret the profitability of the firm - profit earning capacity of the firm
To identify the operating efficiency of the firm - turnover of the ratios

5.3 UTILITY OF THE RATIO ANALYSIS
Easy to understand the financial position of the firm: The ratio analysis facilitates
the parties to read the changes taken place in the financial performance of the firm
from one time period to another.
Measure of expressing the financial performance and position: It acts as a
measure of financial position through Liquidity ratios and Leverage ratios and also
a measure of financial performance through Profitability ratios and Turnover ratios.

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Ratio Analysis


Intra firm analysis on the financial information over many number of years:
The financial performance and position of the firm can be analysed and interpreted
within the firm in between the available financial information of many number of

years; which portrays either increase or decrease in the financial performance.

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Inter firm analysis on the financial information within the industry: The financial
performance of the firm is studied and interpreted along with the similar firms in
the industry to identify the presence and status of the respective firm among others.
Possibility for financial planning and control: It not only guides the firm to earn
in accordance with the financial forecasting but also facilitates the firm to identify
the major source of expense, which drastically has greater influence on the earnings.
Check Your Progress 1
1.

2.

3.

Ratio is an expression of:
(a)

Quotient

(b) Time

(c)

Percentage

(d) Fraction

(e)

(a), (b), (c) & (d)

Accounting ratios are to study:
(a)

Accounting relationship among the variables

(b)

The relationship in between the variables of financial statements

(c)

The relationship in between the variables of financial statements for
analysis and interpretations

(d)

None of the above

Accounting ratios are of:
(a)

Income statement ratios

(b) Positional statement ratios

(c)

Both (a) & (b)

(d) None of the above

5.4 CLASSIFICATION OF RATIOS
The accounting ratios are classified into various categories viz.:
On the basis of financial statements
On the basis of functions

5.4.1 On the Basis of Financial Statements
1.

Income Statement Ratios: These ratios are computed from the statements of
Trading, Profit & Loss account of the enterprise. Some of the major ratios are as
following GP ratio, NP ratio, Expenses Ratio and so on.

2.

Balance Sheet or Positional Statement Ratios: These types of ratios are
calculated from the balance sheet of the enterprise which normally reveals the
financial status of the position i.e. short-term, long-term financial position, Share of
the owners on the total assets of the enterprise and so on.

3.

Inter Statement or Composite Mixture of Ratios: Theses ratios are calculated
by extracting the accounting information from the both financial statements, in

order to identify stock turnover ratios, debtor turnover ratio, return on capital
employed and so on.


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5.4.2 On the Basis of Functions
1.

On the basis of Solvency position of the firms: Short-term and Long-term solvency
position of the firms.

2.

On the basis of Profitability of the firms: The profitability of the firms are
studied on the basis of the total capital employed, total asset employed and so on.

3.

On the basis of Effectiveness of the firms: The effectiveness is studied through
the turnover ratios - Stock turnover ratio, Debtor turnover ratio and so on.

4.

Capital Structure ratios: The capital structure positions are analysed through
leverage ratios as well as coverage ratios.

5.4.3 Short-term Solvency Ratios
To study the short-term solvency or liquidity of the firm, the following are various ratios:
Current Assets Ratio

Acid Test Ratio or Quick Assets Ratio
Super Quick Assets Ratio
Defensive Interval Ratio
Current Assets Ratio: It is one of the important accounting ratios to find out the ability
of the business fleeces to meet out the short financial commitment. This is the ratio
establishes the relationship in between the current assets and current liabilities.
What is meant by current assets?
Current assets are nothing but available in the form of cash, equivalent to cash or easily
convertible into cash.
What is meant by the current liabilities?
Current liabilities are nothing but short-term financial resources or payable in short span
of time within a year.
Current Ratio =

Current Assets
Current Liabilities

Current Ratio

Current Assets

Current Liabilities

Marketable Securities
Trade creditors

Inventory

Bank overdraft
Debtors

Bills Payable
Bills Receivable
Provision for taxation
Prepaid expenses
Outstanding expenses
Outstanding Incomes
Pre-received incomes
Cash at Bank
Cash in Hand

Figure 5.2: Current Assets Ratio

Ratio Analysis


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Standard norm of the current ratio:

International Financial and
Management Accounting

Implication of High ratio of current assets over the current liabilities: High ratio
leads to greater the volume of current assets more than the specified norm denotes that
the firm possess excessive current assets than the requirement portrays idle funds invested
in the current assets.
Limitation of the current ratio: Under this ratio, the current assets are equally weighed
each other to match the current liabilities. Under the current ratio, one rupee of cash is
equally weighed at par with the one rupee of closing stock, but the closing stock and
prepaid expenses cannot be immediately realized like cash and marketable securities.

Acid Test Ratio: It is a ratio expresses the relationship in between the quick assets and
current liabilities. This ratio is to replace the bottleneck associated with the current ratio.
It considers only the liquid assets, which can be easily translated into cash to meet out
the financial commitments.
Acid Test Ratio (Quick Assets Ratio) =

Liquid Assets
Current Liabilities

Liquid Asset = Current Assets - (Closing Stock + Prepaid expenses)
Quick /Liquid Assets Ratio

Quick Assets

Marketable Securities
Debtors
Bills Receivable
Cash at Bank
Cash in Hand

Current liabilities

Trade creditors
Bank overdraft
Bills Payable
Provision for taxation
Outstanding expenses
Pre-received incomes

Figure 5.3: Liquid Assets Ratio

Standard norm of the ratio:
The ideal norm is that 1:1 means: One rupee of current liabilities is matched with
one rupee of quick assets.
Super Quick Assets Ratio: It is the ratio, which establishes the relationship in between
the super quick assets and quick liabilities of the firm.
The super quick assets are nothing but the current assets, which can be more easily
converted into cash to meet out the quick liabilities.
The super quick liabilities are the current liabilities should have to be met out at faster
pace within shorter span in duration.
Super Quick Assets = Cash + Marketable Securities
Super Quick Liabilities = Current Liabilities - Bank Over Draft
Super Quick Assets Ratio =

Super Quick Assets
Super Quick Liabilities


Standard norm of the ratio:

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Ratio Analysis

Higher the ratio is the better the position of the firm.
Illustration 1
From the following calculate current ratio
Current Assets:

Rs.

Cash in hand

4,00,000

Sundry Debtors

1,60,000

Stock

2,40,000

Current Liabilities:
Sundry creditors

3,00,000

Bills Payable

1,00,000

Current Ratio =

Current Assets
Rs. 8,00 ,000
=
=2
Current Liabilities
Rs.4,00 ,000

Illustration 2
The firm satisfies the standard norm of the Current assets ratio and Liquid assets ratio:
M/s Shanmuga & Co
Balance sheet as on dated 31st Mar, 2005
Particulars

Rs. Particulars

Share capital

42,000 Fixed Assets Net

Reserve

3,000 Stock

Annual profit

5,000 Debtors

Bank overdraft

4,000 Cash

Sundry creditors

34,000
12,400
6,400
13,200

12,000

Total
Current Ratio =

Rs.

66,000 Total

66,000

Rs.32,000
Current Assets
=
=2
Rs.16,000
Current Liabilities

It satisfies the standard norm of the current asset ratio.
Liquid assets ratio =

=

Current Assets – Closing Stock
Quick Assets
=
Current Liabilities
Current Liabilities
Rs.19,600

= 1.225
Rs.16,000

The firm financial position satisfies the standard norm of the Liquid assets ratio.


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Illustration 3
Liquid Assets Rs.65,000; Stock Rs.20,000; Prepaid expenses Rs.5,000;Working capital
Rs.60,000. Calculate current assets ratio and liquid assets ratio
For the computation of current assets ratio, current assets volume must be known. It is
not available in our problem, instead the liquid assets and prepaid expenses are given
together which will facilitate to find the total volume of current assets.
Current Assets = Liquid Asset + Prepaid expenses + closing stock
= Rs.65,000

+ Rs.5,000

+ 20,000

= Rs.90,000
The next step is to find out the current liabilities. The volume of current liabilities could
be found out through the available information of working capital.
Net working capital = Current Assets – Current Liabilities
Rs.60,000

= Rs.70,000 – Current liabilities

Current liabilities = Rs.90,000 – Rs.60,000 = Rs.30,000
From the above, the current ratio could be found out
Current Ratio =

Rs.90,000
=3>2
Rs.60,000

The firm satisfies the more than the norm of the current ratio. It means that the firm
keeps excessive current assets more than that of requirement.
Quick Assets Ratio =

Rs.65,000
= 2.17
Rs.30,000

The firm keeps more liquid assets than that of the specified norm means that excessive
liquid assets are held by the firm than the requirement in the form of idle not productive
in utility.
Illustration 4
The current ratio of Bicon Ltd is 4.5: 1 and liquidity ratio is 3:1 stock is Rs.6,00,000. Find
out the current liabilities.
To find out the volume of current liabilities, initially the share of closing stock should be
found out in the total of current assets.
Share of stock = Current Assets Ratio – Liquid Assets Ratio
= 4.5 – 3.0 = 1.5
Share of the stock = 1.5
If the share of the stock is 1.5 which amounted Rs.6,00,000
What is the volume of current liabilities for the ratio of 1?

Current liabilities =

Rs.6,00,000
= Rs.4,00,000
1.5


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5.4.4 Leverage Ratios/Capital Structure Ratios

Ratio Analysis

The capital structure ratios are classified into two categories:
Leverage Ratios: Long-term solvency position of the firm - Principal repayment
Coverage Ratios: Fixed commitment charge solvency of the firm - Dividend
coverage and Interest coverage

Capital Structure Ratio

Leverage Ratios

Coverage Ratios

Debt–Equity Ratio
Total Debt–Equity Ratio
Proprietary Ratio
Fixed Assets Ratio

Interest Coverage Ratio

Dividend Coverage Ratio

Figure 5.4: Capital Structure Raio

Under the capital structure ratios, the composition of the capital structure is analysed
only in the angle of long-term solvency of the firm.

5.4.5 Debt-Equity Ratio
It is the ratio expresses the relationship between the ownership funds and the outsiders'
funds. It is more specifically highlighted that an expression of relationship in between the
debt and Shareholders' funds. The debt-equity ratio can be obviously understood into
two different forms
Long term debt–equity ratio
Total debt–equity ratio
Long-term debt-equity ratio: It is a ratio expresses the relationship in between the
outsiders' contribution through debt financial resource and Shareholders' contribution
through equity share capital, preference share capital and past-accumulated profits. It
reveals the cover or cushion enjoyed by the firm due to the owners' contribution over the
outsiders' contribution.
Debt-Equity Ratio =

Debt (Long-term debt – Debentures/Term Loans)
Net worth/Equity (Shareholder's fund)

Higher ratio indicates the riskier financial status of the firm, which means that the firm
has been financed by the greater outsiders' fund rather than that of the owners' fund
contribution and vice versa.
Standard norm of the Debt-Equity Ratio:
The ideal norm is that 1:2 which means that every one rupee of debt finance is
covered by the 2 rupees of shareholders' fund.

The firm should have a minimum of 50% margin of safety in meeting the long-term
financial commitments. If the ratio exceeds the specification, the interest of the firm will
be ruined by the outsiders' during the moment at when they are unable to make the


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payment of interest in time as per the terms of agreement reached earlier. During the
moment of liquidation, the greater ratio may facilitate the creditors to recover the amount
due lesser holding held by the owners.
Total Debt-Equity Ratio: The ultimate purpose of the ratio is to express the relationship
total volume of debt irrespective of nature and shareholders' funds. If the owners'
contribution is lesser in volume in general irrespective of its nature leads to worse situation
in recovering the amount of outsiders' contribution during the moment of liquidation.
Total Debt-Equity Ratio =

Short-term debt + Long-term debt
Equity (Shareholder's fund)

5.4.6 Proprietary Ratio
The ratio illustrates the relationship in between the owners' contribution and the total
volume of assets. In simple words, how much funds are contributed by the owners in
financing the assets of the firm. Greater the ratio means that greater contribution made
by the owners' in financing the assets.
Proprietary Ratio =

Owners' Funds or Equity or Shareholders' funds
Total Assets

Standard norm of the ratio:
Higher the ratio is better the position
Higher ratio is better position for the firm as well as safety to the creditors.

5.4.7 Fixed Assets Ratio
The ratio establishes the relationship in between the fixed assets and long-term source
of funds. Whatever the source of long-term funds raised should be used for the acquisition
of long-term assets; it means that the total volume of fixed assets should be equivalent to
the volume of long-term funds i.e the ratio should be equal to 1
Fixed Assets Ratio =

Shareholders' funds + Outsiders' funds
Net Fixed Assets

If the ratio is lesser than one means that the firm made use of the short-term fund for the
acquisition of long-term assets. If the ratio is greater than one means that the acquired
fixed assets are lesser in quantum than that of the long-term funds raised for the purpose.
In other words, the firm makes use of the excessive funds for the built of current
assets.
Standard norm of the ratio:
The ideal norm of the ratio is 1:1 which means that the long-term funds raised
only utilised for the acquisition of long-term assets of the enterprise.
It facilitates to understand obviously about the over capitalization or under capitalization
of the assets of the enterprise.

5.4.8 Coverage Ratios
These ratios are computed to know the solvency of the firm in making the periodical
payment of interest and preference dividends. The interest and preference dividends are
to be paid irrespective of the earnings available in the hands of the firm. In other words,

these are known as fixed commitment charge of the firm.


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5.4.9 Interest Coverage Ratio

Ratio Analysis

The firms are expected to make the payment of interest on the amount of borrowings
without fail. This ratio facilitates the prospective lender to study the strength of the
enterprise in making the payment of interest regularly out of the total income. To study
the capacity in making the payment of interest is known as interest coverage ratio or
debt service coverage ratio.
The ability or capacity is analysed only on the basis of Earnings before interest and taxes
(EBIT) available in the hands of the firms.
Greater the ratio means that better the capacity of the firm in making the payment of
interest as well as greater the safety and vice versa
Interest coverage ratio =

Earnings before interest and taxes
Interest

Lesser the times the ratio means that meager the cushion of the firm which may lead to
affect the solvency position of the firm in making payment of interest regularly.
Dividend coverage ratio: It illustrates the firms' ability in making the payment of
preference dividend out of the earnings available in the hands of the firm after the
payment of taxation. If the size of the Profits after taxation is greater means that greater
the cushion for the payment of preference dividend and vice versa.
The preference dividends are to be paid without fail irrespective of the profits available

in the hands of the firm after the taxation.
Dividend coverage ratio =

Earnings after taxation
Preference Dividend

Standard norm of the ratio:
Higher the ratio means that the firm has greater cushion in meeting the needs of
preference dividend payment against Earnings after taxation (EAT) and vice versa.
Profitability Ratios: The ratios are measuring the profitability of the firms in various
angles viz
On sales
On investments
On capital employed and so on
While discussing the measure of profitability of the firm, the profits are normally classified
into various categories:
Gross Profit
Net Profit
Earnings before interest and taxes
Earnings after taxation and so on
All profitability ratios are normally expressed only in terms of (%). The return is normally
expressed only in terms of percentage, which warrant the expression of this ratio to be
also in percentage.


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GP Ratio: The ratio elucidates the relationship in between the Gross profit and sales

volume.
It facilitates to study the profit earning capacity of the firm out of the manufacturing or
Trading operations.
Gross Profit Ratio =

Gross Profit
× 100
Sales

Standard norm of the ratio:
Higher the ratio is better the position of the firm, which means that the firm
earns greater profits out of the sales and vice versa.
NP Ratio: The ratio expresses the relationship in between the Net profit and sales
volume. It facilitates to portray the overall operating efficiency of the firm. The net
profit ratio is an indicator of overall earning capacity of the firm in terms of return out of
sales volume .

Net Profit
× 100
Sales

Net Profit Ratio =

Standard norm of the ratio:
Higher the ratio is better the operating efficiency of the firm which means that
the firms earn greater volume of both operating as well as non-operating profit
out of sales and vice versa.
Operating profit ratio: The operating ratio is establishing the relationship in between
the cost of goods sold and operating expenses with the total sales volume.
Operating ratio =

Cost of goods sold + Operating expenses
× 100
Net Sales

Standard norm of the ratio:
Lower the ratio is better as well as favourable position for the firm, which
highlights % of absorption cost of goods sold and operating expenses out of
sales and vice versa. The lower ratio leads to have the higher margin of operating
profit.

5.4.10 Return on Assets
This ratio portrays the relationship in between the earnings and total assets employed in
the business enterprise. It highlights the effective utilization of the assets of the firm
through the determination of return on total assets employed.
Return on Assets =

Net Profit After Taxes
× 100
Average Total Assets

Standard norm of the ratio:
Higher the ratio illustrates that the firm has greater effectiveness in the utilization
of assets, means greater profits reaped by the total assets and vice versa.
Return on capital employed: The ratio illustrates that how much return is earned in the
form of Net profit after taxes out of the total capital employed. The capital employed is


nothing but the combination of both non-current liabilities and owners' equity. The ratio
expresses the relationship in between the total earnings after taxation and the total volume

of capital employed.
Return on total capital employed =

Net profit after taxes
× 100
Total capital employed

Standard norm of the ratio:
Higher the ratio is better the utilization of the long-term funds raised under the
capital structure means that greater profits are earned out of the total capital
employed.

5.4.11 Turnover Ratio
Activity Turnover Ratio: It highlights the relationship in between the sales and various
assets. The ratio indicates that the rate of speed which is taken by the firm for converting
the assets into sales.
Stock Turnover Ratio: The ratio expresses the speed of converting the stock into sales.
In other words, how fast the stock is being converted into sales in a year? The greater
the ratio of conversion leads to lesser the number of days/weeks/months required to
convert the stock into sales.
Stock turnover ratio =

Cost of Goods Sold
Sales
or
Average Stock
Closing Stock

Standard norm of the ratio:
Higher the ratio is better the firm in converting the stock into sales and vice

versa.
The next step is to find out the number of days or weeks or months taken or consumed
by the firm to convert the stock into sales volume.
Stock velocity =

365 days/52 weeks/12 months
Stock turnover ratio

Standard norm of the ratio:
Lower the duration is better the position of the firm in converting the stock into
sales and vice versa.
Debtors turnover ratio: This ratio exhibits the speed of the collection process of the
firm in collecting the overdues amount from the debtors and against Bills receivables.
The speediness is being computed through debtors velocity from the ratio of Debtors
turnover ratio.
Debtors turnover ratio =

Net Credit Sales
Net Credit Sales
or
Average Debtors
Debtors Bills Receivable

Standard norm of the ratio:
Higher the ratio is better the position of the firm in collecting the overdue means
the effectiveness of the collection department and vice versa.

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Ratio Analysis

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Debtors velocity: This is an extension of the earlier ratio to denote the effectiveness of
the collection department in terms of duration.
Debtors velocity =

365 days/52 weeks/12 months
Debtors turnover ratio

Standard norm of the ratio:
Lesser the duration shows greater the effectiveness in collecting the dues which
means that the collection department takes only minimum period for collection
and vice versa.
Creditors turnover ratio: It shows effectiveness of the firm in making use of credit
period allowed by the creditors during the moment of credit purchase.
Creditors Turnover ratio =

Credit Purchase
Credit Purchase
or
Bills Payable Sundry Creditors
Average Creditors

Standard norm of the ratio:
Lesser the ratio is better the position of the firm in liquidity management means
enjoying the more credit period from the creditors and vice versa.
Creditors velocity =

365 days/52 weeks/12 months
Creditors Turnover Ratio

Standard norm of the ratio:
Greater the duration is better the liquidity management of the firm in availing the
credit period of the creditors and vice versa.
Check Your Progress 2
1.

2.

3.

Solvency position of the firm studied and interpreted through:
(a)

Short-term solvency ratios

(b) Long-term solvency ratios

(c)

Coverage ratios

(d) (a), (b) & (c)

Efficiency and effectiveness of the firm is studied through:
(a)

Liquidity ratios

(b) Leverage ratios

(c)

Turnover ratios

(d) Profitability ratios

Profitability ratios to study the potential to earn profits on:
(a)

On Assets

(b) On Capital employed

(c)

On Sales

(d) (a), (b) & (c)

Illustration 5
Sundaram & Co. sells goods on cash as well as credit basis. The following particulars
are extracted from the books of accounts for the calendar 2005:
Particulars

Rs.

Total Gross sales

2,00,000
Contd....


Cash sales (included in above)

40,000

Sales returns

14,000

Total Debtors

18,000

Bills receivable

4,000

Provision for doubtful debts

2,000

Total creditors

20,000

Calculate average collection period
To find out the average collection period, first Debtors turnover ratio has to computed

Net credit sales
Bills receivable Debtors

Debtors turnover ratio =

Net credit sales = Gross sales – cash sales – sales return
= Rs.2,00,000 – Rs.40,000 – Rs.14,000 = Rs.1,46,000
Debtor turnover ratio =

Rs.1,46,000
Rs.4,000 + Rs.18,000

= 6.64 times

365 days
365 days
=
= 55 days
Debtors turnover ratio 6.64 times

Debtors velocity =
Illustration 6

Find out the value of creditors from the following:
Sales Rs.1,00,000

Opening stock Rs10,000

Gross profit on Sales 10%

Closing stock Rs.20,000

Creditors velocity 73 days

Bills payable Rs.16,000

Note: All purchases are credit purchases:
To find out the volume of purchases, the formula of cost of goods sold should taken into
consideration.
Cost of goods sold = Opening stock + Purchases - Closing stock
X = Rs.10,000 + Y - Rs.20,000
Cost of goods sold = Sales – Gross profit
= Rs.1,00,000 –10% on Rs.1,00,000
= Rs.90,000
The next step is to apply the found value in the early equation
Purchases = Rs. 90,000 – Rs.10,000 + Rs.20,000
= Rs.1,00,000
To find out the value creditors, the creditor velocity and creditors turnover ratio
Creditors velocity =

365 days
Creditors turnover ratio

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Ratio Analysis

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Creditors turnover ratio =

Credit purchases
Bills payable Sundry creditors

=

Rs.1,00,000
Rs.16,000 + Sundry Creditors

The next step is to find out the sundry creditors, the reversal process to be adopted
73 days =

365 days
Creditors turnover ratio

The next step is to substitute the found value in the equation of creditors turnover ratio
Rs.16,000 + Sundry creditors =

Rs.1,00,000
5

Sundry creditors = Rs.20,000 – Rs.16,000 = Rs.4,000
Illustration 7
From the following information, prepare a balance sheet. show the workings:
Rs.

1.

Working capital

75,000

2.

Reserves and surplus

3.

Bank overdraft

4.

Current ratio

1.75

5.

Liquid Ratio

1.15

6.

Fixed assets to proprietors' fund

.75

7.

Long-term liabilities

Nil

1,00,000
60,000

(B.Com. Madras, April 1980)
First step is to find out the current liabilities
Current ratio =

Current Assets
1.75
=
Current Liabilities
1

Working capital = Rs.75,000 = 1.75-1 = .75
If .75 is the share of working capital, what would be the share of current assets?
Current assets =

Rs.75,000
× 1.75 = Rs. 1,75,000
75

Working capital = Current assets – Current liabilities

Current liabilities = Current Assets – Working Capital
CL = Rs.1,75,000 – Rs.75,000 = Rs.1,00,000
Quick assets ratio = 1.15 =

Quick Assets
Quick Liabilities


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Quick Assets
=
Current Liabilities – BOD

Ratio Analysis

1.15 (Rs.1,00,000 – Rs.60,000) = Quick Assets
1.15 (Rs.40,000) = Quick assets
Rs. 46,000 = Quick assets
The next step is to find out the amount of the closing stock. This can be found out
through finding out the difference in between the current assets and quick assets.
Closing stock = Current assets – Quick assets
= Rs.1,75,000 – Rs.46,000 = Rs.1,29,000
The next one is to find out the proprietors' fund
The fixed assets to proprietors' fund is .75
This has to be found out on the basis of Double Entry Accounting Concept
Total liabilities = Total Assets

.........(1)

Long-term funds + Short-term financial resources = Total liabilities
In the long-term funds, there is no long-term liabilities, which means the structure of
long-term funds consist of the shareholders' funds. The shareholder funds are known as
proprietors' fund.
Short-term financial resources are known as current liabilities
Proprietors' fund + Current liabilities = Total liabilities
Current assets + Fixed assets = Total assets
To substitute the values in the equation (1)
Proprietors' fund + Current liabilities = Current assets + Fixed assets
Proprietors' fund – Fixed assets= Current assets - Current liabilities
1– 0.75 = Rs.1,75,000 – Rs.1,00,000
0.25 = Rs.75,000
If 0.25 is bearing the volume of Rs. 75,000; what would be the volume of investment of
fixed assets for .75 and proprietor's fund for 1
Proprietor's fund =

Rs.75,000
= Rs. 3,00,000
.25

.75 portion of the owners' funds are contributed to fixed assets i.e .75 on Rs.3,00,000
= Rs.2,25,000
To find out the exact share of the equity share capital, the following formula has to be
used:
Shareholder's funds = Equity share capital + Reserves and surpluses
In this problem, reserves and surpluses is given
Rs.3,00,000 = Equity share capital + Rs 1,00,000
Equity share capital = Rs.2,00,000

98

The Balance sheet of the company Ltd as on dated

International Financial and
Management Accounting

Liabilities

Rs

Assets

Rs

Share capital

2,00,000 Fixed assets

2,25,000

Reserves and surpluses

1,00,000 Stock

1,29,000

Bank overdraft

60,000 Quick assets

Quick liabilities

40,000

46,000

4,00,000

4,00,000

Check Your Progress 3
1.

2.

3.

Standard norm of the current ratio is
(a)

2:1

(b) 1:.5

(c)

1:2

(d) 3:1

Super quick assets do not include:
(a)

Closing stock

(b) Prepaid expenses

(c)

Sundry debtors

(d) Both (a) & (b)

Standard norm of the Debt to Capital:
(a)

1:2

(b) 1:1

(c)

2:1

(d) 1:5

Illustration 8
Debtors velocity
Creditors velocity

Stock velocity
Capital turnover ratio
Fixed assets turnover ratio
Gross profit turnover ratio

3 months
2 months
8 times
2.5 times
8 times
25%

Gross profit in a year amounts to Rs.1,60,000. There is no long-term loan or overdraft.
Reserves and surplus amount to Rs. 56,000. Liquid assets are Rs.1,94,666. Closing stock
of the year is Rs. 4,000 more than the opening stock. Bill receivable amount to Rs 10,000
and bills payable to Rs.4,000.
Find out:
Sales

Closing stock

Sundry debtors

Fixed assets

Sundry creditors

Proprietors' fund

Draft the balance sheet with as many as details possible.

The first step is to find out the sales
Gross profit ratio = 25%
The total volume of gross profit is given = Rs.1,60,000


Gross Profit
GP ratio =
× 100
Sales

25% =

Sales =

Rs.1,60,000
× 100
Sales
Rs.1,60,000
= Rs. 6,40,000
25%

The next step is to find out the closing stock value
In our problem, two important informations given are stock velocity and details about the
closing stock in terms of opening stock.
Stock velocity = 8 times
Closing stock is Rs.4,000 excess of opening stock
The information stock velocity given denotes that the stock turnover ratio.
Stock turnover ratio =

Cost of goods sold

Average stock

Now the volume of cost of goods sold has to be found out from the early available
information i.e sales and gross profit
Cost of goods sold = Sales – Gross profit
= Rs.6,40,000 – Rs.1,60,000 = Rs.4,80,000
The next step is to find out the volume of average stock through the earlier formula
8 times =

Rs. 4,80,000
Average Stock

Average stock = Rs.60,000
The next step is to apply the conditionality with regards to closing stock

Opening Stock Closing Stock
= Rs. 60,00
2
Opening Stock
2

4,000

= Rs. 60,000

2 Opening stock +Rs.4,000= Rs.1,20,000
2 Opening stock = Rs.1,20,000-Rs.4,000
Opening stock = Rs.58,000
Closing stock = Opening stock + Rs.10,000 = Rs.58,000 + Rs.10,000=Rs.68,000
The next fact is to be found that sundry debtors

To find out the debtors, the most information given debtors velocity and bills receivable
have to be made use of

99
Ratio Analysis


100
International Financial and
Management Accounting

Debtors velocity =

12 months
Debtors turnover ratio

Debtors turnover ratio =

4 times =

12 months
= 4 times
3 months

Credit Sales
Bills Receivable Sundry Debtors

Rs.10,000 + Sundry debtors =

Rs. 6,40,000

4

Sundry debtors = Rs.1,60,000 – Rs.10,000 = Rs.1,50,000
The next important stage is to find out the sundry creditors.
To find out the sundry creditors, the creditors velocity has to be applied in the formula.
In addition to the earlier, one missing information has to be found out i.e Credit purchases.
The volume of purchase to be found out through the formula of cost of goods sold
Cost of goods sold = Opening stock + Purchases – Closing stock
Rs.4,80,000 = Rs.58,000 + Purchases – Rs.68,000
Purchases = Rs.4,80,000 – Rs.58,000 +Rs.68,000
= Rs.4,80,000 + Rs.10,000 = Rs.4,90,000
Creditors velocity =

12 months
Creditors turnover ratio

Creditors turnover ratio =

6times =

12 months
= 6 times
2 months

Rs. 4,90,000
Rs. 4,000 Sundry Creditors

Rs.4,000 + Sundry creditors = Rs.81,667
Sundry creditors = Rs 77,667
The next step is to find out the volume of fixed assets.

This could be found out with the help of fixed assets turnover ratio = 5 times
Fixed assets turnover ratio = 5 times =

Fixed assets =

Sales
Fixed Assets

Rs.6, 40,000
5 times = Rs.1,28,000


101

Proprietors' fund

Ratio Analysis

Proprietor's fund = Fixed assets + Current Assets – Current liabilities
The above equation is coined on the basis of Double accounting concept
Fixed assets + Current assets = Total assets = Total Liabilities
Total Assets – Current liabilities = Total Liabilities – Current liabilities
Current assets volume is not known. In such cases the stock volume should be added
with the Liquid assets to derive the early mentioned.
Current assets = Closing stock + Liquid Assets
= Rs.68,000+ Rs.1,94,666=Rs2,62,666
Proprietor's fund = Rs.1,28,000 + Rs.2,62,666 - Rs.81,667
= Rs.3,08,999
Share capital = Proprietor's fund - Reserves and surpluses
= Rs.3,08,999- Rs.56,000= Rs.2,52,999

Cash and Bank Balances to be found out in the next stage
Liquid Asset = Rs.1,94,666
Less : Debtors

Rs.1,50,000

Bills receivable

10,000
Rs. 1,60,000
Rs. 34,666

From the above found information the detailed balance sheet with as many as information
possible to portray
Balance sheet as on dated ----------------------------Liabilities
Share capital
Reserves and surpluses
Bills receivable
Sundry creditors

R s Assets
2,52,999 Fixed assets
56.000 Stock
4,000 Debtors
77,667 Bills receivable
Cash and Bank Balance
3,90,666

Rs
1,28,000

68,000
1,50,000
10,000
34,666
3,90,666

Illustration 9
From the following particulars, prepare trading, profit and loss account and a balance
sheet
Current ratio
Liquid ratio

3
1.8

Bank overdraft

Rs.20,000

Working capital

Rs.2,40,000


102

Debtors velocity

1 month

International Financial and
Management Accounting

Gross profit ratio

20%

Proprietary ratio (Fixed assets / shareholders' fund)

9

Reserves and surpluses

.25 of share capital

Opening stock

Rs.1,20,000

8% Debentures

Rs. 3,60,000

Long-term investments

Rs.2,00,000

Stock turnover ratio

10 times

Creditors velocity

1/2 month

Net profit to share capital

20%
(B.Com Bharathidasan, April 1989)

First step is to find out the current assets and current liabilities through current ratio
Current ratio =

Current Assets
=3
Current Liabilities

Current Assets – Current Liabilities = Working capital
3

–

1

=

2

= Rs.2,40,000

The volume of working capital Rs 2,40,000 is equated to share 2
What is the volume of current liabilities for the share of 1
Current liabilities =

Rs.2,40,000
= Rs.1,20,000
2

The volume of current assets = Rs.1,20,000 × 3 = Rs.3,60,000
The next step is to find out the volume of liquid assets
Liquid assets ratio = 1.8 =

Liquid assets
Liquid liabilities

When the Bank overdraft is given, the liquid liabilities should be computed.
Liquid liabilities = Current liabilities - Bank overdraft
= Rs.1,20,000 - Rs.20,000= Rs.1,00,000
Liquid assets is 1.8 times greater than the Liquid liabilities
Liquid assets = 1.8 × Rs.1,00,000 = Rs.1,80,000
To find out the volume of the stock
Stock = Current assets – Liquid assets
= Rs.3,60,000 – Rs.1,80,000
= Rs.1,80,000


The next step is to find out the cost of goods sold

103
Ratio Analysis

To find out the cost of goods sold, the stock turnover ratio has to be found out
10 times =

Cost of goods sold
Average stcok

Average stock =

Opening Stock Closing Stock
Rs.1,20,000 Rs.1,80,000
=
2
2

= Rs.1,50,000
Cost of goods sold = Rs.1,50,000 × 10= Rs.15,00,000
Next step is to find out the volume of sales in order to find out the volume of debtors
The volume of sales could be found out through Gross profit ratio
Sales – Profit = Cost of goods sold
100 – 20 = 80
The Rs. 15,00,000 worth of cost of goods sold is equated to share of 80
What would be the volume of sales?

Rs.15,00,000 80
=
Sales
100
= Sales =

Rs.15,00,000 100
×
= Rs.18,75,000
80
1

Gross profit = Rs.18,75,000-Rs.15,00,000= Rs.3,75,000
The next step is to find out the volume of debtors
The debtors could be found out with the help of debtors turnover ratio and collection period
Debtors velocity or collection period =

Debtors turnover ratio =

12 times =

12 months
Debtors turnover ratio

12 months
= 12 times
1 month

Credit sales
Average debtors

Average Debtors =

Rs.18,75,000
= Rs.1,56,250
12

The next step is to find out the creditors. The volume of creditors; to find out the volume
of the creditors, the creditors turnover ratio and creditors average payment period should
have to be applied
Creditors average payment period =

12months
Creditors turnover ratio


104
International Financial and
Management Accounting

Creditors turnover ratio =

12months
= 24 times
.5 month

Creditors turnover ratio =

Credit Purchase
Average Creditors

Average creditors =

Credit Purchase
24 times

Now the volume of credit purchase to be found out with the help of cost of goods sold
formula
Cost of goods sold = Opening stock+ Purchases - Closing stock
Rs.15,00,000 – Rs.1,20,000+Rs.1,80,000 = Purchases
Rs 15,60,000 = Purchases
Average creditors = Rs.65,000
The next step is to find out the proprietary fund; this could be found out by using the ratio
proprietary fund to fixed assets ratio
Total Assets= Total Liabilities
Long term liabilities + Short term liabilities = Fixed assets + Current assets + Investments
Share holders' fund - Fixed assets = Current assets + Investment - Current liabilitiesDebenture
1–.9= Rs.2,00,000 + Rs.3,60,000 – Rs.1,20,000 – Rs.3,60,000
1–.9 = Rs.80,000
.1=Rs.80,000
If .1 share is the volume of Rs.80,000 what is the volume of proprietary fund for the
share of 1?
The volume of proprietary fund = Rs.8,00,000
The volume of fixed assets = Rs.8,00,000 × .9= Rs.7,20,000
The next step is to find out the volume of the share capital . This could be found out only
with the help of the ratio given Reserves and surpluses to share capital.
Reserves and surpluses = 25% of share capital
It means that % is Share capital.
Share capital + Reserves and surpluses = Shareholders' fund
100+25 = 125
To find out the share of share capital from the shareholders' fund, the following is the
computation

Rs. 8,00,000
× 100 = Rs.6,40,000 = Share capital
125

Reserves and surpluses = 25% on the Share capital = 25% on Rs.6,40,000 =Rs.1,60,000
The last step is to find out the Net profit, which could be found out through the Net profit
to share capital.


105

Net profit is 20% on share capital

Ratio Analysis

Net profit = 20% on Rs.6,40,000= Rs.1,28,000
Next stage is to prepare the Trading, Profit & Loss A/c for the year ended and Balance
sheet as on dated
Trading Profit & Loss Account for the year ended ..........
Dr

Cr

Particulars

Rs Particulars

To opening stock
To purchases
To Gross profit c/d

Rs

1,20,000 By sales

15,60,000 By closing stock
3,75,000
20,55,000
28,800 By Gross profit B/d

To Debenture Interest 8%
3,60,000
To Balancing figure
other expenses
To Net profit c/d*

18,75.000
1,80,000
20,55,000
3,75,000

2,18,200
1,28,000
3,75,000

3,75,000

Balance sheet as on dated
Liabilities
Share capital
Reserves and Surpluses
Profit during the year
8% Debentures
Current liabilities
Overdraft

Creditors
Others

Rs

Rs Assets

6,40,000 Fixed assets
Investments
1,60,000
3,60,000
Current Assets
20,000
Stock
65,000
Debtors
35,000
1,20,000 Other current asset
12,80,000

Rs

Rs
7,20,000
2,00,000

32,000
1,28,000

1,80,000

1,56,250
23,750

3,60,000
12,80,000

5.5 LIMITATIONS OF THE RATIO ANALYSIS
It is dependant tool of analysis: The perfection and effectiveness of the
analysis mainly depends upon the preparation of accurate and effectiveness
of the financial statements. It is subject to the availability of fair presentation
of data in the financial statements
Ambiguity in the handling of terms: If the tool of analysis taken for the
study of inter firm analysis on the profitability of the firms lead to various
complications. To study the profitability among the firms, most required financial
information are profits of the enterprise. The profit of one enterprise is taken
for analysis is Profit After Taxes (PAT) and another is considering Profit Before
Interest and Taxes (PBIT) and third one is taking Net profit for study
consideration. The term profit among the firms for the inter firm analysis is
getting complicated due to ambiguity or poor clarity on the terminology.


106
International Financial and
Management Accounting

Qualitative factors are not considered: Under the ratio analysis, the
quantitative factors only taken into consideration rather than qualitative factors
of the enterprise. The qualitative aspects of the customers and consumers are
not considered at the moment of preparing the financial statements but while
granting credit on sales is normally considered.

Not ideal for the future forecasts: Ratio analysis is an outcome of analysis
of historical transactions known as Postmortem Analysis. The analysis is
mainly based on the yester performance which influences directly on the future
planning and forecasting; it means that the analysis is mainly constructed on
the past information which will also resemble the same during the future
analysis.
Time value of money is not considered: It does not give any room for time
value of money for future planning or forecasting of financial performance;
the main reason is that the fundamental base for forecasting is taken from the
yester periods, which never denominate the timing of the benefits.

5.6 DUPONT ANALYSIS
This was an analysis established by the DUPONT INC., USA to study the Return on
investment. It was the first company developed the chart which depicted the influences
of Return on Investment .The company underwent for the consideration two important
ratios for the return on investment is Net profit ratio and Capital turnover ratio. A
change in the any one of the two ratios that will immediately reflect on the Return on
investment. The various associated factors are considered to study the impact of the
profitability of the firm. This type of analysis to correct the problems not only to identify
the specific cause which drastically affects the profitability but also to find the possible
ways and means to improve the profitability. Having developed the chart for analysis
was called as DUPONT Chart
Net profit

Sales

Net profit ratio

Cost of goods
sold

Sales
Expenses

Return on
capital
employed

Administrative,
Selling and
distribtution
expense

Re

Working capital

Current assets

Fixed asset

Current
liabilities

Sales
Capital turnover ratio
Capital
employed

Figure 5.5: DUPONT Chart

5.7 LET US SUM UP
Ratio analysis is one of the important tools of financial statement analysis to study the
financial structure of the business fleeces. Ratios are classified as follows: Liquidity,
leverage, profitability, activity, integrated and growth ratio. We have dealt all these in
detail. We have also studied limitations of the ratio analysis and Dupont analysis.