Chapter - 5

1. Introduction
Definition: Accounting ratios are quantitative measures derived from financial statement items, used to assess a company’s performance, financial health, and efficiency.

• Purpose:

  • Evaluate profitability, liquidity, solvency, and efficiency.

  • Facilitate comparisons over time and between different companies.

  • Assist in investment and credit decisions.

 

2. Types of Accounting Ratios

• Liquidity Ratios: Measure the ability to meet short-term obligations.

• Solvency Ratios: Measure the ability to meet long-term obligations.

• Profitability Ratios: Measure the ability to generate profit.

• Efficiency Ratios: Measure how effectively assets are utilized.

• Market Ratios: Measure the market perception of a company.

 

3. Liquidity Ratios
Current Ratio: Measures the ability to pay short-term liabilities with short-term assets.
Formula:
Current Ratio = Current Assets / Current Liabilities
Ideal Ratio: Generally, a ratio of 2:1 is considered satisfactory.
Quick Ratio (Acid-Test Ratio): Measures the ability to pay short-term liabilities with the most liquid assets.
Formula:
Quick Ratio = (Current Assets - Inventory) / Current Liabilities
Ideal Ratio: Generally, a ratio of 1:1 is considered satisfactory.
 

4. Solvency Ratios
Debt to Equity Ratio: Measures the proportion of debt to equity in the company’s capital structure.
Formula:
Debt to Equity Ratio = Total Debt / Total Equity
Interpretation: Lower ratios indicate lower financial risk.
Interest Coverage Ratio: Measures the ability to pay interest on outstanding debt.
Formula:
Interest Coverage Ratio = EBIT / Interest Expense
Interpretation: Higher ratios indicate better ability to meet interest obligations.
 

5. Profitability Ratios
Gross Profit Margin: Measures the percentage of revenue that exceeds the cost of goods sold.
Formula:
Gross Profit Margin = (Gross Profit / Net Sales) × 100
Interpretation: Higher margins indicate better profitability.
Net Profit Margin: Measures the percentage of revenue remaining after all expenses are deducted.
Formula:
Net Profit Margin = (Net Profit / Net Sales) × 100
Interpretation: Higher margins indicate better profitability.
Return on Assets (ROA): Measures the efficiency of asset utilization in generating profit.
Formula:
Return on Assets = (Net Profit / Total Assets) × 100
Interpretation: Higher ratios indicate better efficiency.
Return on Equity (ROE): Measures the return generated on shareholders’ equity.
Formula:
Return on Equity = (Net Profit / Shareholders’ Equity) × 100
Interpretation: Higher ratios indicate better returns to shareholders.
 

6. Efficiency Ratios
Inventory Turnover Ratio: Measures how efficiently inventory is managed and sold.
Formula:
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
Interpretation: Higher ratios indicate better inventory management.
Accounts Receivable Turnover Ratio: Measures how efficiently receivables are collected.
Formula:
Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable
Interpretation: Higher ratios indicate efficient collection of receivables.
Asset Turnover Ratio: Measures how efficiently assets are used to generate sales.
Formula:
Asset Turnover Ratio = Net Sales / Total Assets
Interpretation: Higher ratios indicate better utilization of assets.
 

7. Market Ratios
Earnings Per Share (EPS): Measures the profit attributed to each share of common stock.
Formula:
Earnings Per Share = Net Profit / Number of Outstanding Shares
Interpretation: Higher EPS indicates higher profitability per share.
Price to Earnings Ratio (P/E Ratio): Measures the market price per share relative to EPS.
Formula:
Price to Earnings Ratio = Market Price per Share / Earnings Per Share
Interpretation: Higher ratios indicate higher market expectations of future growth.
 

8. DuPont Analysis
Definition: A detailed approach to analyze Return on Equity (ROE) by breaking it into three components: Profit Margin, Asset Turnover, and Financial Leverage.
Formula:
ROE = (Net Profit / Net Sales) × (Net Sales / Total Assets) × (Total Assets / Shareholders’ Equity)
Interpretation: Provides insights into the factors driving ROE.
 

9. Limitations of Ratio Analysis

• Historical Data: Ratios are based on past financial statements and may not predict future performance.

• Different Accounting Policies: Companies may use different accounting methods, affecting comparability.

• Inflation: Ratios do not account for changes in purchasing power.

• Qualitative Factors: Ratios do not consider qualitative factors such as management quality or market conditions.

 

10. Practical Illustrations

Example Problems: Various scenarios demonstrating the calculation and interpretation of different accounting ratios.
 

Key Terms

• Liquidity: The ability to meet short-term obligations.

• Solvency: The ability to meet long-term obligations.

• Profitability: The ability to generate profit.

• Efficiency: The effectiveness of using resources.

• Market Ratios: Measures reflecting market perceptions and valuations.

 

These notes cover the essential aspects of accounting ratios, focusing on different types of ratios used to evaluate a company's financial performance and position, and how to calculate and interpret these ratios.