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Accounting Ratios

Types of Ratios

‘Ratio’ is an arithmetical expression of the relationship between two interdependent or related items. When we calculate ratios on the basis of accounting information, are called Accounting Ratios. There are two ways in which we can classify the ratios. These are: (a) Traditional classification and (b) Functional Classification. Let us know more about Types of Ratio in detail.

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Types of Ratio

Ratios as a tool of analysis, we can classify them into two categories. These are:

Traditional Classification

In Traditional Classification, we classify the ratios on the basis of accounting statements.

Types of Ratios based on Traditional Classification

Profit and Loss Ratio

When we calculate ratio from the two variables which we extract from Statement of Profit and Loss only, is known as Profit and Loss Ratio.

For Example Gross Profit Ratio, which we derive from Gross Profit to Revenue from Operations. Both the variables are from Statement of Profit and Loss.

Balance Sheet Ratio

When we obtain both the variables from the balance sheet, it is known as Balance Sheet Ratio.

For Example Current Ratio, which we obtain from Current Assets to Current Liabilities.

Composite Ratio

Composite Ratio compares the two variables from two different accounts. One from Statement of Profit and Loss and other from Balance Sheet.

For Example Trade Receivables Turnover Ratio, where we take Net Credit Sales from Statement of Profit and Loss and Average Trade Receivables from Balance Sheet.

 

Types of Ratio

Functional Classification

Functional Classification groups the ratios according to the functions performed by them.

Types of Ratio based on Functional Classification

Liquidity Ratios

These are ratios which we compute to evaluate the capability of the entity to meet its short-term liabilities.

Liquidity ratios and their formulas are:

  • Current Ratio =   \(\frac{Current Assets}{Current Liabilities}\)
  • Liquid Ratio = \(\frac{ Liquid Assets}{Current Liabilities}\)
  • Absolute Liquid Ratio = \(\frac{Cash and Bank + Marketable Securities}{Current Liabilities}\)
  • Net Working Capital Ratio = Current Assets – Current Liabilities

Leverage Ratios

Leverage ratios are the ratios which show whether the enterprise will be able to meet its long-term liabilities. Solvency ratios are:

  • Equity Ratio = \(\frac{Shareholders’ Equity}{Capital Employed}\)
  • Debt to Equity ratio = \(\frac{Debt}{Equity (shareholders’ funds)}\)
  • Total Assets to Debt Ratio = \(\frac{Total Assets}{Debt (Long-term Debts)}\)
  • Proprietary Ratio = \(\frac{Proprietors’ Funds}{Total Assets}\)
  • Capital Gearing Ratio = \(\frac{Preference Share Capital + Debentures + Other      Borrowed Funds}{Equity Share Capital + Reserve and Surplus – Losses}\)
  • Interest Coverage Ratio = \(\frac{Net Profit before Interest and Tax}{Interest on Long-term Debts}\)
  • Debt-service Coverage Ratio = \(\frac{Earnings available for debt services}{Interest + Installment}\)
  • Preference Dividend Coverage Ratio = \(\frac{Earnings after Tax}{Preference Dividend}\)
  • Fixed Charges Coverage Ratio = \(\frac{EBIT + Fixed Charges before tax}{Interest + Fixed Charges before tax}\)

Turnover Ratios

Turnover ratios measures how well the resources are utilized by the enterprise. In other words, these ratios measure the effectiveness with which the enterprise uses its available resources.

We express these ratios in ‘Times’.

Turnover ratios and their formulas are:

  • Inventory Turnover Ratio = \(\frac{Cost of Goods Sold (Cost of Revenue from Operations)}{Average Inventory}\)
  • Trade Receivables Turnover Ratio = \(\frac{Net Credit Sales}{Average Trade Receivables}\)

Average Collection Period = \(\frac{365}{ Trade Receivables Turnover Ratio} = … Number of Days

Or,

\(\frac{12}{Trade Receivables Turnover Ratio}\) = … Number of Months

  • Trade Payables Turnover Ratio = \(\frac{Net Credit Purchases}{Average Payables}\)

Average Payment Period = \(\frac{Average Trade Payables}{Net Credit Purchases}\) x no. of Months/Days in a year

Or,

\(\frac{Months (Days) in a year}{Trade Payables Turnover Ratio}\) = … Number of Months/Days

  • Total Assets Turnover Ratio = \(\frac{Sales or Cost of Goods Sold}{Total Assets}\)
  • Fixed Assets Turnover Ratio = \(\frac{Sales or Cost of Goods Sold}{Fixed Assets}\
  • Capital Turnover Ratio = \(\frac{Sales or Cost of Goods Sold}{Net Assets}\)
  • Current Assets Turnover Ratio          = \(\frac{Sales or Cost of Goods Sold}{Current Assets}\)

Profitability Ratios

Profitability refers to the financial performance of the business. Accounting Ratios measuring profitability are known as Profitability Ratios. We express these ratios in ‘Percentage’.

Types of Profitability Ratios

1. On the basis of sales:

  • Gross Profit Ratio = \(\frac{Gross Profit}{Revenue from Operations}\) x 100

 

  • Operating Ratio = \(\frac{Cost of Revenue from Operations + Operating Expenses}{Revenue from Operations}\) x 100

 

  • Operating Profit Ratio =\(\frac{Operating Profit}{Revenue from Operations}\) x 100

 

  • Net Profit Ratio = \(\frac{Net Profit}{Net Sales}\) x 100
  • Expenses Ratio = \(\frac{Cost of Goods Sold}{Sales}\) x 100

2. On the basis of return on investment:

  • Return on Investment = \(\frac{Net Profit before Interest, Tax and Dividend}{Capital Employed}\) x 100

 

  • Return on Assets = \(\frac{Net Profit after tax}{Average Total Assets}\)

 

  • The Return on Capital Employed = \(\frac{EBIT}{Capital Employed}\) x 100

 

  • Return on Equity = \(\frac{Net Profit after tax – Preference dividend}{Net Worth}\) x 100

3. On the basis of owners’ point of view:

  • Earnings per Share = \(\frac{Net Profit available to Equity Shareholders}{No. of Equity Shares}\)

 

  • Dividend per Share = \(\frac{Total Dividend paid to Equity Shareholders}{No. of Equity Shares}\)

 

  • Dividend Payout Ratio = \(\frac{Dividend per Equity Share}{Earnings per Share}\)

4. On the basis of market/investors:

  • Price –Earnings Ratio = \(\frac{Market price per share}{Earnings per Share}\)
  • Dividend and Earning Yield Ratio:

Dividend Yield = \(\frac{Dividend per Share}{Market price per share}\)

Earnings Yield = \(\frac{Earnings per Share}{Market price per share}\)

  • Market Value/Book value per share:

Market Value/Book value per share = \(\frac{Average share price}{Net worth}\) x No. of equity shares

Solved Example on Types of Ratios

From the following information, calculate:

  • Gross Profit Ratio;
  • Inventory Turnover Ratio;
  • Current Ratio

 

         ₹          ₹
Revenue from operations 25,20,000 Average inventory 8,00,000
Net profit 3,60,000 Current assets (other than inventory) 7,60,000
Cost of revenue from operation 19,20,000 Fixed assets 14,40,000
Long-term debts 9,00,000 Current liabilities 6,00,000
Trade payables 2,00,000 Net profit before interest and tax 8,00,000

Ans:

  • Gross Profit Ratio:

Gross Profit Ratio =\(\frac{Gross Profit}{Revenue from Operations}\) x 100

= \(\frac{600000}{2520000}\) x 100

= 23.81%

Gross Profit = Revenue from Operations – Cost of Revenue from Operations

₹ 25,20,000 – ₹ 19,20,000 = ₹ 6,00,000

  • Inventory Turnover Ratio:

Inventory Turnover Ratio = \(\frac{ Cost of Revenue from Operations }{Average Inventory}\)

=\(\frac{1920000}{800000}\)

= 2.4 times

  • Current Ratio:

Current Ratio = \(\frac{Current Assets}{Current Liabilities}\)

= \(\frac{1560000}{600000}\)

= 2.61: 1

Current assets = liquid assets + inventory

= ₹ 7,60,000 + ₹ 8,00,000 = ₹ 15,60 000

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