Ratio Analysis

APS ACADEMY
 Topics to Study
1. Liquidity ratio

2. Solvency ratio

3. Activity ratio

4. Profitability ratio
 What is Liquidity Ratio?
 Liquidity is the ability of a company to meet its current
liabilities.
 Liquidity ratios help us determine the capability of the
company to meet its short-term liabilities.
 Liquidity Ratio
 There are two liquidity ratios:

i. Current ratio

ii. Liquid ratio

 Current Ratio
 Current Ratio = Current Assets/Current Liabilities
 The ideal current ratio is 2:1

 Higher current ratio means better capacity to meet its

current obligation.
 If it is too high, it shows that the funds are lying idle.
 Current Assets and
Liabilities
Current Assets Current Liabilities
 Assets that are in the form of cash or  Liabilities payable within 12
cash equivalents. months or within operating cycle.
 They include:  They include:
1. Current investments
1. Short-term borrowings
2. Short term securities
3. Inventory (except loose tools) 2. Trade payables (B/P + Creditors)
4. Trade Receivables 3. Short-term provisions
5. Cash in hand, cash at bank ...
4. Outstanding expenses, calls-in-
6. Prepaid expenses, interest receivable advance, unclaimed dividend etc.
etc.
Why are Loose Tools not considered
as CA in Current Ratio?
 Loose tools are parts of
machinery and treated as
current assets normally.
 However, for calculating
current ratio, loose tools
are not considered as CA
because it can’t be
converted into cash
easily.
 Working Capital
 Working capital is the capital used in the day-to-day
trading operations.
 Working capital = current assets – current liabilities
Assets and Liabilities Formulae

1. Total Assets = Fixed assets + non-current investments

+ current assets

2. Total liabilities = SHF + Current Liabilities + long-

term debts

i.e., CL + NCL + SHF = Total Liabilities

 Example
 From the following information, compute current ratio:

Particulars Rs. Particulars Rs.

Trade Receivable 100,000 Bills payable 20,000

Prepaid expenses 10,000 Sundry creditors 40,000

Cash and cash equivalents 30,000 Debentures 200,000

Short-term investments 20,000 Inventories 40,000

Machinery 7,000 Expenses payable 40,000

 Example contd.
 Let us classify the items:
Particulars Rs. Particulars Rs.
Trade Receivable (CA) 100,000 Bills payable (CL) 20,000
Prepaid expenses (CA) 10,000 Sundry creditors (CL) 40,000
Cash and cash equivalents (CA) 30,000 Debentures 200,000
Short-term investments (CA) 20,000 Inventories (CA) 40,000
Machinery 7,000 Expenses payable (CL) 40,000

 Current Asset = 100,000 + 10,000 + 30,000 + 20,000

+40,000 = 200,000
 Current liabilities = 20,000 + 40,000 + 40,000 = 100,000
 Example
 Calculate current ratio from the information:

Particulars Rs. Particulars Rs.

Total assets 300,000 Non-current liabilities 80,000
Fixed assets (tangible) 160,000 Non-current investments 100,000
Shareholders’ funds 200,000
 Example contd.
 Current Ratio = Current Assets/Current Liabilities
Particulars Rs. Particulars Rs.
Total assets 300,000 Non-current liabilities 80,000
Fixed assets (tangible) 160,000 Non-current investments 100,000
Shareholders’ funds 200,000

 Total assets = CA + Fixed Assets + Non-current Invest.

 300,000 = CA + 160,000 + 100,000

 CA = 40,000
 Example contd.
 Let us now find CL:
Particulars Rs. Particulars Rs.
Total assets 300,000 Non-current liabilities 80,000
Fixed assets (tangible) 160,000 Non-current investments 100,000
Shareholders’ funds 200,000

 CL + NCL = Total liabilities (excluding SHF)

 CL + 80,000 = Total liabilities (exc. SHF) —(1)

Now, total assets – total liabilities = SHF
 300,000 – Total liabilities = 200,000
 Example contd.
 From (1) and (2),

Current liability = 20,000

Therefore, Current Ratio = CA/CL = 40000/20000

=2
 Example
 Current ratio is 2.5; Working Capital is 60,000.

 Calculate the amount of current assets and current

liabilities.
 Example contd.
 Current ratio is 2.5

 CA/CL = 2.5 —(1)

 Working Capital is 60,000

 CA – CL = 60,000 —(2)

From (1) and (2),

CA = 100,000 and CL = 40,000

 Example
 Current assets are 400,000; inventories are 200,000;
working capital is 240,000.
 Find the current ratio
 Example contd.
 Given: Current assets are 400,000; inventories are
200,000; working capital is 240,000.

WC = CA – CL = 240,000

 400,000 – CL = 240,000

 CL = 160,000

 Current Ratio = CA/CL = 2.5

 Example
 Current Assets are 525,000; Inventories are Rs. 200,000
(including loose tools Rs. 75,000); working capital is
Rs. 225,000.
 Calculate Current Ratio.
 Example contd.
 Given:

1. Current Assets are 525,000

2. Inventories are Rs. 200,000 (loose tools of Rs. 75,000)

3. Working capital is Rs. 225,000.

Working capital = CA – CL

 CL = 300,000
 Example contd.
 When we compute current ratio, we do not consider
loose tools.

So, current assets to be used in computing current ratio:

= 525,000 – 75,000

= 450,000

Therefore, Current Ratio = 450,000/300,000

= 1.5
 Example
 Calculate current ratio:

i. Working capital = 150,000

ii. Total liabilities (other than SHF) = 325,000

iii. Long term debts = 250,000

 Example contd.
 Answer: 3:1
 Example
 A company had current assets of Rs. 300,000 and
current liabilities of 140,000.
 Afterwards, it purchased goods for Rs. 20,000 for
credit.
 Calculate current ratio after the purchase.
 Example
 Current liabilities of a company were 100,000 and its
current ratio was 2.5.
 It paid Rs. 25000 to a creditor.

 Calculate current ratio after the payment.

 Example contd.
 3:1
 Example
 Ratio of current assets (600,000) to current liabilities
(400,000) is 1.5.
 The accountant of the firm is interested in maintaining a
current ratio of 2:1, by paying a part of the current
liabilities.
 Calculate amount of current liabilities that should be
paid, so that current ratio at the level of 2:1 be
maintained.
 Example contd.
 Answer = 200,000
 Liquid Ratio
 It measures the ability of an enterprise to meet short-
term financial obligations.
 It establishes the relationship between liquid assets
and current liabilities.
 The ideal liquid ratio is 1:1
 Liquid Ratio
 The difference with current ratio is that liquid ratio is
only based on current assets which are highly liquid.
 So, inventories and prepaid expenses are excluded
from the current assets that were used in current ratio.
 Higher the liquid ratio, better the short-term financial
position.

Note: current liabilities are the same for both current

ratio and liquid ratio.
 Why are inventories and
prepaid expenses excluded?
1. It takes time to convert inventories into cash.

2. Prepaid expenses are expenses paid in advance, and

hence cannot be converted into cash.
 Liquid Ratio
 Liquid Ratio = Quick Assets/Current Liabilities

 Quick Assets = Current Assets – inventories – prepaid expense

 Example
 Compute Current Ratio and Liquid Ratio:

Particulars Rs. Particulars Rs.

Cash and cash equivalents 5,000 Sundry Creditors 25,000
Debtors 29,000 Bills Payable 16,000
Bills Receivable 5,000 Outstanding Expenses 8,000
Marketable Securities 15,000 Provision for Expenses 5,000
Inventories 54,000
 Example contd.
 CA = 5000 + 29000 + 5000 + 15000 + 54000 = 108,000

CL = 54,000 Particulars Rs. Particulars Rs.

Cash and equivalents 5,000 Sundry Creditors 25,000

 Current Ratio: Debtors 29,000 Bills Payable 16,000

Bills Receivable 5,000 Outstanding Expenses 8,000

= 108000/54000
Marketable Securities 15,000 Provision for 5,000
Expenses
=2 Inventories 54,000
 Example contd.
 Quick Assets = CA – Inventories = 108,000 – 54,000 = 54,000

 CL = 54,000 Particulars Rs. Particulars Rs.

Cash and equivalents 5,000 Sundry Creditors 25,000

 Liquid Ratio: Debtors 29,000 Bills Payable 16,000

= 1:1 Bills Receivable 5,000 Outstanding Expenses 8,000

Marketable Securities 15,000 Provision for 5,000

Expenses
Inventories 54,000
 Example
 Calculate Liquid Ratio
Particulars Rs.

Working Capital 180,000

Total debts 390,000

Long-term debts 300,000

Inventories 90,000
 Example contd.
 Working Capital = CA – CL = 180,000 —(1)

Also, Total debts = long-term debts + CL

 CL = 390,000 – 300,000 = 90,000—(2) Particulars Rs.

Working Capital 180,000
From (1) and (2), CA = 270,000 Total debts 390,000
Long-term debts 300,000
Quick Assets = 270,000 – inventories
Inventories 90,000
= 180,000

 Liquid Ratio = 180,000/90,000 = 2

 Example
 A company has current ratio of 4 and liquid ratio of
2.5.
 Assuming inventories are 22,500; find the total current
assets and total current liabilities.
 Example contd.
 Current Ratio = CA/CL = 4

 CA = 4 × CL
 Liquid Ratio = (CA–Inventories)/CL = 2.5

 CA – Inventories = 2.5 × CL

 4 × CL – 22,500 = 2.5 × CL

 1.5 × CL = 22,500

 CL = 15,000

 CA = 60,000
 Example
 Current Assets of a company are 1,700,000. Its current
ratio is 2.5 and liquid ratio is 0.95.
 Calculate current liabilities, liquid assets and
inventory.
 Example contd.
 Given:

1. Current Assets of a company are 1,700,000

2. Its current ratio is 2.5

3. liquid ratio is 0.95

From (1) and (2), CL = 680,000 —(4)

From (3) and (4), Quick Assets/680,000 = 0.95

 Quick Assets = 680,000 × 0.95 = 646,000

 Example
 A company had current assets of Rs. 450,000 and
current liabilities of Rs. 200,000.
 Afterwards it purchased goods for Rs. 30,000 on
credit.
 Calculate current ratio after the purchase.
 Example contd.
 After purchase on credit, both assets and creditors will
increase by 30,000.
 So, new assets = Rs. 480,000

 New liabilities = Rs. 230,000

 Current Ratio = 480,000/230,000

= 2.09
 Topics to Study
1. Liquidity ratio

2. Solvency ratio

3. Activity ratio

4. Profitability ratio
 Solvency Ratio
 Solvency of a business means the business is in a
position to meets its long-term financial obligations as
and when they become due.
 Solvency ratios are the ratios which show whether the
enterprise will be able to meet its long-term financial
obligations, i.e., long-term obligations.
 Types of Solvency Ratios

 Important Solvency Ratio:

1. Debt to Equity Ratio

2. Total Assets to Debt Ratio

3. Proprietary Ratio

4. Interest Coverage Ratio

 Debt to Equity Ratio
 It shows the relationship between long-term external
debts and shareholders funds.
 D-E Ratio is given by:

D/E = (long term debt)/(Shareholders Fund)

i.e., D/E = NCL/SHF

Note: D/E of 2:1 is considered an appropriate ratio.

 Debt to Equity Ratio
 Non-Current liabilities include:

1. Long-term borrowings

2. Long-term provisions

3. Other non-current liabilities

There is another formula:

Total liability = NCL + CL + SHF

 Capital Employed
 Capital Employed means the total capital that has
been put in the company. It can come from two
sources:

1. Loan (Debt) from banks and other sources

2. Owner’s Capital or Equity (shareholders’ fund)

 Capital Employed = Long term Debt + Equity

 Example
 Calculate the D/E from the information:

Particulars Rs. Particulars Rs.

Share Capital 100,000 Debentures 75,000
General Reserve 45,000 Long-term Provisions 25,000
Surplus 30,000 Outstanding Expenses 10,000
 Example contd.
 Debt = debentures + long-term provisions = 75000 + 25000
Particulars Rs. Particulars Rs.
= 100,000
Share Capital 100,000 Debentures 75,000
Equity is SHF General Reserve 45,000 Long-term Provisions 25,000
Surplus 30,000 Outstanding Expenses 10,000

SHF = Share Capital + General Reserve + Surplus

= 100,000 + 45,000 + 30,000 = 175,000

 D/E = 100,000/175,000 = 0.57

Why were Reserve and Surplus
added to Share Capital?
 This is because both reserves and surplus are then
added to capital of the owners.
 So, it is part of the equity.

 Similarly, Profit and Loss (Dr.), if given, will be

deducted from SHF because it is eventually
adjusted to the capital of the partners.
 Example
 Compute the D/E ratio:

Shareholders Funds: Rs. Long-term borrowings Rs.

Equity share capital 200,000 10% debentures 350,000

Reserves and surplus 150,000 Current liabilities 100,000

 Example contd.
 D/E = long term debt/equity

Long term debt = 350,000

Equity = 350,000

 D/E = 350,000/350,000

=1
 Example
 Calculate D/E from the given information:

i. Total assets: 125,000

ii. Total debts: 100,000

iii. Current liabilities: 50,000

 Example contd.
 D/E = Debt/SHF

Given:

i. Total assets: 125,000

ii. Total debts: 100,000

iii. Current liabilities: 50,000

Common Error: Debt is given as 100,000 but we need long

term debts only. Students often solve using debt = 100,000.
 Example contd.
 Long-term debt = Total debt – Current liability

= 100,000 – 50,000 = 50,000

 Total Assets = CL + NCL + SHF

 125,000 = 50,000 + 50,000 + SHF

 SHF = 25,000

D/E = 50,000/25,000 = 2
 Example
 Find D/E from the following information:

Particulars Rs. Particulars Rs.

Long-term Provisions 100,000 Profit and Loss (Dr.) 100,000

Long-term Borrowings 500,000 Equity Share Capital 200,000

General Reserve 200,000

 Example contd.
Particulars Rs. Particulars Rs.
Long-term Provisions 100,000 Loss in Statement of P&L 100,000
Long-term Borrowings 500,000 Equity Share Capital 200,000
General Reserve 200,000

 Debt = Long term provisions + borrowings = 600,000

 SHF = Equity Share Capital + Surplus + GR

= 200,000 + 200,000 – 100,000 = 300,000

 D/E = 600,000/300,000 = 2
 Example
 Calculate D/E ratio:

1. long-term borrowings = 200,000

2. Long-term provisions = 100,000

3. Current liabilities = 50,000

4. Non-current assets = 360,000

5. Current assets = 90,000

 Example contd.
 D/E = 3:1
 Example
 Calculate debt to equity ratio:

1. Fixed assets (Gross) = 600,000

2. Accumulated depreciation = 100,000

3. Non-current investments = 30,000

4. Long term loans and advance = 20,000

5. Current assets = 250,000

6. Current liabilities = 200,000

7. Long term borrowings = 300,000

 Example contd.
 D/E = 2:1
 Total Assets to Debt Ratio
 TADR = (Total Assets)/(Non-Current Liability)

 This ratio measures the safety margin available to

lenders of long-term debts.
 It measures the extent to which debt is being covered
by assets.
 Example
 Calculate Total Assets to Debt Ratio using:

1. Long-term debts = Rs. 1,600,000

2. Total Assets = Rs. 2,400,000

 Example contd.
 TADR = (Total Assets)/(Non-Current Liability)

= 2,400,000/1,600,000

= 1.5
 Example
 Calculate total assets to debt ratio:

Particulars Rs. Particulars Rs.

Capital Employed 2,220,000 Equity share capital 1,050,000
Current liabilities 180,000 8% debentures 300,000
Fixed assets 1,500,000 Capital Reserve 240,000
Accumulated depreciation 200,000 Profit and Loss (Dr.) 30,000
Non-current investment 700,000 Cash and cash equivalent 150,000
Trade receivables 250,000
 Example contd.
 TADR = (Total Assets)/(Non-Current Liability)

Current Assets = Trade Rec. + Cash = 400,000

Non-Current Assets = Fixed Assets – Dep. + Non-

current investment = 2,000,000

Total Assets = Non-Current Assets + Current Assets

 Total Assets = 2,000,000 + 400,000 = 2,400,000

We now need to find debt

 Example contd.
We know that Capital Employed = SHF + Long-term debts
 SHF = Share Capital + Capital Reserve + Surplus

= 1,050,000 + 240,000 – 30,000

= 1,260,000
 Capital Employed = SHF + Long-term debts

 2,220,000 = 1,260,000 + Long-term debts

 Long-term debts = 960,000

 Example contd.
 TADR = 2,400,000/960,000

= 2.5
 Proprietary Ratio
 Proprietary ratio establishes the relationship between
proprietors’ funds and the total assets.
 Proprietary Ratio = SHF/Total Assets

 This ratio shows the extent to which total assets have

been financed by the proprietor.
 The higher the ratio, the higher the safety for lenders
and creditors.
 Example
 From the following information, calculate Proprietary
ratio.
Particulars Rs. Particulars Rs.
Equity Share Capital 200,000 Current Liabilities 680,000
10% pref. share capital 300,000 Fixed Assets 2,100,000
General Reserve 250,000 Long-term trade investments 200,000
Surplus 150,000 Current Assets 880,000
12% Debentures 1,600,000
 Example contd.
 Proprietary Ratio = SHF/Total Assets

 SHF = Share Capital + Reserves + Surplus

= 200,000 + 400,000 + 300,000

= 900,000
 Total Assets = Current Assets + Fixed Assets + Long-
term trade investments = 2,100,000 + 200,000 + 880,000

= 3,180,000
 Example contd.
 Proprietary Ratio = SHF/Total Assets

= 900,000/3,180,000

= 0.28
 Example
 Calculate Proprietary ratio:

i. Share capital = 500,000

ii. Reserves and surplus = 300,000

iii. Non-current assets = 22,00,000

iv. Current assets = 10,00,000

 Example
 Answer: 0.25
 Example
 Calculate Proprietary Ratio:

i. non-current assets = 40,00,000

ii. Current assets = 40,00,000

iii. Long-term borrowings = 25,00,000

iv. Long-term provisions = 15,00,000

v. Current liabilities = 20,00,000

 Example
 Answer: 0.25
 Example
 The proprietary ratio of M Ltd. is 0.8:1.

 How will Proprietary ratio change if:

i. The firm obtained a loan of 2,00,000 from the bank

payable after 5 years

ii. Purchased machinery for cash 75,000

 Example contd.
(i) Decrease

(ii) No change
Interest Coverage Ratio (ICR)
 ICR = Profit before Interest and Tax/Interest on long-
term debt.

We calculate ICR to find the amount of profit available to

cover interest on long-term debt.

A higher ratio is considered better for the lenders as it

shows higher margin to meet interest cost.

Note: Profit has to be taken ‘before’ interest and tax.

 Example
 Prakash Ltd. has a term-loan of Rs. 1,000,000.

 Interest on the loan for the year is 125,000 and its

profit before interest and tax is 500,000.
 Calculate ICR.
 Example contd.
 PBIT = 500,000

 Interest on long-term debt = 125,000

 ICR = 500,000/125,000

= 4 times
 Example

 Calculate the ICR using:

 Net profit after tax = Rs. 120,000

 12% long-term debt = Rs. 2,000,000

 Tax Rate = 40%

 Example contd.
 Interest on long-term loans = 12% of 2,000,000 = 240,000

 Let PBIT be x

So, Profit after interest = x – 240,000

Tax is 40%

So, Profit after interest and tax = 60% of (x–240,00)

 0.6(x–240,000) = 120,000

 x = 440,000
 Example contd.
 Therefore, Profit before interest and tax = 440,000

And interest on long-term loans = 240,000

 ICR = 440,000/240,000

= 1.83

Note: while calculating Profits, we first subtract interest

from PBIT and then tax is deducted.
 Example
 Find the ICR using:

 Profit after tax = Rs. 170,000

 Tax = Rs. 30,000

 Interest on long-term funds = 50,000

 Example contd.
 Let PBIT be x

Profit after interest = x – 50,000

Profit after interest and tax = x – 50,000 – 30,000 = x – 80,000

 x – 80,000 = 170,000

 x = 250,000

Therefore, ICR = 250,000/50,000 = 5 times

 Example
 From the following information, calculate ICR:
Particulars Rs.
10,000 Equity Shares of Rs. 10 each 100,000
8% Preference Shares 70,000
10% Debentures 50,000
Long-term loans from bank 50,000
Interest on long-term loans from bank 5,000
Profit after tax 75,000
Tax 9,000
 Example contd.
 Interest to be paid = interest on deb + interest on loan

= 5,000 + 5,000 = 10,000

Let PBIT be x

 Profit after interest = x – 10,000

 Profit after tax = x – 10,000 – 9,000 = x – 19,000

 x – 19,000 = 75,000

 x = 94,000
 Example contd.
 ICR = 94,000/10,000

= 9.4 times
 Topics to Study
1. Liquidity ratio

2. Solvency ratio

3. Activity ratio

4. Profitability ratio
 Activity Ratio
 We shall discuss four activity ratios:

i. Inventory turnover ratio

ii. Trade receivables turnover ratio

iii. Trade payables turnover ratio

iv. Working capital turnover ratio

 Activity Ratio
 It is also known as turnover ratio.

 It measures how well the resources have been used by

the enterprise.
 The result is expressed in “number of times”

 These ratios are calculated on the basis of:

i. Cost of goods sold (COGS)

ii. Net sales

 Activity ratio
 Higher turnover ratio means better use of resources.
 Inventory Turnover Ratio
 Inventory Turnover Ratio establishes relationship between
COGS and average inventory carried during that period.
 ITR = COGS/(Average Inventory) = ... Times

 It measures how fast inventory is moving and generating

sales.
 Higher the ITR, more efficient management of inventories.
 Inventory Turnover Ratio
 COGS is given by:

 COGS = Opening Inventory + Net purchases + direct

expenses – closing inventory
 COGS = Net Sales – Gross Profit

 COGS = Net Sales + Gross Loss

 COGS = Cost of materials consumed + Purchase of S.I.T

+ Change in inventory
 Average Inventory = (Opening + Closing)/2
 Example
 Calculate ITR:

i. COGS = 450,000

ii. Inventories in the beginning of the year = 100,000

iii. Inventories at the end of the year = 125,000

 Example contd.
 Average inventory = (100,000 + 125,000)/2

= 112,500
 COGS = 450,000

 ITR = 450,000/112,500

= 4 times
 Example
 Calculate Inventory Turnover Ratio:

i. Opening Inventory: 29,000

ii. Closing inventory: 31,000

iii. Net Sales: 300,000

iv. Gross Profit: 25% on cost

 Example contd.
 Average inventory = Rs. 30,000

 COGS = 240,000

 ITR = 240,000/30,000 = 8 times

 Example
 Calculate ITR:

i. Total Sales = 220,000

ii. Sales Return = 20,000

iii. Gross Profit = 50,000

iv. Closing Inventory = 60,000

v. Excess of closing inventory over opening inventory is

Rs. 20,000
 Example contd.
 Net Sales = 200,000

Opening inventory = Rs. 40,000

 Average inventory = Rs. 50,000

Since net sales = Rs. 200,000 and gross profit = Rs. 50,000

 COGS = 150,000

Therefore, ITR = 150,000/50,000 = 3

 Example
 280,000 is Cost of revenue from operations (COGS);
inventory turnover ratio 8 times; inventory in the
beginning is 1.5 times more than the inventory at
the end.
 Calculate values of opening and closing inventory.
 Example contd.
 ANSWER: 20,000 and 50,000
 Example
 Average inventory = 60,000; revenue from operations
= 600,000; rate of gross loss on sales = 10%.
 Calculate the inventory turnover ratio.
 Trade Receivables
Turnover Ratio (TRTR)
 TRTR = Net Credit Sales/Average Trade Receivables

= ….... times
 This ratio shows efficiency in the collection of amount
due from trade receivables.
 Higher the ratio, better it is, since it indicates that debts
are being collected more quickly.
 Trade Receivables
Turnover Ratio (TRTR)
 Net Credit Sales = Net Sales – Cash Sales

 Trade Receivables = Debtors + Bills Receivables

 Average TR = (Opening TR + Closing TR)/2

Note: In the formula for TR, do not deduct provision for

bad debts from debtors.

This is because the purpose is to calculate the number of

days for which sales are tied up in trade receivables.
 Trade Receivables
Turnover Ratio (TRTR)
 TRTR indicates the number of times, trade receivables
are turned over in an year in relation to credit sales.
 It shows how quickly TR are converted into cash and
cash equivalents and thus, shows the efficiency in
collection of amounts due against trade receivables.
 A high ratio (such as 10 times) shows that debts are
collected more promptly (10 times) in the year.
 Trade Receivables
Turnover Ratio (TRTR)
 Debt collection period provides an approximation of the
average time that it takes to collect debtors.
 Debt Collection Period is given by:
i. 365/TRTR days
ii. 12/TRTR months

E.g., if TRTR is 6 times, it means that the debts are collected

by the firm 6 times in an year. Then, using the debt
collection period formula, it takes 12/6 = 2 months to
 Example
 Calculate TRTR and Average Collection Period:

i. Net Credit Sales = 600,000

ii. Debtors and Bills Receivable = 60,000 and 40,000

 Example contd.
 Trade receivables = 100,000

 Net Credit Sales = 600,000

 TRTR = 600,000/100,000

= 6 times

Collection Period = 12/6 = 2 months

 Example
 Calculate TRTR from the following:

Particulars Rs.
Total Net Sales for 2018-19 200,000
Net Cash Sales for 2018-19 40,000
Debtors as at 1st April, 2018 35,000
Debtors as at 31st March, 2019 55,000
 Example contd.
 Net Credit Sales = 200,000 – 40,000 = 160,000

 Average TR = 45,000
Particulars Rs.
 TRTR = 160,000/45,000 Total Net Sales for 2018-19 200,000
Net Cash Sales for 2018-19 40,000
= 3.56 times Debtors as at 1st April, 2018 35,000
Debtors as at 31st March, 2019 55,000
 Example
 From the following information, calculate TRTR:

Particulars Rs. Particulars Rs.

Open: 20,000 Net Sales 200,000
Trade Receivables
Close: 25,000 Cash Sales 87,500
Open: 2,000
Provision for bad debts
Close: 2,500
 Example contd.
 Credit sales = 112,500

 Average TR = 22,500

 TRTR = 5 times
Particulars Rs. Particulars Rs.
Trade Receivables Open: 20,000 Net Sales 200,000
Close: 25,000 Cash Sales 87,500
Provision for bad debts Open: 2,000
Close: 2,500
 Trade Payables Turnover
Ratio (TPTR)
 TPTR = Credit Purchases/Average Trade payables

= …... times

 TPTR shows the number of times the creditors are

turned over in relation to credit purchases.

1. Credit Purchases = Net Purchases – Cash Purchase

2. Average Trade Payables = (Opening + Closing)/2

 Trade Payables Turnover
Ratio (TPTR)
 Average Trade Payables = (Opening Trade Payables +
Closing Trade Payable)/2

Average Payment Period is given by:

i. 12/TPTR months

ii. 365/TPTR days

 Trade Payables Turnover
Ratio (TPTR)
 Suppose TPTR is 6 times, it means that payment is
completed 6 times in an year and if TPTR is 10, it
means that payment is completed 10 times in an year.
 High TPTR means a shorter payment period. This
indicates early payments.
 A low TPTR means that creditors are not paid in time
or increased credit period.
 Example
 From the following particulars taken from the books
of Tata Press Ltd., calculate TPTR and Average
Payable Period.

Particulars Rs. Particulars Rs.

Total Purchases 850,000 Creditors at end of year 160,000
Cash Purchases 100,000 Creditors in the beginning 120,000
Purchases Return 50,000
 Example contd.
 TPTR = Credit Purchases/Avg. Trade Payables

Credit Purchases = 800,000 – 100,000 = 700,000

Average Creditors = 140,000
TPTR = 5 times
Particulars Rs. Particulars Rs.
Total Purchases 850,000 Creditors at end of year 160,000
Cash Purchases 100,000 Creditors in the beginning 120,000
Purchases Return 50,000
 Example
 Opening sundry creditors: 80,000

 Opening bills payable: 3,000

 Closing sundry creditors: 100,000

 Closing bills payable: 17,000

 Purchases: 14,00,000

 Cash purchases: 5,00,000

 Purchase returns: 1,00,000

Calculate TPTR
 Example
 Closing trade payables: 90,000

 Net purchases: 720,000

 Cash purchases: 1,80,000

 Calculate TPTR

Answer  6 times
 Example
 Cash purchases: 25% of total purchases

 Revenue from operations: 10,00,000

 Gross profit: 25% of revenue from operations

 Opening inventory: 2,50,000

 Closing inventory: 5,00,000

 TPTR = 3 times

 Closing TP were 250,000 in excess of opening trade payables

 Example contd.
 Opening T.P. = 125,000

 Closing T.P. = 375,000

 Working Capital Turnover
Ratio (WCTR)
 WCTR shows the relationship between working
capital and Net Sales.
 WCTR = Net Sales/Working Capital

= … ... times

Working Capital = Current Assets – Current Liabilities

 Working Capital Turnover
Ratio (WCTR)
 WCTR = Net Sales/Working Capital

 WCTR helps in determining whether the working

capital has been effectively used in generating revenue.
 A high ratio shows efficient use of working capital,
whereas low ratio shows inefficient use.
 Suppose working capital is Rs. 100,000 and net sales is
Rs. 600,000, WCTR is 6, which means that for Re. 1
invested in WC, the net sale is Rs. 6.
 Example
 Calculate WCTR from the following:

Particulars Rs.
Working capital 250,000
COGS 1,000,000
Gross Profit on Sales 20%
 Example contd.
 Working Capital = 250,000

 Let Net Sales be x

Gross profit on sales = 20%

So, it means that profit will be calculated on sales (not cost

price, as is the normal practice)

So, x – 20% of x = COGS

 x – 0.2x = 1,000,000

 0.8x = 1,000,000
 Example contd.
 Since 0.8x = 1,000,000

 x = 1,250,000

i.e., Net Sales = 1,250,000

WCTR = 1,250,000/250,000

= 5 times
 Example
 Current assets: 900,000

 Revenue from operations: 30,00,000

 Current liabilities: 300,000

 Sales return: 50,000

Calculate WCTR
 Topics to Study
1. Liquidity ratio

2. Solvency ratio

3. Activity ratio

4. Profitability ratio
 Profitability Ratios
 Efficiency in business is measured by profitability.

 Accounting ratios measuring profitability are known as

profitability ratios.
 Profitability Ratios
 Different Profitability Ratios:

1. Gross Profit Ratio

2. Operating Ratio

3. Operating Profit Ratio

4. Net Profit Ratio

5. Return on Investment
 Gross Profit Ratio (GPR)
 GPR = (Gross Profit/Net Sales) × 100

= …... %

Gross Profit = Gross Sales – COGS

Sometimes, we also find Gross Profit from Trading A/c.

 The objective of computing GPR is to determine the
efficiency with which production and/or purchase
operations and selling operations are carried on.
 Example
 Calculate Gross Profit Ratio from the information:

i. Cash sales are 25% of total sales

ii. Purchases are 690,000

iii. Credit sales are 600,000

iv. Excess of closing inventory over opening inventory

is Rs. 50,000.
 Example contd.
 Given: credit sales = 600,000

Also, credit sales is 75% of total sales

 Total sales = 800,000

Gross Profit = Gross Sales – COGS

Gross Sales = 800,000

COGS = Opening inventory + purchases – closing inventory

 COGS = 690,000 – 50,000 = 640,000

 Example contd.
 Therefore, Gross Profit = 800,000 – 640,000

= 160,000

 Gross Profit Ratio = (160,000/800,000) × 100

= 20%
 Example
 Find Gross Profit Ratio using the information:

Particulars Rs. Particulars Rs.

Cash Sales 25,000 Decrease in inventory 10,000
Purchases: Cash 15,000 Returns outward 2,000
60,000 Wages 5,000
Credit
Carriage Inwards 2,000 Ratio of Cash Sales to
Credit Sales 1:3
Salaries 25,000
 Example contd.
 Gross Profit = (Gross Profit/Net Sales) × 100

Net Sales = Cash Sales + Credit Sales

= 25,000 + 75,000 = 100,000

Now, we need to find Gross Profit using Sales – COGS

Net Purchases = Cash Purchases + Credit Purchases –

Return Outward

= 15,000 + 60,000 – 2,000 = 73,000

 Example contd.
 COGS = Opening Inventory + Purchases + direct
expenses – closing inventory

Direct expenses are wages and carriage inwards = 7,000

COGS = 73,000 + 10,000 + 7,000 = 90,000

Therefore, Gross Profit = 100,000 – 90,000 = 10,000

 Gross Profit Ratio = 10,000/100,000 × 100

= 10%
 Example
 Opening inventory: 500,000

 Closing inventory: 300,000

 Inventory turnover ratio: 8 times

 Selling price: 25% above cost

Calculate Gross profit ratio

Answer  20%
 Operating Ratio (OR)
 Operating Ratio = (Operating Cost/Net Sales) × 100

 Operating Cost is the COGS + Operating Expenses

So, OR assesses the operational efficiency of the business.

 It shows the percentage of revenue from operations
that is absorbed by the cost of operations.
 Lower OR is better because it means that the operating
activities are more efficient and profit margin is higher.
 Example
 Find the operating ratio:

i. COGS: 600,000

ii. Revenue from Operations: 800,000

iii. Operating Expenses: 40,000

 Example contd.
 Operating Ratio = (Operating Cost/Net Sales) × 100

Operating Cost = 600,000 + 40,000 = 640,000

Net Sales = 800,000

 Operating Ratio = (640,000/800,000) × 100

= 80%
 Example
 Calculate operating ratio:

i. Operating cost: 680,000

ii. Operating expenses: 80,000

iii. Gross Profit Ratio: 25%

 Example contd.
Given:
i. Operating cost: 680,000
ii. Operating expenses: 80,000
 COGS = 600,000
Gross Profit is given 25% (we calculate it on sales)
Let net sales be x (we know that COGS = 600,000)
 x – 25% of x = 600,000
 0.75x = 600,000
 x = 800,000
 Example contd.
 Therefore, Net Sales = Rs. 800,000

Operating Ratio = (680,000/800,000) × 100

= 85%
 Operating Profit Ratio
(OPR)
 It shows the relationship between operating profit and
revenue from operations.
 OPR = (Operating Profit/Net Sales) × 100

 OPR determines the operational efficiency of the business.

 An increase in the ratio over the previous period shows

improvement in the operational efficiency.
Operating Profit v. Gross Profit
 Gross Profit (G.P.) = Total Revenue – COGS

So, G.P. includes only those expenses directly related to the

production of goods such as raw materials and labour.
 Operating Profit includes other expenses such as other
wages, rent, insurance, shipping, freight as well as
amortization and depreciation.
 All expenses required for running the business are included.

 O.P. = G.P. + other operating income – other operating

expenses.
 Operating Profit v. Net
Profit
 Operating profit includes all the operating expenses such
as rent, freight, insurance, amortization, depreciation etc.
 There are some non-operating expenses such as interest
payment on debts, additional income from investments or
taxes, loss by fire, loss by theft, loss on sale of asset,
dividend paid. These are not included in operating profit,
but included in net profit.

So, OP = Net Profit (Before tax) + Non-operating

expenses/losses – Non-operating incomes
 Operating Profit
 Operating Profit is given by:

i. OP = Gross Profit + Other operating income –

Other operating expense

ii. OP = Net Profit (Before tax) + Non-operating

expenses/losses – Non-operating incomes

iii. OP = Revenue from Operations – Operating Cost

 Example
 Calculate operating profit ratio from this information:

Particulars Rs. Particulars Rs.

Opening Inventory 50,000 Selling Expenses 60,000
Purchases 500,000 Dividend on Shares 15,000
Sales (Gross) 750,000 Loss by Theft 10,000
Closing inventory 75,000 Sales Return 15,000
Administrative Expenses 25,000
 Example contd.
 OPR = Operating Profit/Net Sales × 100
 Net Sales = Gross Sales – Sales Return = 735,000
 Operating Profit = Net Sales – Operating Expenses

= Net Sales – (Purchases + change in inventory +

administrative Expenses + selling expenses)
Particulars Rs. Particulars Rs.
Opening Inventory 50,000 Selling Expenses 60,000
Purchases 500,000 Dividend on Shares 15,000
Sales (Gross) 750,000 Loss by Theft 10,000
Closing inventory 75,000 Sales Return 15,000
Administrative Expenses 25,000
 Example contd.
 O.P. = 735,000 – (500,000 – 25,000 + 25,000 + 60,000)

= 175,000

Therefore, OPR = (O.P./Net Sales) × 100

= 23.8%
Particulars Rs. Particulars Rs.
Opening Inventory 50,000 Selling Expenses 60,000
Purchases 500,000 Dividend on Shares 15,000
Sales (Gross) 750,000 Loss by Theft 10,000
Closing inventory 75,000 Sales Return 15,000
Administrative Expenses 25,000
 Wages is already included
in COGS
 Sometimes to confuse students, wages and COGS are
both given.
 However, since wages is a direct expense and is
already included in COGS, it is not added separately.
 Example
 Calculate Operating Profit Ratio from the information:

Particulars Rs. Particulars Rs.

Net Sales 47,99,600 Distribution Expenses 450,400
COGS 24,40,200 Interest on loan 50,000
Wages 304,000 Income from investment 60,000
Office Expenses 251,200 Loss by theft 30,000
 Example contd.
 OPR = Operating Profit/Net Sales × 100

Net Sales = Rs. 47,99,600

We need to find O.P. now

O.P. = Net Sales – (Operating Expenses)

Operating Exp. = COGS + Office Exp. + Distribution Exp. —(1)

= 24,40,200 + 251,200 + 450,400 = 31,41,800

 O.P. = 47,99,600 – 31,41,800 = 16,57,800

*wages was not added in (1) since it is already included in COGS

 Example contd.
 Operating Profit Ratio = 16,57,800/47,99,600 × 100

= 34.5%
 Operating Ratio and
Operating Profit Ratio
 There is a relationship between these two:

 OR + OPR = 100%

Derivation:

Operating Ratio = (Operating Cost/Net Sales) × 100

OPR = (Operating Profit/Net Sales) × 100

 OR + OPR = (O.P. + O.C.)/Net Sales × 100

= Net Sales/Net Sales × 100

= 100%
 Net Profit Ratio (NPR)
 NPR = (Net Profit after Tax/Net Sales) × 100

 It is an indicator of overall efficiency of the business.

 Higher the NPR, better it is for business.

 Example
 Gross Profit Ratio of a company was 25%.

 Its cash sales were Rs. 200,000 and credit sales were 90%
of the total sales.
 If the indirect expenses of the company were Rs. 20,000,
calculate NPR.
 Example contd.
 GPR = (Gross Profit/Net Sales) × 100 = 25% —(1)

Net Sales = cash sales + credit sales

It is given that cash sales are 200,000 and 10% of the

total sales.

 Net Sales = Rs. 2,000,000 —(2)

We now need to find Gross Profit

From (1) and (2), Gross Profit = 500,000

 Example contd.
 NPR = (Net Profit after Tax/Net Sales) × 100

We need to calculate net profit

Net Profit = G.P. – Indirect expenses

 N.P. = 480,000

 NPR = (480,000/2,000,000) × 100

= 24%
 Example
 Gross Profit Ratio of a company was 25%.

 Its cash revenue from operations were Rs. 500,000

and its credit revenue from operations were 90% of
total revenue from operations.
 If the indirect expenses of the company were Rs.
150,000, calculate its net profit ratio.
 Example contd.
 Total revenue = 50,00,000

 Gross Profit ratio = 25%

=> Gross Profit = 12,50,000

Indirect expenses = Rs. 1,50,000

=> Net Profit = 11,00,000

So, Net Profit Ratio = 11,00,000/50,00,000 * 100 = 22%

 Example
 Calculate Net Profit Ratio:

i. Revenue from operations = Rs. 25,00,000

ii. Operating ratio = 90%

iii. Loss on sale of fixed assets = Rs. 25,000

iv. Interest on long-term borrowings = Rs. 30,000

v. Income from investment = Rs. 40,000

 Example contd.
 Operating profit ratio = 10% (since operating ratio = 10%)

=> Operating Profit = 10% of 25,00,000 = 2,50,000

Net Profit = O.P. + N.O.I – N.O.E.

Net Profit = 250,000 + 40,000 – 25,000 – 30,000

=> Net Profit = 235,000

So, net profit ratio = 235,000/25,00,000 * 100 = 9.4%

Return on Investment (ROI)
 ROI = [(Net Profit before Interest, Tax, Dividend) /
Capital Employed] × 100
 ROI assesses profitability of the company.
 Capital Employed
 Capital can be put in the company by shareholders
or by borrowing/provisions.
 Capital Employed (CE) is given by:

i. CE = SHF + Non-current liabilities (long-term

borrowings and provisions)

ii. CE = Non-current assets + working capital (current

assets – current liabilities)

Let us understand the 2nd formula

 Capital Employed
 We know that Assets = SHF + NCL + CL

 Current Assets + Non-Current Assets = SHF + NCL + CL

We know that: SHF + NCL = Capital Employed

 CA + NCA = Capital Employed + CL

 (CA–CL) + NCA = Capital Employed

 Capital Employed = NCA + Working Capital

 Example
 Calculate ROI from the following information:

Particulars Rs. Particulars Rs.

Net Profit after Interest and tax 120,000 Equity Share Capital 50,000

Tax 120,000 Pref. Share Capital 50,000

Net Fixed Assets 500,000 Reserves and Surplus 100,000

Long-term Trade Invest. 50,000 Current Liabilities 170,000

Current Assets 220,000 12% debentures 400,000

 Example contd.
 ROI = [(Net Profit before Interest, Tax, Dividend) /
Capital Employed] × 100

Capital Employed = SHF + Long-term borrowings/prov.

= Eq. Share Capital + Reserves and Surplus + Pr. Share

Capital + 12% debenture

= 50,000 + 100,000 + 50,000 + 400,000

= 600,000
 Example contd.
 We need to find net profit before interest, tax and dividend.

Net Profit after interest and tax = 120,000

Tax = 120,000

Interest = 12% of debentures = 12% of 400,000 = 48,000

 Net Profit before interest and tax = 120,000 + 120,000 +

48,000

= 288,000
 Example contd.
 Therefore, ROI = 288,000/600,000 × 100

= 48%
 Example
 From the information, calculate ROI:
Particulars Rs. Particulars Rs.

Net Profit (before tax) Ratio 24% Non-current trade 45,000

investment

Tax rate 50% Current assets 90,000

Revenue from Operations 900,000 Total debts 405,000

Net fixed assets 450,000 15% long-term borrowings 360,000

Accumulated depreciation 112,500

 Example contd.
 Net Profit Ratio = (Net Profit before Tax/Net Sales) × 100

 (Net Profit before tax/net sales) × 100 = 24%

Net sales = 900,000

 Net Profit before tax = 216,000

 Net Profit before interest and tax = 216,000 + interest

Interest = 15% of debentures = 15% of 360,000 = 54,000

 Net profit before interest and tax = 270,000

 Example contd.
 ROI = [(Net Profit before Interest, Tax, Dividend) /
Capital Employed] × 100

Net Profit before Interest, Tax, Dividend = 270,000

Capital Employed = Non-current assets + CA – CL

Non-current assets = fixed assets + non-current trade

investments = 450,000 + 45,000

 Capital Employed = 450,000 + 45,000 + 45,000

= 540,000
 Example contd.
 ROI = 270,000/540,000 × 100

= 50%