Proprietary ratio

Definition and Explanation: Proprietary ratio (also known as Equity Ratio or Net worth to total assets or shareholder equity to total equity). Establishes relationship between proprietor's funds to total resources of the unit. Where proprietor's funds refer to Equity share capital and Reserves, surpluses and Tot resources refer to total assets. Formula: Following formula is used to calculate proprietary ratio: Proprietary ratio = Proprietor's funds / Total assets This relationship highlights the fact as to what is the proportion of Proprietors and outsiders in financing the total business. Suppose, in a business total assets amount of $4,00,000 and Proprietors equity is $3,00,000 then Proprietary ratio = 3,00,000 / 4,00,000 = 0.75 times. or 75% meaning hereby that 25% of the funds have been supplied by the outside creditors. Example: From the balance sheet given below calculate the proprietary ratio. Balance Sheet Liabilities Equity share capital Reserves & surplus Debentures Creditors $ 3,00,000 50,000 1,00,000 50,000 Assets Fixed assets Current assets Good will Investment $ 2,00,000 1,00,000 50,000 1,50,000

5,00,000

5,00,000

Solution: Proprietary ratio = Proprietor's funds / Total assets Where,

proprietor's funds = Share capital + Reserves and surplus i.e., 3,00,000 + 50,000 = 3,50,000 and total assets are 5,00,000 Hence the ratio is = 3,50,000 / 5,00,000 = 7 : 10 Note: Some accountants exclude intangible assets from the term total assets. If so, then assets are (5,00,000 - goodwill) = 4,50,600 in that case. Proprietary = 3,50,000 / 4,50,000 =7:9

Current Ratio Definition and Explanation:

Current ratio is also known as working capital ratio or 2 : 1 ratio. It is the ratio of total current assets to total current liabilities. Current assets are those which are usually converted into cash or consumed with in short period (say one year). Current liabilities are required to be paid in short period (say one year). Examples of current assets and current liabilities are as follows: Current Assets Cash Bank Stock: Raw materials Work-in-progress Finished goods Short-term investments Sundry debtors (less provision) Bills receivable Recoverable advances, Prepaid Expenses Current Liabilities Sundry creditors Bills payable Outstanding expenses Bank overdraft Taxes etc., payable Dividend payable Short-term advances

In case where bank overdraft is permanent feature and minimum investment in stock cannot be en-cashed the same should not be treated as current items. But normally these are include under the current items. Formula of Current Ratio: Current ratios is calculated by using the following formula: Current ratio = Current assets / current liabilities Interpretation of Current Ratio:

Current ratio indicates the liquidity of current assets or the ability of the business to meet its maturing current liabilities. High current ratio finds favor with short-term creditors whereas low ratio causes concern to them. An increase in the current ratio reflects improvement in the liquidity position of the business while the decrease signals that there has been a deterioration in the liquidity position of the business. As a convention 2 :1 is regarded as satisfactory level i.e. current assets should be almost double than the current liabilities. The idea is to provide for loss in the value of current assets due to probable decrease in the market value and to offered for any possible delay in the realization of current assets. However there is no scientific reasoning behind 2 : 1 norm. Current ratio compares only the quantity of current assets rather than the quality of assets. A high current ratio though considered to be desirable may prove to be otherwise due to following reasons: 1. In case of slow moving stocks, these will pile up and will lead to higher ratio. 2. In case of slow collection of trade debts it will also lead to higher ratio. 3. Cash and bank balance may be more then necessary consequently significant portion may remain idle which is not at all desirable: 4. On the other hand if the current ratio is low due to following reasons it is again undesirable: 5. Lack of sufficient funds to meet current obligations and 6. Trading level beyond the capacity of the business. Before arriving at any conclusion based on the interpretation of current ratio the following factors should be considered: Nature of Business: Public utility undertakings like electricity boards, transport corporations, municipal committees have the legal force to collect their dues in time so even a low current ratio need not cause any worry but normal trading business must have satisfactory current ratio. Nature of Product: A business dealing in consumer goods will require better current ratio as compared to a business which is dealing in durable or capital goods. Reputation of the Business also Influences the Requirement of Liquidity: A business having better reputation can do with small cash and bank balance as compared to comparatively unknown business house. It is so because well-known business shall enjoy favorable terms of credit. Seasonal Influence:

In a business where raw material is a seasonal commodity like wheat or sugarcane, it will require the purchase of annual consumption in the season itself, thus, requiring higher investment in stock as compared to the business where purchases can be spread over evenly throughout the year. Example: From the following balance sheet, calculate current ratio: Liabilities Equity share capital Reserve and surplus Debentures Trade creditors Bills payable Bank overdraft Outstanding expenses Income tax payable Proposed dividends $ 1,50,000 50,000 60,000 6,000 5,000 5,000 1,000 30,000 10,000 Assets Land & building Plant & machinery Goodwill Cash Investments (Short-term Bills receivable Sundry debtors Less provision Inventories Work in progress 22,000 2,000 20,000 30,000 15,000 $ 100,000 80,000 20,000 5,000 15,000 5,000

2,90,000 Solution:

2,90,000

Current assets are: cash, investments, bills receivable, sundry debtors (net), inventories and work-in-progress. $5,000 + 15,000 + 5,000 + 22,000 - 2,000 + 30,000 + 15,000 = $90,000. Current liabilities are trade creditors, bills payable, bank overdraft, outstanding expenses, income tax payable and proposed dividend. $6,000+ 5,000+ 5,000+1,000+3,000+10,000 = $30,000 Current ratio = Current assets/Current liabilities

90,000 / 30,000 3:1 This means that for every $1 worth of current liability there are current assets worth $3. It also means that the firm will be able to pay off its current liabilities in full even if current assets realizable value is 1/3rd of its book value.

Profitability Ratio

The main object of a business concern is to earn profit. In general terms, efficiency in business is measured by profitability. A low profitability may arise due to lack of control over the expenses. Bankers financial institutions and other creditors look at the profitability ratios as an indicator whether or not the firm earns substantially more than it pays interest for the use of borrowed funds and whether the ultimate repayment of their debt appears reasonably certain. Owners are also interested to know the profitability as it indicates the return which they can get on their investments. Following are some of the most important profitability ratios: (1) Gross Profit Ratio: Gross profit ratio is the ratio of gross profit to net sales i.e. sales less sales returns. Read more about gross profit ratio.

Definition and Explanation:

Gross profit ratio is the ratio of gross profit to net sales i.e. sales less sales returns. The ratio thus reflects the margin of profit that a concern is able to earn on its trading and manufacturing activity. It is the most commonly calculated ratio. It is employed for inter-firm and inter-firm comparison of trading results.

Formula:
Following formula is used to calculated gross profit ratio (GP Ratio): Gross profit / (Net sales 100) Where Gross profit = Net sales - Cost of goods sold Cost of goods sold = Opening stock + Net purchases + Direct expenses - Closing stock Net sales = Sales - Returns inwards Gross profit is what is revealed by the trading account. It results from the difference between net sales and cost of goods sold without taking into account expenses generally charged to the profit and loss account. The larger the gap, the greater is the scope for absorbing various expenses on administration, maintenance, arranging finance, selling and distribution and yet leaving net profit for the proprietors or shareholders. In case, there is increase in the percentage of gross profit as compared to the previous year, it is indicator of one or more of the following factors.

The selling price of the goods has gone up without corresponding increase in the cost of goods sold. The cost of goods sold has gone down without corresponding decrease in the selling price of the goods. Purchases might have been omitted or sales figures might have been inflated. The valuation of the opening stock is lower than what it should be or the valuation of the closing stock is higher than what it should be. In case, there a decrease in the rate of gross profit, it may be due to one or more of the following reasons. There may be decrease in the selling rate of the goods sold without corresponding decrease in the cost of goods sold. There may be increase in the cost of goods sold without corresponding increase in the selling price of the goods sold. There may be omission of sales. Stock at the end may have been under-valued or opening stock may have been over-valued.

Example:
Calculate gross profit ratio (GP Ratio) from the following particulars.

particulars Sales Sales returns Opening stock Solution:

$ 1,55,000 5,000 40,000

particulars Purchases Purchases returns Closing stock

$ 80,000 10,000 10,000

Cost of goods sold = Opening stock + Net purchases - Closing stock = 40,000 + 70,000 - 10,000 = 1,00,000 Net sales = 1,55,000 - 5,000 = 150,000 Gross profit = 1,50,000 - 1,00,000 = 50,000 Gross profit ratio = (50,000 / 1,50,000) x 100 = 33.33 %

(4) Operating Ratio: This ratio is determined by comparing the cost of the goods sold and other operating expenses with net sales.Read more about operating ratio. Operating net profit ratio is calculated by dividing the operating net profit by sales. This ratio helps in determining the ability of the management in running the business.

Formula:
Operating profit ratio = (Operating profit / Net sales) 100 Operating profit = Gross profit - Operating Expenses OR Operating profit = Net sales - Operating cost OR Operating profit= Net sales - (Cost of goods sold + Administrative and office expenses + Selling and distribution exp.) OR (Net profit + Non-operating expenses) - (Non-operating incomes) Higher the ratio, better it is

Example:
Particulars Sales less returns Gross profit Administration expenses Solution: Operating profit = Gross profit - Administration and selling expenses = 1,40,000 - (35,000 + 25,000) = 1,40,000 - 60,000 = $80,000 Operating profit ratio = (80, 000 / 4,00,000) 100 = 20 % $ 4,00,000 1,40,000 35,000 Particulars Selling expenses Income from investment Loss on account of fire $ 25,000 1,000 2,000

Net profit ratio (NP ratio) expresses the relationship between net profit after taxes and sales. This ratio is a measure of the overall profitability net profit is arrived at after taking into account both the operating and non-operating items of incomes and expenses. The ratio indicates what portion of the net sales is left for the owners after all expenses have been met.

Formula:
Following formula is used to calculate net profit ratio:

Net profit ratio = (Net profit after tax / Net sales) 100 It is expressed in percentage. Higher the net profit ratio, higher is the profitability of the business.

Example:
From the following information calculate net profit ratio (NP ratio) Total sales = $520,000; Sales returns = $ 20,000; Net profit $40,000 Net sales = (520,000 20,000) = 500,000 Net Profit Ratio = [(40,000 / 500,000) 100] = 8%

Significance:
Net profit ratio is used to measure the overall profitability and hence it is very useful to proprietors. The ratio is very useful as if the net profit is not sufficient, the firm shall not be able to achieve a satisfactory return on its investment. This ratio also indicates the firm's capacity to face adverse economic conditions such as price competition, low demand, etc. Obviously, higher the ratio the better is the profitability. But while interpreting the ratio it should be kept in mind that the performance of profits also be seen in relation to investments or capital of the firm and not only in relation to sales. The operating ratio is determined by comparing the cost of the goods sold and other operating expenses with net sales.

Formula:
Following formula is used to calculate operating ratio: [(Cost of goods sold + Operating expenses / Net sates)] 100 Here cost of goods sold = Operating stock + Net purchases + Manufacturing expenses - Closing stock OR = Net sales - Gross profit Operating expenses = Office and administrative expenses + Selling and distribution expenses

Interpretation:
This ratio is a test of the efficiency of the management in their business operation. It is a means of operating efficiency. In normal conditions, the operating ratio should be low enough so as to leave portion of the sales sufficient to give a fair return to the investors. Operating ratio plus operating profit ratio is 100. The two ratios are obviously interrelated. For example, if the operating profit ratio is 20%, it means that the operating ratio is 80%. A rise in the

operating ratio indicates a decline in the efficiency. Lower the operating ratio, the better is the position because greater is the profitability and management efficiency of the concern. The higher the ratio, the less favorable is the situation, because there will be smaller margin of profit available for the purpose of payment of dividend and creation of reserves.

Example:
From the following details, calculate the operating ratio: Cost of goods sold Operating Expenses Sales Sales returns Solution: Operating ratio = [(Cost of goods sold + Operating expenses) / Net Sales] 100 = [(6,00,000 + 40,000) / 800,000*] 100 = 640,000 / 800,000 = 80 % *(8,20,000 - 20,000) 6,00,000 40,000 8,20,000 20,000

Definition and Explanation:

Expense ratios are calculated to ascertain the relationship that exists between operating expenses and volume of sales. Expense ratios are calculated by dividing each item of expense or group of expenses with the net sales so analyze the cause of variation of the operating ratio. It indicates the portion of sales which is consumed by various operating expenses.

Formula:
Ratio of material used to sales: (Direct material cost / Net sales) 100 Ratio of labor to sales: (Direct labor cost / Net sales) 100 Ratio of factory overheads to sales: (Factory expenses / Net sales) 100 Ratio of office and administration expenses to sales: (Office and administration expenses / Net sales) 100 Ratio of selling and distribution expenses to sales: (Selling and distribution expenses / Net sales) 100

These ratios are expressed in terms of percentage. The total of the above ratios will be equal to the operating ratio. The total revenue expenditure may be sub-divided into two categories with fixed and variable. In the case of a fixed expense, the ratio will fall with increase in sales and for a variable expense, the ratio in proportion to sales shall nearly remain the same.

Example:
The following is the trading and profit and loss account of a Private Ltd. company for the year ended June 30, 1998. Details Stock in hand Purchases Carriage and freight Wages Gross profit c/d $ 76,250 3,15,250 2,000 5,000 2,00,000 5,98,500 Administrative expenses Finance expenses Selling and distribution expenses Non-operating expenses: loss on sale of securities Provision for legal suit Net profit 84,000 2,06,000 2,06,000 350 1,650 2,000 1,01,000 7,000 12,000 Gross profit b/d Non-operating incomes: Interest on 1,500 securities Dividend on 3,750 shares Profit on sale of 750 shares Details Sales Stock in hand $ 5,00,000 98,000

5,98,500 2,00,000

6,000

You are required to calculate: Administration express ratio Finance expenses ratio Selling and distribution expenses ratio Non-operating expenses ratio

Solution: Administration express ratio = (Administration express / Net sales) 100 = (1,01,000 / 5,00,000) 100 = 20.2 % Finance expenses ratio = (Finance express / Net sales) 100 = (7,000 / 5,00,000) 100 = 1.4 %

Selling and distribution expenses ratio = (Selling and distribution express / Net sales) 100 = (12,000 / 5,00,000) 100 = 2.4 % Non-operating expenses ratio = (Non-operating ratio / Net sales) 100 = (2,000 / 5,00,000) 100 = 0.4 %