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SPECTRUM STUDY CIRCLE

(The Acme of Excellence)


+ 15/22 IInd Floor Ashok Nagar, New Delhi-110018.
Ph.: 25499279, 55711031(O), 9810378235(M)

PREPARED BY: MR. ROHIT KOHLI


[98106-34853]
Class: XII Accountancy Ratio Analysis P.No.:1
1. Gross Profit Ratio. This ratio is calculated as gross profit divided by net sales. Gross Profit is the excess of
sales over cost of goods sold. To find net sales return, sales tax and excise duty should be deducted from sales.
It is calculated as follows:
Gross Profit × 100
Net Sales
Gross profit = Net Sales – Cost of goods sold
Net sales = Gross sales – (sales return + Sales tax + Excise duty)
Significance. This ratio indicates the relationship between gross profit and sales. Higher the ratio, less is the
cost of goods sold. Increase in the gross profit ratio over the period is the indicator of better profitability.
Decrease in the ratio should be properly investigated to find the exact reason. The possible reasons are: increase
in cost of goods sold due to increase in the cost of material, productive wages or manufacturing expenses or due
decrease in the selling price. This ratio can be used in controlling cost of goods sold, fixing the price of the
products and in comparing gross margin over various years. For the purpose of analysis the actual gross profit
ratio should ratio should be compared with either industry average or standard gross profit ratio.
2. Net Profit Ratio. This ratio is calculated as net profit divided by sales. Net profit may be taken as before tax or
after tax., but net profit after tax is preferred. It is calculated as follows:
Net Profit after Tax × 100
Net Sales
Significance. This ratio shows relationship between net profit and net sales. Objectives of net profit ratio is to
determine the over all efficiency of the business. Higher the net profit ratio, the better the business. This ratio
helps in comparing the performance over various years. An increase in the net profit ratio over the previous year
shows improvement in the operational efficiency.
3. Operating Profit Ratio. The ratio is calculated as operating profit divided by net sales. Operating profit is
excess of sales over operating cost. Operating cost includes cost of goods sold and operating expenses (i.e.,
administrative expenses and selling and distributing expenses). It is calculated as follows:
Operating Profit × 100
Net Sales
Operating cost = Gross profit – Operating expenses (office and administration expenses + Selling and distribution
expenses)
Significance. This ratio indicates the relationship between operating profit and net sales. This ratio shows
efficiency of operating business as non-operating incomes and non-operating expenses are not considered.
Indirectly it reveals the relationship between operating cost and prices. By comparing this ratio over several
years, trends in operating profit can be examined.
4. Operating Ratio. It may be defined as a ratio which indicates operating cost as a percentage of total sales.
Operating ratio is calculated as operating cost divided by net sales. Formula is as follows:
Operating Cost × 100
Net Sales
Operating cost = Cost of goods sold + Operating expenses
Significance. This ratio indicates the relationship between operating cost and net sales. This ratio
shows operating efficiency of the business. Lower the ratio, better the efficiency. This ratio is just
opposite of operating profit ratio. This ratio helps in controlling the operating cost of the business.
5. Return on Investment (ROI). This ratio is also known as return on capital employed. It shows the relationship
between the profit earned (before interest and tax) and the capital employed to earn such profit. It is considered
an indicator of overall profitability. This ratio is calculated as follows:
= profit before interest and Tax (PBIT) × 100
Capital Employed
Calculation of Capital Employed
(i) Fixed Assets + Investments + Current Assets – Current Liabilities
SPECTRUM STUDY CIRCLE
(The Acme of Excellence)
+ 15/22 IInd Floor Ashok Nagar, New Delhi-110018.
Ph.: 25499279, 55711031(O), 9810378235(M)

PREPARED BY: MR. ROHIT KOHLI


[98106-34853]
(ii) Paid up Capital + Reserves and Surplus + Long-term loans – Fictitious assets or Miscellaneous Expenditure
Class: XII Accountancy Ratio Analysis P.No.:2
Significance. This ratio judges the overall performance and efficiency of the business it show efficiently the
resources invested in the business are being used. ROI is a fair measure of the profitability of any firm, which
can be compared with the terms of the same industry as well as with the firms of other industries. This ratio is
also used to compare the profitability and efficiency over various years.
6. Return on Equity (ROE). This ratio is also known as return on shareholders’ investment. This ratio shows hoe
much net profit a firm has earned with the use of Rs. 100 of shareholders’ funds. Regarding this ratio analysts
have two different concepts of equity. According to one concept equity means shareholders’ fund, some analysts
use equity shareholders’ funds. The seconds concept is used to calculate this ratio in this book. Both the formula
are: (i) Return on Shareholder’s Funds
= Net Profit after T ax (PAT) × 100
Shareholders’ Funds
Shareholders Funds = Equity Share Capital + Preference Share Capital + Reserves and surplus – Fictitious assets
(like preliminary expenses etc.)
(ii) Return on Equity Shareholder’s Funds
= Net Profit after Tax – Preference Dividend × 100
Equity Shareholders’ Funds
Equity Shareholders Funds = Equity Share Capital + Reserves and Surplus – Fictitious assets (like preliminary
expenses etc.)
7. Current Ratio. It is also knows as working capital ratio. It is the ratio of total current assets and current
liabilities. Current assets are those assets which are converted into cash during the ordinary course of business.
Current liabilities are those liabilities which are repayable within a year’s time. It is calculated as follows:
= Current Assets
Current Liabilities
Current Assets : Cash + Bank + debtors + B/R + Accrued Income + stock + Prepaid Expenses + Marketable or
short-term investment.
It is to be noted that loose tools is not considered a current asset for the purpose of this ratio, although it may be
classified as current asset in the Balance Sheet of a company.
Current Liabilities: = Creditors + B/P + Outstanding expenses + Bank overdraft + Income received in advance +
provision for tax + Proposed Dividend + Unclaimed Dividend and any other liability payable within a year.
Significance. This ratio is used to judge the short-term financial position or liquidity of the concern. The current
ratio measures the ability of the firm to meet its current liabilities. Higher the current ratio the greater the short
term solvency. 2:1 is considered ideal current ratio. However, a very high current ratio will indicate idleness of
working capital only.
8. Quick Ratio. It is also called Liquid ratio or acid-test ratio. It is a ratio between quick assets and current
liabilities. Quick or liquid assets includes those current assets which can easily and readily be converted into
cash. Thus these includes cash in hand, cash at bank, debtors, B/R, accrued income and marketable securities. It
is calculated as follows:
= Quick Assets or Liquid Assets
Current Liabilities
Quick Assets = Current Assets or Liquid Assets
Current Liabilities
Quick Assets = Current Assets – (Stock + Prepaid expenses)
Significance. The quick ratio is a fairly stringent measure of liquidity. It is based on those current assets which
are highly liquid. A quick ratio of 1:1 is considered satisfactory. Higher the quick ratio better the short-term
financial position.
9. Debt – Equity Ratio. It is a ratio between long-term debts and equity. For the purse of this ratio, the meaning of
equity is shareholders’ funds. Some of the analysis consider it as a ratio between external liabilities (short-term
as well as long-term) and owners’ funds. It is calculated as follows:
SPECTRUM STUDY CIRCLE
(The Acme of Excellence)
+ 15/22 IInd Floor Ashok Nagar, New Delhi-110018.
Ph.: 25499279, 55711031(O), 9810378235(M)

PREPARED BY: MR. ROHIT KOHLI


[98106-34853]
= Debt(long – term)
Equity (Shareholders’ funds)
Class: XII Accountancy Ratio Analysis P.No.:3
Significance. This ratio judges the long-term financial position and soundness of the long-term financial policies
of the firm. In general lower the debt equity ratio the higher the degree of protection enjoyed by the lenders. A
debt equity ratio of 2:1 may be considered satisfactory in India.
10. Debt to Total Funds Ratio. It is also knows as solvency ratio. It is a ratio between long-term debt and total
long-term funds (i.e., capital employed). It is calculated as follows:
= Debt (long term)
Total Long term funds (Debt + Equity)
Significance. This ratio measures the long-term financial position and soundness of long-term financial policies.
It shows the proportion of long term funds which is raised by way of debt. A higher proportion is not considered
good. 2:3 or 0.67 is acceptable in India.
11. Interest Coverage Ratio. It is a ratio between ‘profit earned before interest and tax’ and interest on long-term
loans. This ratio indicates the number of times interest (on long-term loans) is covered by the profits available
for payment of it. This ratio is also known as ‘times interest earned ratio’. It is calculated as follows:
= Profit before Interest and Tax
Interest on Long-Term Debt
Significance. This ratio indicates how many times the profit covers the interest. It measures the margin of
safety for lenders and debenture holders. A high interest coverage ratio means that the firm can easily meet its
interest burden even if earning before interest and tax suffer a considerable loss due to adverse business
conditions.
12. Fixed Assets Turnover Ratio. It is a ratio between sales and fixed assets. It is expressed in times.
= Net Sales
Net Fixed Asset
Significance. This ratio measures the efficiency with which fixed assets are employed. A high ratio indicates a
high degree of efficiency in the utilization of fixed assets and a low ratio represents insufficient use of assets.
13. Capital Turnover Ratio. It is a ratio between sales and capital employed. Capital employed consist of long-
term funds including debts. The ratio indicates the times by which the capital employed is used to generate sales.
It is calculated as follows:
= Sales
Capital Employed
Significance. This ratio shows the number of times the capital has been rotated in the process of doing business.
Higher the ratio, better the efficiency in the utilization of capital. However, too high ratio may indicate over
trading resulting in the shortage of funds.
14. Stock Turnover Ratio.
STR = Cost of Goods sold
Average stock
Cost of goods sold = Opening stock + Net Purchase of raw material + Direct expenses – Closing stock.
Cost of Goods sold = Net sales – Gross profit
Average stock = Opening stock + Closing Stock
2
Significance. This ratio measures how fast the stock is moving through the firm and generating sales. This ratio
reflects the efficiency of inventory management. Higher the ratio, the more efficient management of inventories
and vice-versa. A high inventory turnover may be caused by a low level of inventory which may result in
frequent stock-outs and loss of sales and customer goodwill.
15. Debtor Turnover Ratio.
DTR = Net Credit Sale
Average creditors
Average Collection Period
SPECTRUM STUDY CIRCLE
(The Acme of Excellence)
+ 15/22 IInd Floor Ashok Nagar, New Delhi-110018.
Ph.: 25499279, 55711031(O), 9810378235(M)

PREPARED BY: MR. ROHIT KOHLI


[98106-34853]
= 365/12/52
DTR