Accounting Ratio
•Accounting ratio shows the relationship between two or more group of items in Balance sheet or profit & loss account statement.
• This financial statement is prepared & presented annually
• Also little use for guidance to investor, co-investor, debtors, creditors, even management.
There are two classification of Accounting Ratio
• Traditional Classification
There are three types
1) Revenue statement ratio: It is based on profit & loss account.
2) Balance sheet Ratio: When two or more groups of items appearing in
balance sheet are compared the ratio is a balance sheet ratio.
3) Composite Ratio: The relationship between one item taken from profit
& loss statement and another item taken from balance sheet is known as composite ratio.
• Functional Classification
There are four types
1) Liquidity Ratio: These ratios to indicate the position of liquidity.
For example, of current ratio and liquid ratio. Current ratio shows the capacity to meet its current liabilities.
2) Profitability Ratio: These ratios to indicate the profitability of business.
for example, Gross profit ratio, Net profit ratio, return on sale holder ratio etc.
3) Leverage Ratio: the composition of capital of business and the
owners capital and capital provided by outsiders are reflected by Leverage ratio.
For example, Proprietor ratio, Debts equity ratio, Fixed assets ratio, Gearing ratio etc.
4) Activity or Efficiency Ratio: The ratio showing effectiveness with which the
resources of the business are employed.
For example, Stock turnover ratio, Debtors ratio, Creditors ratio, Total assets turn over ratio etc.
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Advantages of Accounting Ratio
1)Profitability:-
• It gives important information about profit of a business. Net profit and gross profit ratio give good idea of business profit.
2)Liquidity:-
• The current ratio and liquid ratio will tell whether the business will be able to meet its current liabilities.
3)Efficiency:-
• The turnover ratio will give the information about the efficiency of business.
For Example, Stock turnover ratio will indicate how efficiently the sale is being made.
4)Inter Firm Comparison:-
• They are comparing with similar ratio of other firm.
• It will saw the strength and weakness of the firm as compare with other firm.
5)Indicate Trend:-
• The ration of last three to five years indicates the trend of a business.
6)Useful for Budgetary Control:-
• Regular budget reports are prepared in business.
• If various ratios are included in budget report then it will give good idea about the financial position of business.
7)Useful for Decision Making:-
• On the base of accounting ratio, Management can take decision of business.
For Example:- If liquid ratio is unsatisfactory then management can collect other fund from other side for business.
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Here, I have discussed some important ratio of accounting.
Gross Profit Ratio (GP ratio)
• The purpose of gross profit ratio is to show profit ability of business.
• It is a ratio which expresses relationship between gross profit and net sales.
• Gross Profit Ratio = Gross Profit
• Net Sales * 100
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Net Profit Ratio (NP ratio)
• The purpose of net profit ratio is to show net profit ability of business.
• It is a ratio which expresses relationship between net profit and net sales.
• Net Profit Ratio = Net Profit
• Net Sales * 100
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Debtors Ratio
• The purpose of debtor ratio is to show the number of the days taken to collect the dues of credit sales.
• The average daily sales are obtained by dividing the total annual sales by 365.
• Debtors Ratio = Debtors + Bills Receivable
• Average daily Sales
Where Average daily sales = Credit sales
365
OR
• Debtors Ratio = Debtors + Bills Receivable
• Credit Sales * 365
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Creditors Ratio
• Creditor’s ratio to shows the number of days within which we can pay amount to our creditors for credit purchase.
• Creditors Ratio = Creditors + Bills Payable
• Average daily purchase
• Where Average daily purchase = Credit purchase
• 365
• OR
• Creditors Ratio = Creditors + Bills Payable
• Credit purchase * 365
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Acid Test Ratio
• Dividing the value of quick assets by liquid liabilities.
• Not included stock and debtors only include bank balance, cash amount, market securities etc.
Acid Test Ratio = Quick Assets
Liquid Liabilities
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Debt Equity Ratio
• Is another form of proprietary ratio
• Relationship between the outside long term liabilities and owners funds.
• It shows the long term external equities and internal equities.
• Long term creditors, share holders or proprietors.
• Debt Equity Ratio = Long term liabilities
Share holders fund * 100
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Limitation of Accounting Ratio
• There are no standard definitions of the ratios. So firms may be using different formulas for the ratios.
• One such example is Current Ratio, where some firms take into consideration all current liabilities but others ignore bank overdrafts from current liabilities while
calculating current ratio.
• Ratios ignore the price level changes due to inflation.
• Many ratios are calculated using historical costs, and they overlook the changes in price level between the periods. This does not reflect the correct financial
situation.
• Accounting ratios completely ignore the qualitative aspects of the firm. They only take the monetary aspects (quantitative).
• And finally, accounting ratios do not resolve any financial problems of the company.
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