NTA UGC NET - Commerce: UNIT 02: Accounting and Auditing (PART 04)

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UNIT 02

Accounting and Auditing

PART 04

 

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MCQ:  The index of efficiency and profitability of the business
 

a. Operating ratio
 

b. Operating profit ratio
 

c. Expense ratio
 

d. Net profit ratio
 

Ratio analysis is the analysis of financial statements with the help of ratios

Important tool for checking the efficiency of a firm
 

Classification of ratio
 

A) Liquidity ratios/ Short term liquidity ratio
 

1. Current Ratio:

• Measuring liquidity

• Also called working capital ratio

• Current ratio = Current Assets / Current Liability

• Current assets – cash in hand, cash at bank, bill receivable, sundry debtors, stock, prepaid expenses, short-term investments etc.

• Current liabilities – creditors, bills payable, bank OD, outstanding expenses, income tax payable, proposed dividend etc.

• Ideal ratio =2:1

• Measures a firm’s ability to meet short term obligations

 

• A high ratio indicates sound solvency position and a low ratio indicates inadequate working

 

2. Quick Ratio

• Acid test ratio / Liquidity Ratio

• Quick ratio = Quick Asset/ current liability

• Quick asset (CA asset except stock and prepaid expenses)

• Ideal ratio = 1:1

• If ratio is less than 1:1 – financial position of the concern is deemed to be unsound

• If the ratio is more that 1:1 - financial position of the concern is good and sound

• True test of business solvency

3. Absolute Liquidity Ratio

• Cash position ratio

• Absolute Liquidity Ratio = cash + marketable securities / current liability

• Ideal ratio = 0.75 : 1 

 

B) Long Term Financial Ratios (Leverage Ratios)
 

1. Debt-Equity Ratio

• Measure long term financial solvency of a firm

• Relationship between borrowed funds and owners capital

• Debt-Equity Ratio = Debt/ Equity - Outsides fund / shareholders fund

• Debt – current liability, loan, debenture etc. 

 

• Equity – Share Capital + Reserves and surplus – Fictitious Assets

• Ideal Debt-Equity ratio = 2:1

• High ratio shows – claims of creditors are greater than those of owners

• High ratio is unfavourable for the firm

 

2. Proprietary Ratio

• Shows Financial strength of a company ( helps creditors)

• Proprietary Ratio = Shareholders funds / Total asset

• Ideal ratio – 1:3 (i.e., 0.33)

• High ratio – Secured position to creditors

• Low ratio – Risk to creditors

 

3. Solvency Ratio

• Solvency Ratio – Total liabilities to outsiders / Total asset

• Lower ratio is more satisfactory

 

4. Fixed Asset Ratio

• Fixed Asset Ratio = Fixed Asset (after depreciation) / Total long term fund

• It is better if the total of fixed asset is equal to long term funds.

• If it is more, it means that some of the fixed assests are financed from current liabilities, which is not a good financial policy.

 

5. Capital gearing ratio

• Leverage ratio

• Used to analyse capital structure of a company

• Capital gearing ratio = Fixed interest bearing funds / Equity share capital + Reserves and surplus 

 

C) Profitability Ratio
 

I. General profitability ratio 

II. Overall profitability ratio
 

I. General profitability ratio
 

1. Gross Profit Ratio

• Gross profit * 100/ net sales

• Important tool in shaping the pricing policy of the firm

• Indicator of the firm’s ability to utilise effectively outside source of fund

 

2. Net profit ratio

• Net profit ratio = Net profit * 100 / sales

• Net profit means – net profit after interest and tax but before dividend
  

• Measure the overall profitability

 

3. Operating ratio

• Operating ratio = operating cost / net sales * 100

• Operating cost = cost of goods sold + operating expenses

• Lower the ratio the more profitable are the operations

 

II Overall Profitability Ratios
 

1. Return on shareholders fund
= Net profit (after interest and tax) * 100 / Shareholders funds

•  Profit on net worth ratio

 

2. Return on Equity Share Capital
= Net Profit (after interest, tax and preference dividend) * 100 / Equity share capital 

 

3. Return on capital Employed
= Net Profit (before interest, tax and dividend) * 100 / Net 

capital employed
 

4. Earnings per share (E.P.S)
= Net profit available to equity shareholders / number of equity shares issued

• Helps to determine the market price of the equity shares of the company

 

5. Capital Turnover ratio
= cost of goods sold / capital employed * 100

• Capital employed = Equity share capital + preference share capital + reserves and surplus + long term borrowings – Fictitious assets

 

D) Turnover Ratios (Activity ratios)

• Efficiency ratio

 

1. Inventory turnover ratio

• Stock Turnover Ratio

• Stock Velocity

• Investment in inventory is effectively used or not

• = cost of goods sold / average stock

• Cost of goods sold = ( opening stock + purchases + direct expenses ) – closing stock

• Avg. Stock = O.S + C.S / 2

• No Standard ratio

• Higher ratio indicates brisk sales

• Low turnover result in blocking of fund in inventory

 

2. Fixed asset turnover ratio

• = Net sales / Fixed Asset

 

3. Working Capital Turnover Ratio

• Measure of over trading and under trading

 

• = Net sales / Net working capital

 

4. Debtors Turnover Ratio

• Debtors Velocity

• Credit collection power and policy

• = Net credit sales / Average accounts receivables

• Higher ratio indicates debts are being collected promptly

 

5. Creditors turnover ratio
= net credit purchase / Avg. accounts payable

• Credit period enjoyed by the firm in paying its creditors 

 

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