Accounting Ratios – II Part 1

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III. Solvency Ratios:

Solvency refers to the ability of the business entity to meet its long term and medium-term obligations like liability towards debenture holders, financial institutions and other creditors selling on credit. Basically, company pays interest and principal amounts on a regular basis for a long period of time. Solvency ratio helps in determining the firm’s ability to meet its medium- and long-term liabilities. There are two different solvency ratios.

Debt-Equity Ratio:

It is the ratio between Outsider’s fund (Debt funds) and Shareholders’ funds (Equity funds).

Debt-Equity Ratio =

Outsider’s Funds include funds from Debentures, long term funds from financial institutions.

Shareholders’ funds include funds from preference share capital and equity share capital, reserves and accumulated profits.

Significance:

This ratio is very useful to assess the soundness of long-term financial position of the firm. Also, it describes about the funds collection from debt and equity sources. Debt to Equity Ratio is acceptable if 2:1 and if it is more than that not favorable.

Example: From the following, calculate the debt-equity ratio

Equity Shares Capital Rs.1,00,000

General Reserve Rs.45,000

Accumulated Profits Rs.30,000

Debentures Rs.75,000

Sundry trade creditors Rs.40,000

Outstanding expenses Rs.10,000

Solution:

Shareholders’ fund = Equity share capital + Reserves + Accumulated profits

= Rs100000 + Rs45000 + Rs30000

= 175000

Long term Debt = Funds from Debentures = 75,000

Debt-Equity Ratio =

= = 3:7

Proprietary Ratio: It is also known as equity ratio. It is the ratio between Shareholders’ funds and total assets of the firm.

Proprietary Ratio =

Significance:

It shows the general financial position of the enterprise. It helps creditors to take decisions. A high ratio shows that there is safety for creditors of all types. Higher the ratio, the better it is for concerned. A ratio below 50% may be alarming for the creditors since they may have to lose heavily in the event of company’s liquidation on account of heavy losses.

Example:

From the following calculate the proprietary ratio: Rs

Equity share capital 1,00,000 Fixed assets 1,25,000

Preference share capital 50,000 Current Assets 50,000

Reserves and surpluses 25,000 Investment 75,000

Debentures 60,000 Total 2,50,000

Creditors 15,000

Total 2,50,000

Solution:

Proprietary Ratio =

=

=

= 0.7 or 70%

II. PROFITABILITY RATIOS:

Main motto of any business is to earn profit. Profit alone from the financial statements does not convey the exact functioning of the business. It is important to know how much earned for the amount invested in the business. This can be understood by profitability ratios. These ratios help in determining the performance and efficiency of the business concern. The ratios are

Gross Profit Ratio: It is the ratio between gross profit and net sales.

Gross Profit Ratio =

Net Sales = Total Sales – (Sales return + Excise duty)

Gross profit = Net Sales – Cost of Goods sold

Significance: It shows the margin of profit. High ratio is preferable and it indicates the less cost of goods sold and more number of sales.

Net Profit Ratio: It is the ratio between Net Profit and Net sales.

Net Profit Ratio =

Significance: Net profit denotes the overall profitability of the business. So, This ratio describes the overall efficiency of the business. Higher ratio is preferable and it denotes reduction in the operational expenses.

Example: Calculate gross profit ratio and net profit ratio from the following figures.

Sales Rs 150,000

Cost of goods sold Rs 120,000

Operating expenses Rs 12,000

Solution:

Gross Profit Ratio =

Gross profit = Sales – Cost of goods sold

Gross Profit Ratio = =

Net Profit Ratio =

Net profit = Gross profit – operating expenses

Net Profit Ratio =