# Accounting: Accounting Ratios – I: Types and Significance of Accounting Ratios

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• In accounting we record all business transactions and prepare financial statements to know profitability and the financial soundness of the company. For this we use different financial statements like Trading and Profit and Loss A/c and Balance Sheet etc. They provide absolute figures for profits and losses. The absolute figures do not convey full meaning. So, Ratios are used to draw the conclusions.

• The Ratio is an arithmetical expression which can be expressed in proportion, fraction, and percentage or in terms of number of times.

Ex: Company A earned Rs.10000 profit and Company B earned Rs.8000 profit. As per absolute figures of the profits we can say Company A is doing better. But we cannot do this. The capital invested by Company B is very less compared to Company A. Capital invested by A is Rs.1 L and capital invested by B is Rs.70000. Then Profit to Capital invested ratio will be more for Company B. So, company B is doing well.

Accounting Ratio can be classified into different groups based on requirement. Those are –

## Types of Accounting Ratios

### Liquidity Ratios

Liquidity refers to the ability of the company to meet its short term or current liabilities using current or liquid assets. There are two ratios

#### Current Ratio

Main objective of this ratio is to measure ability to meet its short-term liability. Current Ratio is the ratio of current assets and current liabilities.

Current Ratio =

#### Current Assets

Assets which can be converted into cash within a short period (< 1 year). They include Cash in Hand, Cash at Bank, Bill receivables, Short term investment, Sundry Debtors, Stock (or inventory) and Prepaid expenses.

#### Current Liabilities

Liabilities which are expected to be paid within a year. They include Bills Payable, Sundry creditors, Bank overdraft, Provision for tax, Outstanding expenses.

### Significance of Current Ratio

• It indicates current assets available for repayment of current liabilities.

• Preferable current ratio is 2:1

• Too high ratio indicates the lying of current assets idle.

• Too low ratio indicates the solvency of the firm is not good.

### Quick Ratio or Acid Test Ratio or Liquid Ratio

It is the ratio between quick assets and current liabilities. This considers current assets which can be converted into cash in very short period. This also indicates the instant debt paying ability of the firm to meet its current liabilities. Ratio of 1:1 is preferable for a company.

Quick Assets = Current Assets – (Stock + Prepaid Expenses)

Quick Ratio =

Example:

Calculate current ratio and quick ratio from the following : Rs.

 Sundry debtors Stock Marketable securities Cash Prepaid expenses Bill payables Sundry creditors Debentures Outstanding Expenses

Solution:

1. Current Ratio =

Current Assets = Sundry debtors + Stock + Marketable securities + Cash + Prepaid expenses

= Rs

= Rs

Current liabilities = Bill Payables + Sundry creditors + Outstanding Expenses

= Rs

= Rs

Current Ratio = =

The company is maintaining preferable current ratio i.e. 2:1

1. Quick Ratio =

Quick Assets = currents assets – (Stock + Prepaid expenses)

Quick Ratio =

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