Subject: Principles of Accounting
Ratio analysis is the mathematical form of expressing the numerical or arithmetical relationship between two figures. It is a widely used financial analysis tool which is expressed when one figure is divided by another. It is the systematic use of ratios that determines and interprets the numerical relationship between two financial items. Ratio analysis assesses the strength and weakness as well as evaluates the historical performances and current financial conditions of a firm.
According to Kohler, “A ratio is the relationship of one amount to another expressed as the ratio of or as a simple, fraction, integer, decimal fraction or percentage.”
According to Hunt, William and Donaldson, “Ratios are simply a means of highlighting in arithmetical terms of the relationship between figures draw from financial statements.”
The ratio is the numerical relationship between 2 financial items and the relationship can be expressed as:
1. Current ratio:
This ratio shows the quantitative relationship between current assets and current liabilities. Also known as the working capital ratio, it indicates the ability of the firm in meeting the current obligation as expressed in terms of current liabilities. It can be calculated as:
where,
Current Assets = Assets that can be converted into cash or cash equivalent within a year or an accounting period. Some common Current Assets are:
· Cash in hand · Bills receivable · Sundry debtors (after deducting provision)/ Book debts · Stocks in trade/ Inventories · Prepaid/ Unexpired expenses · Short term investment · Accrued income | · Cash at bank · Account receivable · Marketable securities · Loan and advance · Stores and spares · Advance payment of tax |
Current liabilities = Liabilities that are dischargeable within a year or an accounting period. Some common Current Liabilities are:
· Sundry creditors · Notes payable · Bills payable · Accounts payable · Income tax payable · Income received in advance · Proposed dividend · Unclaimed dividend | · Dividend payable · Outstanding expenses · Provision for taxation · Short term loan · Bank overdraft · Instalments of loan payable with 12 months · Provision made regarding current assets |
Illustration:
The Balance Sheet of ‘ARMY Co.’ as on 31^{st} December is given below. Calculate the Current ratio.
Liabilities | Amount (Rs.) | Assets | Amount (Rs.) |
Share capital 20% debentures Sundry creditors Short term loans Term loans Provision for taxation | 4,00,000 1,50,000 30,000 25,000 45,000 50,000 | Investments Sundry debtors Prepaid expenses Goodwill Stock Cash and bank | 2,50,000 1,30,000 1,00,000 55,000 45,000 1,20,000 |
7,00,000 | 7,00,000 |
Solution:
Here,
Current assets = Sundry debtors + Prepaid expenses + Stock + Cash and bank
= Rs. (1,30,000 + 1,00,000 + 45,000 + 1,20,000)
= Rs. 3,95,000
Current liabilities = Sundry creditors + Short term loans + Provision for taxation
= Rs. (30,000 + 25,000 + 50,000)
= Rs. 1,05,000
Finally,
Current ratio = \(\frac {Current assets}{Current liabilities}\)
= \(\frac {3,95,000}{1,05,000}\)
= 3.76: 1 times
2. Quick/ Liquid Ratio:
This ratio shows the relationship between quick assets and current liabilities. Also called the Acid-test ratio, it is the improvised version of current ratio and gives a more precise measure of liquidity than the current ratio. It is calculated as:
where,
Quick Assets = Current assets – Prepaid expenses – inventories / stock
Illustration:
The SME Co.’s current ratio is 2 times and its quick ratio is 1.5 times. Holding current assets of Rs. 3,50,000, what is its level of current liabilities and its level of inventories?
Solution:
Given,
Current assets = Rs. 3,50,000
Current ratio = 2 times
Quick ratio = 1.5 times
current liabilities = ?
We have,
Current ratio = \(\frac {Current assets}{Current liabilities}\)
or, 2 = \(\frac {3,50,000}{Current liabilities}\)
or, C.L = Rs. 1,75,000
Again,
Quick ratio = \(\frac {Current assets-inventory}{Current liabilities}\)
or, 1.5 = \(\frac {3,50,000-inventory}{1,75,000}\)
or, Inventory = Rs. 87,500
1. Debt equity ratio (Debt to shareholders’ fund ratio):
This ratio shows the relationship between total debts or long-term debts and shareholders’ funds. Also known as the solvency ratio, it tests the long-term solvency of the firm. It can be calculated as:
Below are some long-term debts:
Long-term loan Secured loan Loan from bank Mortgage loan Loan from financial institutions (except bank overdraft) | Debentures Bonds Debentures premium Public deposit |
Below are some of the examples of Shareholders’ fund or equity:
Equity share capital Preference share capital Share forfeited account Share premium General reserve Capital reserve Contingency reserve Reserve & surplus Capital redemption reserve Workmen accident compensation funds | Profit & loss (Cr.) Profit & loss appropriation (Cr.) Sinking fund Retained earnings Earned in surplus Assets replacement fund Development equalization fund Development rebate reserve Other funds |
Less: Miscellaneous expenditures (Preliminary expenses, underwritten commission, discount or loss on issue of shares or debentures) Research & development expenditures Deferred advertisement expenses Profit & loss a/c (Dr.) Profit & loss appropriation a/c (Dr.) |
Illustration:
The Balance Sheet of ‘Carat Co.’ as on 31^{st} December is given below. Calculate the Current ratio.
Liabilities | Amount (Rs.) | Assets | Amount (Rs.) |
Equity capital 10% debentures 7% preference share capital Sundry creditors P/L account Loan Reserve Bank overdraft Provision for taxation | 16,000 21,000 10,000 9,000 5,000 6,000 12,000 3,000 7,000 | Long-term investment Sundry debtors Prepaid insurance Preliminary expenses Goodwill Stock Furniture | 22,000 14,000 9,000 3,000 7,000 20,000 14,000 |
89,000 | 89,000 |
Required: Debt equity ratio
Solution:
Here,
Total debts
= Debenture + Loan
= Rs. (21,000 + 6,000)
= Rs. 27,000
Shareholders’ fund
= Equity share + Preference share + reserve + P/L account – Preliminary exp.
= Rs. (16,000 + 10,000 + 12,000 + 5,000 – 3,000)
= Rs. 40,000
Finally,
Debt equity ratio
= \(\frac {Total debts}{Shareholders’ fund}\)
= \(\frac {27,000}{40,000}\)
= 67.5%
2. Debt to capital ratio:
This ratio shows the relationship between debt and total capital of a company. It helps in establishing a link between total long-term funds available in the business and funded debt. It is calculated as:
Debt to capital ratio = \(\frac {Long-term debts}{Capital employed}\)
where,
Capital employed = Sum of debts & Permanent capital
Illustration:
Liabilities | Amount (Rs.) | Assets | Amount (Rs.) |
Share capital 10% debentures 7% preference share capital 5% bond P/L account Loan Reserve Share premium Provision for taxation | 16,000 21,000 10,000 15,000 5,000 6,000 12,000 7,000 7,000 | Long-term investment Sundry debtors Prepaid insurance Preliminary expenses Goodwill Stock Furniture Underwriter’s commission Cash & bank | 20,000 14,000 6,000 3,000 7,000 16,000 14,000 12,000 7,000 |
99,000 | 99,000 |
Required:
Solution:
Total debts:
= Debenture + Loan + Bond
= Rs. (21,000 + 6,000 + 15,000)
= Rs. 42,000
Shareholders’ fund:
= Equity share + Preference share + reserve + P/L account + Share premium – Preliminary exp. – Underwriter’s commission
= Rs. (16,000 + 10,000 + 12,000 + 5,000 + 7,000 – 3,000 – 12,000)
= Rs. 35,000
Capital employed = Long-term debt + Shareholder’s fund = Rs. (42,000 + 35,000) = Rs. 77,000
Then,
Again
References:
Koirala, Madhav et.al., Principles of Accounting -XII, Buddha Prakashan, Kathmandu
Shrestha, Dasharatha et.al., Accountancy -XII, M.K. Prakashan, Kathmandu
Bajracharya, Puskar, Principle of Accounting-XII, Asia Publication Pvt. Ltd., Kathmandu
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