# Classle

## Types of Ratio in Ratio Analysis

You have learnt in the previous lesson that accounting ratios can be classified into five major groups viz. liquidity

ratios, activity ratios, solvency ratios, profitability ratios and leverage ratio. You have already learnt the meaning,

computations and significance of liquidity and activity ratios. In this lesson, you will learn about the various

solvency  ratios, profitability ratios and leverage ratio and their significance.

OBJECTIVES

After studying this lesson you will be able to :

explain various types of accounting ratios i.e. solvency, profitability and leverage ratios;

calculate the various ratios on the basis of given information;

describe the limitations of accounting ratios.

SOLVENCY RATIOS

The term ‘solvency’ refers to the ability of a concern to meet its long term obligations. The long-term liability of a

firm is towards debenture holders, financial institutions providing medium and long term loans and other

creditors selling goods on credit. These ratios indicate firm’s ability to meet the fixed interest and its costs and

repayment schedules associated with its long term borrowings. The following ratios serve the purpose of

determining the solvency of the business firm.

• Debt equity ratio
• Proprietary ratio

Debt-equity ratio

It is also otherwise known as external to internal equity ratio. It is calculated to know the relative claims of

outsiders and the owners against the firm’s assets. This ratio establishes the relationship between the

outsiders funds and the shareholders fund. Thus,  Debt-equity ratio = Outsiders' funds/Share holders' funds

The two basic components of the ratio are outsiders’ funds and shareholders’ funds. The outsiders’ funds

include all debts/liabilities to outsiders i.e. debentures, long term loans from financial institutions, etc.

Shareholders’ funds mean preference share capital, equity share capital, reserves and surplus and fictitious

assets like preliminary expenses. This ratio indicates the proportion between shareholders’ funds and the

long-term borrowed funds. In India, this ratio may be taken as acceptable if it is 2 : 1. If the debt-equity ratio is

more than that, it shows a rather risky financial position from the long term point of view.

Significance

The purpose of debt equity ratio is to derive an idea of the amount of capital supplied to the concern by the

proprietors. This ratio is very useful to assess the soundness of long term financial position of the firm. It also

indicates the extent to which the firm depends upon outsiders for its existence. A low debt equity ratio implies the

use of more equity than debt.

It is also known as equity ratio. This ratio establishes the relationship between shareholders’ funds to total

assets of the firm. The shareholders’ fund is the sum of equity share capital, preference share capital, reserves

and surpluses. Out of this amount, accumulated losses should be deducted. On the other hand, the total assets

mean total resources of the concern. The ratio can be calculated as under :

Proprietory ratio = Shareholders' funds/Total assets

Significance

Proprietary ratio throws light on the general financial position of the enterprise. This ratio is of particular

importance to the creditors who can ascertain the proportion of shareholders’ funds in the total assets

employed in the firm. 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.

PROFITABILITY RATIOS

The main aim of an enterprise is to earn profit which is necessary for the survival and growth of the business

enterprise. It is earned with the help of amount invested in business. It is necessary to know how much profit

has been earned with the help of the amount invested in the business. This is possible through profitability ratio.

These ratios examine the current operating performance and efficiency of the business concern. These ratios

are helpful for the management to take remedial measures if there is a declining trend. The important

profitability ratios are :

(i) Gross profit ratio

(ii) Net profit ratio

(iii) Operating profit ratio

(iv) Return on investment ratio

(i) Gross profit ratio

It expresses the relationship of gross profit to net sales. It is expressed in percentage. It is computed as

Gross profit ratio = Gross profit/Net sales×100

Significance

Gross profit ratio shows the margin of profit. A high gross profit ratio is a great satisfaction to the management. It

represents the low cost of goods sold. Higher the rate of gross profit, lower the cost of goods sold.

(ii) Net profit ratio

A ratio of net profit to sales is called Net profit ratio. It indicates sales margin on sales. This is expressed as a

percentage. The main objective of calculating this ratio is to determine the overall profitability. The ratio is

calculated as

Net profit ratio =Net profit/Net sales×100

Significance

Net profit ratio determines overall efficiency of the business. It indicates the extent to which management has

been effective in reducing the operational expenses. Higher the net profit ratio, better it is for the business.

(iii) Operating profit ratio

Operating profit is an indicator of operational efficiencies. It reveals only overall efficiency. It establishes

relationship between operating profit and net sales. This ratio is expressed as a percentage. It is calculated as :

Operating profit =Operating profit /Net sales×100

Operationg Profit = Gross Profit – (Administration expenses + selling expenses)

Significance

It helps in examining the overall efficiency of the business. It measures profitability and soundness of the

business. Higher the ratio, the better is the profitability of the business. This ratio is also helpful in controlling

cash.

(iv) Return on investment ratio (ROI)

ROI is the basic profitability ratio. This ratio establishes relationship between net profit (before interest, tax and

dividend) and capital employed. It is expressed as a percentage on investment. The term investment here

refers to long-term funds invested in business. This investment is called capital employed.

Capital employed = Equity share capital + preference share capital+  Reserve and surplus + long term liabilities
– fictitious assets – Non trading investment

Capital employed = (Fixed asset – depreciation) + (Current Asset – Current liabilities)

Capital employed = (Fixed Assets – Depreciation) + (Working capital)

This ratio is also known as Return on capital employed ratio. It is calculated as under

ROI = Net profit before interest, tax and dividend /Capital employed×100

Note : If net profit after interest, tax and dividend is given, the amount of interest, tax and dividend should be

added back to calculate the net profit before interest, tax and dividend.

Significance

ROI ratio judges the overall performance of the concern. It measures how efficiently the sources of the business

are being used. In other words, it tells what is the earning capacity of the net assets of the business. Higher the

ratio the more efficient is the management and utilisation of capital employed.

LEVERAGE RATIO

Leverage ratio is otherwise known as capital structure ratio. The term capital structure refers to the relationship

between various long term forms of financing such as debentures (long term), preference share capital and

equity share capital including reserves and surpluses. Financing the firm’s assets is a very crucial problem in

every business and as a rule there should be a proper mix of debt and equity capital in financing the firm’s

assets. Leverage or capital structure ratios are calculated to test the long term financial position of a firm.

Generally capital gearing ratio is mainly calculated to analyse the leverage or capital structure of the firm

Capital gearing ratio

The capital gearing ratio is described as the relationship between equity share capital including reserves and

surpluses to preference share capital and other fixed interest bearing loans. If preference share capital and

other fixed interest bearing loans exceed the equity share capital including reserves, the firm is said to be highly

geared. The firm is said to be low geared if preference share capital and other fixed interest bearing loans are

less than equity capital and reserves.

Capital gearing ratio = Equity share capital reserves and surpluses/Preference share capital + long term debt

bearing fixed interest

Significance

Capital gearing ratio is very important ratio. Gearing should be kept in such a way that the company is able to

maintain a steady rate of dividend. High gearing ratio is not good for a new company or a company of which

future learnings are uncertain.

LIMITATION OF ACCOUNTING RATIOS

Accounting ratios are very significant in analysing the financial statements. Through accounting ratios, it will be

easy to know the true financial position and financial soundness of a business concern. However, despite the

advantages of ratio analysis, it suffers from a number of disadvantages. The following are the main limitations of

accounting ratios.

Ignorance of qualitative aspect

The ratio analysis is based on quantitative aspect. It totally ignores qualitative aspect which is sometimes more

important than quantitative aspect.

Ignorance of price level changes

Price level changes make the comparison of figures difficult over a period of time. Before any comparison is

No single concept

In order to calculate any ratio, different firms may take different concepts for different purposes. Some firms take

profit before charging interest and tax or profit before tax but after interest tax. This may lead to different results.

Misleading results if based on incorrect accounting data

Ratios are based on accounting data. They can be useful only when they are based on reliable data. If the data

are not reliable, the ratio will be unreliable.

No single standard ratio for comparison

There is no single standard ratio which is universally accepted and against which a comparison can be made.

Standards may differ from Industry to industry.

Difficulties in forecasting

Ratios are worked out on the basis of past results. As such they do not reflect the present and future position. It

may not be desirable to use them for forecasting future events.

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