Accounting Ratios

Accounting ratios are simple comparisons between two accounting numbers.

Financial statements show many numbers.

Ratios help us understand the relationship between those numbers.

Example: Current Assets Rs.2,00,000 and Current Liabilities Rs.1,00,000.

Current Ratio = Rs.2,00,000 : Rs.1,00,000 = 2:1.

This means for every Rs.1 of short-term liability, the company has Rs.2 of current assets.

Simple line: Accounting ratios turn financial numbers into easy business signals.

Ratios help us know whether the company can pay short-term bills.

They show whether the company depends too much on loans.

They show whether the company earns enough profit.

They help us check whether stock, assets, and debtors are used properly.

They help us see whether the company is improving or weakening.

They help compare one company with another company.

Simple line: Ratios help us judge the financial health of a business.

Riya wants to invest in one of two companies.

Company A has profit Rs.2,00,000.

Company B has profit Rs.1,50,000.

At first, Company A looks better.

But after checking ratios, Riya sees the deeper picture.

Company A has high profit, but debt is also very high and current ratio is weak.

Company B has slightly lower profit, but debt is low, current ratio is strong, and cash position is better.

Now Riya understands that one number is not enough.

Simple line: Ratios help us see what is hidden behind big numbers.

Numbers show amounts.

Ratios show relationships.

Example of a number: profit is Rs.1,00,000.

Example of a ratio: profit is 20% of sales.

Example of a number: current assets are Rs.2,00,000.

Example of a ratio: current ratio is 2:1.

Numbers alone can be hard to compare.

Ratios make comparison easier.

Memory line: Numbers give data. Ratios give meaning.

Accounting ratios are usually grouped into four main types.

Liquidity ratios check short-term payment ability.

Solvency ratios check long-term financial strength and debt position.

Profitability ratios check profit earning ability.

Activity or efficiency ratios check how well resources are used.

Each type answers a different business question.

Simple line: Different ratios look at different parts of business health.

Liquidity ratios show whether a company can pay short-term liabilities.

Current Ratio = Current Assets / Current Liabilities.

Example: Current Assets Rs.2,00,000 and Current Liabilities Rs.1,00,000.

Current Ratio = Rs.2,00,000 / Rs.1,00,000 = 2:1.

Meaning: company has Rs.2 current assets for every Rs.1 current liability.

Quick Ratio = Quick Assets / Current Liabilities.

Quick Assets usually means Current Assets - Inventory - Prepaid Expenses.

Example: Quick Assets Rs.1,50,000 and Current Liabilities Rs.1,00,000.

Quick Ratio = 1.5:1.

Simple line: Quick Ratio is stricter than Current Ratio because it does not depend heavily on selling stock.

Solvency ratios show long-term financial strength and debt position.

Debt-Equity Ratio = Debt / Equity.

Example: Debt Rs.3,00,000 and Equity Rs.2,00,000.

Debt-Equity Ratio = Rs.3,00,000 / Rs.2,00,000 = 1.5:1.

Meaning: for every Rs.1 of owner or shareholder funds, the company has Rs.1.50 debt.

Higher debt may mean higher risk.

Proprietary Ratio = Shareholders' Funds / Total Assets.

Example: Shareholders' Funds Rs.4,00,000 and Total Assets Rs.10,00,000.

Proprietary Ratio = 40%.

Simple line: Solvency ratios show how much the business depends on borrowed money.

Profitability ratios show how well a business earns profit.

Gross Profit Ratio = Gross Profit / Revenue from Operations x 100.

Example: Sales Rs.5,00,000 and Gross Profit Rs.2,00,000.

Gross Profit Ratio = Rs.2,00,000 / Rs.5,00,000 x 100 = 40%.

Meaning: for every Rs.100 sales, company earns Rs.40 gross profit.

Net Profit Ratio = Net Profit / Revenue from Operations x 100.

Example: Sales Rs.5,00,000 and Net Profit Rs.1,00,000.

Net Profit Ratio = Rs.1,00,000 / Rs.5,00,000 x 100 = 20%.

Operating Ratio = Operating Cost / Revenue from Operations x 100.

Example: Operating Cost Rs.4,00,000 and Sales Rs.5,00,000.

Operating Ratio = 80%.

Simple line: Profitability ratios show whether the business is earning enough from sales.

Activity ratios show how efficiently the business uses stock, debtors, and assets.

Inventory Turnover Ratio shows how quickly stock is sold and replaced.

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory.

Example: Cost of Goods Sold Rs.4,00,000 and Average Inventory Rs.1,00,000.

Inventory Turnover Ratio = 4 times.

Trade Receivables Turnover Ratio shows how quickly debtors pay the company.

Trade Receivables Turnover Ratio = Credit Revenue from Operations / Average Trade Receivables.

Example: Credit Sales Rs.6,00,000 and Average Debtors Rs.1,00,000.

Trade Receivables Turnover Ratio = 6 times.

Simple line: Efficiency ratios show whether money is moving fast or getting stuck.

Ratio calculation is only the first step.

The real skill is interpretation.

Ask whether the ratio is better than last year.

Ask whether it is better than similar companies.

Ask whether liquidity is too low.

Ask whether debt is too high.

Ask whether profit margin is improving.

Ask whether stock is moving quickly.

Ask whether debtors are paying on time.

Simple line: Ratios should be compared and understood, not just calculated.

Ratios are useful, but they have limits.

Ratios are based on accounting data.

Wrong data gives wrong ratios.

Ratios need comparison to be meaningful.

Different businesses may have different normal ratios.

Ratios do not show everything about the business.

Ratios do not explain the reason automatically.

Non-financial factors are also important.

Example: a company may have a good profit ratio, but customers may be unhappy.

Simple line: Ratios are helpful signals, not final judgement.