A6.

4
4.6.4 Classification the Basis of Nature
on
(Purpose)
Under this classification ratios are classified under
four heads.
() Liquidity Ratios (ii) Leverage Ratios
(iii) Activity or Turnover Ratios (iv)
Profitability Ratios
) Liquidity Ratios
These ratios aim to measure the short-term financial
:
a concern. These ratios indicate the ability a firm to meet its short-term position of
become due. Current ratio, liquid ratio and absolute
obligations when they
liquidity ratio come under this category.
(ü) Leverage Ratios: Leverage ratios show the
proportion of debt and equity in the
financial structure of company. Through these ratios the financial comtribution of the owners is
compared to that of creditors. Therefore, these ratios give an indication of
or otherwise of a firm. These indicate a firm's
long-term solvency
ability to meet the interest cost and repayment
of long-term obligations. Some examples of
Coverage ratio, etc.
leverage ratio are; Debt to Equity ratio, Interest
(ii) Activity Ratios: The effectiveness of the
use of various resources are measured
through activity
ratios. These ratios are otherwise known as Turnover
Ratios. For example, the
Debtor Turnover Ratio indicates the speed at which debtors
repay their dues. The Stock
Turnover Ratio and Fixed Asset Turnover Ratio and
examples of activity ratios.
Working Capital Turnover ratio are some
(iv) Profitability Ratios: The ratios that aim to throw light on the
business profitability of a
enterprise are called profitability ratios. These ratios are intended to measure the end
result of the operation of a bu_iness. Gross profit ratio, Net profit ratio,
Rehurn on Capital Employed Operating
ratio and
are some examples of profitability ratios.
4.7 ANALYSIS OF RATIOS
Ratio analysis to studied under the following heads
1) Analysis of short-term financial position, (ii) Study of activities,
(ii) Profitability (iv) Long-term solvency
4.8
ANALYSIS OF SHORT-TERM FINANCIAL POSITION .LIQUIDITY RATIOS|
The liquidity ratios play a key role in assessing the short-term
solvency of an enterprise.
ne commercial banks and other short-term creditors are generally interested in liquidity or
OTT-term solvency of an enterprise as their claim are to be met in the short-run. Liquidity or
HOrt-term solvency implies the ability of a firm to pay its short-term obligations as and
nen
they become due. Inability to meet the short-term liabilities affects the goodwill of a firm
Cgatively. Further, it becomes difficult for a firm to borrow further to meet the urgent working
apital needs. Besides these, continuous default may lead to commercial bankruptcy and sickness
which ultimately result in dissolution.
 The principal liquidity ratios are;
(i) Quick Ratio
() Current Ratio
(ii) Absolute Liquid Ratio (iv) Internal Interval Measure Ratio.
All these ratios are discussed briefly as under.
1. Current Ratio
current liabilities is knowm as
(a) Meaning: The ratio of current assets to as current ratio,
cur.

current liabilities.
It establishes the relationship between current assets and
(b) Objective: The purpose of computing current ratio
is to measure thethe mo
margin o
capable of meeting the
safety available for short-term creditors i.e., to know whether a firm is capable of meeti
claim of short-term creditors as and when due.
(c) Formula: The ratio is computed by dividing the current assets by the amou
current liabilities.
Current Assets
Current Ratio =
Current Liabilities
(d) Components
) Current Assets: The assets which are either in cash form or are expected tok
converted into cash within an accounting year are termed as current assets. These ae
Cash in hand, Cash at Bank, Debtors excluding provisions, Bills receivable,
Stock
Marketable securities at realised value, Short-term loans and advances, Prepaid expenses,
Accrued income, Advance payment of tax, etc.
) Current Liabilities: The liabilities that are likely to be paid within an
are termed as current liabilities. These
accounting year
are; creditors, bills payable, outstanding expenses
bank overdraft, short-term loans and advances,
provision for tax, unclaimed dividend,
income received in advance, etc.
(e) Example: From the following Balance Sheet of Y. Ltd. calculate the current
ran
Liabilities Amt.() Assets Amt.()
Equity share capital 2,00,000 Land & Building 1,20,000
12% Debentures
1,00,000 Plant& Machine 80,000
General Reserve 30,000 Furniture 42,000
Trade creditors
Bills Payable
40,000 Stock 75,000

Bank overdraft
10,000 Debtors 50,000
20,000 (H Provision 5,000 45,00
Outstanding Expenses 5,000 Marketable Securities 10,000
Provision for Tax 15,000
35,000 Bills Receivable
3,000
Prepaid Expenses 20,000
Preliminary Expenses 28,000
Underwriting Commission 2000
Cash
4,40,000 440,000
2. Quick Ratio (Liquid Ratio)
quick liabiliues. lIs
a) Meaning: It establishes the relationship between auick assets and
also know as Acid Test Ratio.
the ability or a irm to
(b) Objective: The purpose of calculating quick ratio is to measure
meet its short-term obligations as and when due without waiting for realIsaion of
assets as tnese
stock. So, this ratio excludes stock and prepaid expenses from current
are the lecast liquid current assct.
lhablities or
(c) Formula: This ratio is calculated by dividing the quick assets by current
quick liabilities.

Quick Ratio =-
Quick Assets Quick Assets
or,
Current Liabilities Quick Liabilities
(d) Components :
(a) Quick Assets =
Current Assets Stock Prepaid expenses
In other words, it includes Cash, Bank, Debtors, Bills Receivable and Marketable
Securities.
(b) Quick Liabilities = Current Liabilities - Bank overdraft

(e) Example :Current Assets 7 5,40,000, Inventory 2,00,000. Prepaid expenses 20,000,
Current liabilities 2,00,000 and creditor 7 30,000. Calculate
quick ratio.
Solution
Quick Assets =
Current Assets Inventory Prepaid Expense
-
-

=
5,40,000 -7 2,00,000 -7 20,000 R 3,20,000 =

Current liabilities =
2,00,000
 the relationship between cash in hand cash
to establish
os

at
(a) Meaning: This ratio tries absolute liquid asset with that of liquid liahi
bank and marketable securities called
of calculating this ratio is to examine whether an enternri .
liabilities
(b Purpose: The Objective
meet its short-term obligation
without relying upon the realisation of stock and de.
k and
debtors
to calculate the absolute liquid ratio
(c) Formula: The following formula is used
Absolute Liquid Assets
Absolute Liquid Ratio Liquid/Current Liabilities

Cash+Bank + Marketable Securities

Liquid/Current Liabilities

(d) Components: The umerator consists of cash in hand, cash at bank and marketabe
sccurities. The denominator is current liabilities excluding bank overdraft if any, providod
there is a permanent arrangement with the bank for overdraft.
(e) Example: Calculate absolute liquid ratio from the following particulars
Plant & Machinery 75,00,000 Cash in Hand 27,000
Furniture& Fixtures 1,00,000 Cash at Bank 43,000
Stock 60,000 Creditors 35,000
Debtors 50,000 Bills Payable 15,000
Bills Receivable 10,000 Unpaid Expenses 10,000
Provision for doubtful debt. 5,000 Marketable Securities 30,000
Solution
Absolute Liquid Assets =
Cash in Hand + Cash at Bank + Marketable Securities
27,000+ 43,000 + 30,000 T 1,00,000
=

Current Liabilities Creditors +Bills

=

payable + Unpaid expenses

= 35,000 + 15,000+ 10,000 7
=
60,000
Absolute Liquid Assets
Absolute Liquid Ratio = Current Liabilities T1,00,000-167:1
60,000
 1.Stock Turnover Ratio: The inventory level maintained by a firm should not be too
high or too low. Maintaining a high level of inventory has the limitation of unnecessary blocking
of capital, requirement of more space, deterioration in quality and the greater chance of
obsolescence. Conversely, if stock is maintained at a low level, production may be interrupted
at any time. Therefore, maintaining right amount of stock is of
paramount importance for which
stock turnover ratio is calculated
know the speed at which stocks are converted into sales.
to

(a) Meaning: Stock Turnover Ratio or stock velocity establishes relationship between average
stock and cost of goods sold.
b) Purpose: The purpose of this ratio is to measure the rate at which inventory is converted
into sales.
(c) Formula: The following formula is used to calculate the Stock Turnover Ratio.
(i) Stock Turnover
Cost of GoodsSold .... times
RatioAverage Inventory at Cost
For enterprises (like departmental store) valuing inventory at selling prices, the Stock
Turnover Ratio will be;
Net sales
i) Stock Turnover Ratio = - - - times
Average inventory at selling price
 d) Components:
Purchases + Direct expenses Closino.
Opening Stock +
-

i) Cost of Goods sold

Net Sales Gross Profit
or, Cost of Goods Sold
= -

Opening Stock + Clo sing Stock

(ii) Average stock =:

2
N.B.: 1.When cost of goods sold cannot be ascertained the figure of sales may be taken inn
the numerator.
2. When the figure of opening stock is not available, the figure of closing stock may be
taken as the average stock.
(e) Example:
Opening stock 20,000, Closing Stock 30,000, Purchases 1,50,000, Wages 7 5,000,
Carriage in { 2,000, Carriage out 3,000. Calculate Stock Turnover Ratio.
Solution
Cost of Goods Sold = Opening Stock + Purchases + Wages +Carriage in - Closing stock

= 20,000 +7 1,50,000 + 5,000+ 2,000 T 30,000 =

T 1,47,000
Average Stock = (Opening stock + Closing stock)/ 2

=
(T 20,000 + T 30,000) / 2 =
25,000

Stock Turnover Ratio

Cost of Goods Sold 147,000= 5,88 times
Average Stock 25,0000
2. Debtors Turnover
Ratio
When goods are sold on credit debtors are created. They are supposed to pay at a later
date as per the agreed terms. This ratio measures the rate at which debtors are converted into
cash.
(a) Meaning: In this ratio, relationship is established between net credit sales (credit sales
less return) and average trade debtors.
(b) Purpose : The purpose of calculating this ratio is to measure the velocity at which
debtors are converted into cash.
(c) Formula: The following formula is used to calculate the Debtors Turnover Ratio.
Net Credit Sales
Debtor Turnover Ratio =
times.
Average Trade Debtors
 (d) Components:
) Net Credit Sales =Total Credit Sales Sales Return
-

i) Trade Debtors include debtors plus receivables.

Average Debtors = |[(Opening (Drs + B/R) + Closing (Drs + B/R)]/2

Hints
1. Take debtors at gross value without deducting the provisions or else it would give
an impression that the portion of the debtors representing provisions has
alrcady been
collected
2. If opening debtors figure is not available, the closing figure of debtors may be taken
as the average trade debtors.
(e) Example: From the following particulars calculate Debtors Turnover Ratio.
1.4.16 31.3.17
Debtors 15,000
35,000
Bills Receivables 79,000 13,000
Provision for Doubtful Debt. 2,000 3,000
Total sales 7 4,00,000, sales return 13,000
and cash sales 1,35,000
Solution
) Net credit sales =
Total sales -

Sales return -

cash sales
R 4,00,000 F 13,000 -7 1,35,000 R 2,52,000
-

(ii) Average Trade Debtors =

[Opening (Drs
B/R) +Closing (Drs+
+
B/R)|/2
=

[(15,000+9,000)+ (35,000 + 13,000)/2

=
72,000+2 7 36,000

Debtors Turnover Ratioz2,52,000

36,000
= 7 times.
Average collection period (ACP): This period states the
number of days
taken by debtors to pay their dues. To put it otherwise, it is theaverage
average period for which
credit sales remain outstanding. A higher average collection period reflects the inefficiency
of the debt collection machinery.
It can be calculated by applying the following
formula;
12 months/52 weeks/365 days
Average collection period =

Debtor Turnover Ratio

-

months/ weeks / days.

Average Debtors
or, Average collection Period =

Net credit sales per day

Net Credit Sales per annum

Net credit sales per day =

No. of working days p.a.

Example: Considering the preceding illustration, the average collection period will be;
365
52 days (app.). It means debtors take 52 days on an average to pay their dues.
7
3. Creditors Payable Turnover Ratio
When a firm makes credit purchases of goods creditors are created. The creditors are
interested to find out how much time the firm takes to repay their dues on an average
basis.
(a) Meaning: This ratio establishes the relationship between trade creditors and net credit
purchases.
(b) Purpose : The purpose of the Creditors Turnover Ratio is to assess the average time
taken by a firm to pay its creditors.
(c) Formula: The following formula is used to calculate the creditors turnover ratio.
Annual Credit Purchasces
Creditors Turnover Ratio
Average Trade Creditors
 (d) Components
) Annual Credit Purchases =
Total purchase -

Cash
purchase Purchase returns.-

i) Average Trades creditors [Opening (Crs. + B/P) + Closing (Crs. + B/P)/2

=

R1, Do not deduct reserve for discount on creditors or else it will give an impression that,
that amount of creditors have been discharged.
2. If the figure of opening trade creditors is not available, the figure of closing trade
creditors may be taken as the average trade creditors.
e)Example: From the following information calculate Creditors Turnover Ratio'
1.4.16) 31.3.17()
Sundry Creditors 15,000 30,000
Bills Payable 5,000 15,000
Reserve for Discount on Creditor 1,500 3,000
Total purchase R 4,00,000, Return-out 75,000, Cash purchases 70,000
Solution
Net Credit Purchase =
74,00,000 -

7 5,000 -

70,000 =
7 3,25,000
Average Trade Creditors = [(T 15,000 + 5,000) + (30,000+ 15,000)1
=
[ 20,000 + 45,0001/2 7 32,500
Net Credit Purchase 3,25,000 = 10 times
Creditors Turnover Ratio=
Average Trade Creditors 32,500
4. Working Capital Turnover Ratio
(a) Meaning : Working capital refers to the excess of current assets over current liabilities
i.c., C.A -C.L. Maintenance of working capital affects sale as current assets like stock
debtors, bills receivable, cash, etc. change with the change in sale. Therefore, the
working capital ratio establishes relationship between net sales and working capital.
 (b) Purpose: The objective of calculating this fficiency
ratio is to measure the efficiency with whi wnch
the working capital of a firm is being utilised.
It tells us how many times thethe workin

capital has been turned over during a year.

to find the working capital turnover
(c) Formula: The following formula is used ratio ra

Cost of Sales (or, Net Sale

Turnover Ratio -= ---Times
Working Capital Average Net Working Capital
N.B. When cost of sales figure is not available sales figure may be taken in the iunmo
umerator
(d) Components:
) Working Capital
=
Current Assets Current Liabilities
=
Capital Employed -

Net Fixed Assets.

() Cost of Goods sold Sales Gross Profit

W.C in the beginning+ W.C at the end

(i) Average W.C. =

2
When working capital in the beginning is not given, the figure of working capital at the
end may be taken as the average working capital.
(e) Example: From the following information calculate the Working Capital Turnover Ratia
Current Assets 1,60,000, Current Liabilities 1,00,000 in the beginning, Current Assets
2,40,000 and Current Liabilities 1,20,000 at the end of the year and cost of salks
3,60,000.
Solution:
Working Capital (opening) 7 1,60,000 7 1,00,000
=

60,000 =

Working Capital (end) 7 2,40,000 7 1,20,000 7 1,20,000

= -

So, Average W.C (F 60,000 + 1,20,000)/2 7

=

90,000 =

Cost of Sales 3,60,000

Working Capital Turnover = 4 times
Average Working Capital 90,000
1, Gross Profit Ratio
(a) Meaning: This ratio measures the relationship between gross profit and net sales.
(b) Purpose: The purpose of calculating this ratio is to measure the
purchase or production and sales activities efficiency with which
are carried out.
(c) Formula: The formula of this ratio is;

Gross Profit Ratio

Gross Pr on
Net Sales
100
This ratio is expressed in percentage.
(d) Components:
()Gross Profit =Sales Cost of goods sold.
-

Cost of goods sold = Opening stock + Purchase +Direct

Expenses Closing stock. -

(ü) Net sales (Cash sales + Credit Sales) Sales Return.

=
-

(e) Example: Cash sales 1,50,000, Credit sales 2,70,000, Sales return 7
of goods sold 7 3,00,000. Find Gross Profit Ratio.
20,000, Cost
Solution:
Net sales 7
=
1,50,000 +T 2,70,000 T 20,000 =74,00,000
Gross Profit =
Sales Cost of goods sold { 4,00,000 7 3,00,000 =7 1,00,000.
- =

GrossSPr
alofit
ex100=LT1,00,0000
00,000
Gross Profit Ratio x100=25%
Net 4,00,000
2 Net Profit Ratio
Net Pre

This ratio measures the

(a) Meaning: relationship between Net Profit (after tax) and Net
Sales.
Purpose: The purpose of calculating this ratio is to determine the overall
business. It's objective is to express the net
profitability of
profit as a
percentage on sales.
Formula: The formula for
calculating net profit ratio is
Net Profit Ratio= Net ProfitAfter Ta x 100
Net Sales
(d) Components: i) Net sales i.e.; sales less return.
(i) Net Profit =
Gross Profit +
Non-operating incomes Operating as
well as
non-operating expenses.
Operating expenses includes all expenses incurred during the normal business activities
such as administrative expenses, selling expences, discount, bad debt, etc. Financial charges
such its interest, provision for tax, etc. are generally excluded.
Non-operating expenses are the expenses not related to the income earning capacity
of a business such as interest on debentures, Loss of furniture by fire, etc.
Non-operating incomes are the incomes earned by a business not in its ordinary course.
These are interest and dividend received from long-term investment, profit on sale of long-term
ivestment, compensation received for acquisition of land, etc.

Calculation of Net Profit

XXX
Gross Profit
Add: Operating as well as
non-operating incomes XXX
XXX

Less: Operating as well as

non-operating expenses XXX
Net profit before Tax
XX
Less: Tax XXx
Net Profit After Ta*
(e) Example:
Profit Ratio from the following information.
Lalculate Gross Profit and Net
Cost of Goods sold 7 5,25,000

Gross Profit 72,25,000

71,37,500
Net Profit
 Solution
Gross Pr ofit 100
Gross Profit Ratio Net Sales
Profit 7 5,25,000 + 72,25,000
2,25,000 = soa
=7 77,50,000
Cost of Goods Sold+ Gross
=

Net Sales =

Gross Profit Ratio7,50,000

2,25,00 100 30%
Net Profit Ratio =-Net Profitxx100=437,.500x 100 17%
Sales 7,50,000
( Interpretation: This ratio indicates ;
() The average net margin earned on 100 of sales.
() The percentage of sales that is left to pay dividend and create reserves.
Ci) The capacity of a firm to withstand adverse economic situations such as competition
low demand, etc.
The higher the ratio, better is the overall profitability. It is used as an index of efficiençy
as well as profitability.
3. Operating Profit Ratio
(a) Meaning: This ratio establishes relationship between operating profit and net sales.
(b) Purpose: The purpose of calculating this ratio is to measure the operational efficiency
of a business. It indicates howa firm performs its normal business operations profitably.
(c) Formula: The following formula is used to calculate the operating profit ratio.

Operating Profit
Operating Profit Ratio x 100
Net Sales
(d) Components :
i) Net sales Sales = -

Sales return.
(i) Operating profits =
Sales Operating
-

cost.
Operating cost =
Cost of goods sold + Adm.
expenses +Selling and distribution expens
Or, Operating Profit =
Gross profit Cost of
Or, Operating Profit =
Net Profit +
administration and selling.
(e) Example: Calculate
Non-operating expenses Non-operating imc
-

operating profit ratio from the

following data
Cost of Goods sold 7 4,00,000
Gross profit ratio 20% on sales
Operating expenses 50,000
Non-operating expenses 12,000
ution:
Net sales =
Cost of Goodssold +Gross Profit
=
7
4,00,000 +25% of cost of goods sold
= 4,00,000 + 1,00,000 = 5,00,000
Operating cost =
Cost of goods sold + operating
expenses
=
R 4,00,000+ 50,000 7 4,50,000 =

Operating Profit = Net sales - Operating cost

=
5,00,000-F 4,50,000 50,000d
Operating Profitx 100=- 50,000 100 =10%
Operating Profit Ratio Net Sales T5,00,000
x
4. Operating Ratio
establishes relationship between operating
cost and
net sales
(a) Meaning: This ratio
the operational effiei
Purpose The purpose of calculating this ratio is to evaluate
(b) :
administration and selling activi
with which various operations of purchase production,
or
es
are carried out.

(c) Formula
Operating Cost
x 100
Operating Ratio Net Sales
(d) Components:
(i) Operating cost = Cost of Goods sold + Operating Expenses.

(i) Net Sales =

Gross sales -

Return inward.
(e) Example: Considering the above example,
We find operating cost 7,25,000 and Sales 8,50,000

So, Operating Ratio 7,25,000, 100 85.3 %

8,50,000
2. Return on
Shareholders' Fund
(a) eaning: The relationship between Net Profit (after interest and tax) and shareholders
Fund is established through this ratio. This ratio tells us the percentage earned on
shareholders investment.
(b) Objective: The purpose of calculating this ratio is to examine how efficiently the fund
provided by the shareholders (Equity + Preference) have been used.
(c) Example:
Net profit after Interest and Tax x
Return on Shareholders' Fund 100
Shareholders' Fund
(d) Components :
() Net profit is to be taken after deducting interest and tax.
(i) Shareholders' Fund =
Equity share capital XXX

Add: Pref. Share capital XXX

Add: Reserves and Surplus XXX

XXX

Less: Fictitious Assets xx

Shareholders' Fund XXX

(e) Example: From the following information calculate return on shareholders' Fund.
Net profit before Interest and Tax 1,55,200
Interest charges 40,000
Tax rate 50%
Equity share capital T 2,00,000
6% Preference share capital 7 2,00,000
Reserve and Surplus
.

Capital Reserve 30,000

Revenue Reserve 40,000
Reserve for contingency 7 10,000
Solution:
share capital +Preference
share capital +
Shareholders' fund =
Equity
Reserves and surplus
=2,00,000 + 2,00,000 + 80,000 7 4,80,000
Net Profit before Interest and Tax
1,55,200
Less: Interest 40.000
Net profit before Tax 1,15,200
Less: Tax (50%) 57.600
Net profit after Interest and Tax 57.6000
Net profit afterInterest and Tax.
100
Fund
Return on shareholders Shareholders' Fund

57,600x 100 =12%

4,80,000
() Interpretation : This ratio indicates the rate of return earned on shareholders' investment
It tells us the return on 7 100 investment ofshareholders fund. It expresses the abilt
of a firm to generate profit on shareholders' investment. A higher ratio indicates me
efficiency in managing and utilising sharcholders investment. This ratio should be compard
with the ratio of previous years or with the ratio of similar firms or with the industy
average in order to judge whether the ratio is satisfactory.
3. Return on Equity Share Capital
(a) Meaning: Equity shareholders are the real owners of a tcompany. They get the residual
profit after payment of dividend (at a fixed rate) to the preference shareholders.
the Therefore
equity shareholders are interested to know the percentage of earning on ther capial
So, this ratio is calculated. This ratio establishes
Interest and Tax and Equity Shareholders' Fund.
relationship between Net profit ye
(b) Purpose : The objective of calculating this ratio is to examine how efficiently the ruw
provided by equity shareholders have been used.
(c) Formula:

Return Net Profit after Int. & Tax- Pref. Dividend

on
Equity Shareholders Fund
Equity Shareholder' Fund
(d) Components:
0 From the net profit before interest and tax
deduct interest and tax first. Then fron
this, subtract dividend payable to the

claim of equity shareholders on the preference shareholders in order to

finu
net
profit.
Equity shareholders' Fund = Equity Share ous

Assets Capital + Reserves and Surplus- F

 Eyample: From the following information calculate return on equity share capital.
(e)
Equity share capital 1,00,0000
Reserves 50,000
8% Pref. share capital T1,00,000
Miscellaneous Expenses 20,000
profit before Interest and Tax 56,600
Net
Interest 712,000
Tax Rate 50%
Solution
Equity shareholders' Fund =Equity share capital + Reserves Miscellaneous Expenses
=
1,00,000 + 50,000 7 20,000 1,30,000
Net Profit before Interest & Tax 7 56,600
Less Interest 12,000
T 44,600
Less Tax (50%) 22.300
22,300
Less: Preference Dividend 8% on 1,00,000 _8,000
Profit available for Equity 14.300
Profit available for Equity shareholders
x x 100
Rcturn on Equity shareholders' Fund Equity shareholders' Fund

14,300D x 100= 11%

1,30,000
1. Debt - Equity Ratio
insolvency. This ratio establishes rol.
(a) Meaning:
between
Excess liabilities tend
long-term debt and
to
shareholders
cause

fund to examine the proportion of of h

ortion tlong-tionsetmiy
used by a company.
debt in the total capital
this ratio is to find out the relative
(b) Purpose: The purpose of calculating
the assets of a firm.
roportion ef
prono.

debt and equity in financing

Long -term Debt.

(c) Formula: Debt-Equity Ratio Shareholders' Fund

Outsiders Fund External Equities

or, Debt-Equity Ratio Shareholders Fund Internal Equities

expressed
It is as a pure ratio is the form of say 2: 1.

(d) Components:
) Long-term debt includes debentures, bonds, public deposits and loan from financial
institutions maturing after one year.
(i) The denominator consists of equity share capital plus reserves and surplus mins
fictitious assets such as preliminary expenses, discount on issue of shares, Profit
Loss A/c (Dr. balance), advertisement expenses not written off, etc.
N.B. Redeemable preference capital may be included in debt. Irredeemable preference capital
may be treated as owner's capital.
(d) Example: From the following information calculate Debt-Equity Ratio.
Equity Share capital 7 3,00,000
Pref. Share capital (irredeemable) T2,00,000
Reserves and surplus 50,000
10% Debentures 7 3,00,000
Mortgage Loan 1,00,000
Preliminary expenses 50,000
Trade Creditors 1,00,000
Bills payable 40,000
Solution:

Debt-Equity Ratio Long-term Debt

Shareholders' Fund
Long-term Debt =
Debentures +
Mortgage Loan
=
3,00,000 +
1,00,000 7 4,00,000
=

Shareholders Fund = Equity share capital + Irredeemable Pref. share capital

+Reserves -Preliminary expenses

=
7 3,00,000 + 2,00,000 +7
50,0007 50,000 =
7 5,00,000
2. Proprietory Ratio (Equity Ratio)
(a) Meaning : This ratio expresses the rclationship between proprietor's fund (Shareholders
Fund) and Total Assets.
b) Purpose: The purpose of calculating this ratio is to find out the percentage of total
assets that is financed out of sharcholders' fund.
(c) Formula
Shareholders' Fund100
x
Proprietory Ratio Total Assets
(d) Components:
() Total assets exclude fictitious assets.
(ü) Shareholders' Fund Equity share capital+ Preference share capital + Reserves and
surplus Fictitious assets.
(e) Example: Find the proprietory ratio from the following data
Fixed assets 7,00,000
Current assets 3,00,000
Profit/Loss A/c (Dr.) 38,000
Underwriting commission 12,000
Equity share capital T3,00,000
Pref. share capital 2,00,000
Reserves 90,000
3. Solvency Ratio
between Total Liabilities to Outeid
(a) Meaning : This ratio establishes relationship ers and
Total Assets.
this ratio is to find out the percentage
Purpose : The objective of calculating
the outsiders in the assets of a company.
percentage claim of
ela

(c) Formula:
Total Liabilities to Outsiders
) Solveney Ratio x100
Total Assets
(ii) or, Solvency Ratio 100% Proprietory Ratio.
= -

(d) Components:
G) Total liabilities to outsiders = Debentures +Other long-term debt + Currentliabilities
IES.
(ii) Total assets exclude fictitious assets.

(e) Example : From the following information calculate proprietory Ratio and Solvenay
Ratio.
Balance Sheet
Liabilities Amt.() Assets Amt.()
Equity share capital 4,00,000 Fixed Assets 7,00,000
12% Pref. share capital 2,00,000 Current Assets 4,00,000
Reserves 1,20,000 Fictitious Assets 1,00,000
10% Debentures 3,00,000
Long-term loans 50,000
Current Liabilities 1,30,000
12.00.000 12,00.000
Solution:

golhareholders'
Shareholders Fund Equity
=
share capital +
Preference share capital
apital ++ Reserves
Reserves
Fictitious Assets =

4,00,000+7 2,00,000 + 1,20,000

=T6,20,000.
7 1,00,000
Total Assets Fixed Assets + Current Assets 7
7,00,000+ 74,00,000 7 11,00,000
=

Tiability to outsiders= Debentures Long-term loan + Current

+
Liabilities.
3,00,000 + 50,000+ 1,30,000 =R4,80,000
=

Shareholders' Fund
Proprietory Ratio Total Assets 11,00,000
6,20,000x 100
x 100= 56.37%

Total Liabilities to outsiders 4,80,000 100

() Solvency Ratio = 43.63%
Total Assets 11,00,000
or, Solvency Ratio = 100% - Proprietory Ratio = 100% 56.37% = 43.63%

( Interpretation: This ratio explains the percentage of outsiders claim in the assets of the
firm Traditionally, a solvency ratio of 50% or less is considered to be satisfactory.
This ratio throws light on the general financial strength of the company. It is of great
iportance to creditors as it enables them to find out the proportion of outsiders liabilities in the
xal assets of the firm. A low solvency ratio indicates a relatively secure position to creditors
while a high solvency ratio implies greater risks to them.
4 Capital Gearing Ratio
(a) Meaning : This ratio establishes relationship between fired interest bearing securities
and 'Equity shareholders Fund'
the proportion of fixed
(0) Purpose: The objective of calculating this ratio is to find out
nterest bearing securities and equity shareholders'
fund and hence it tries to examine the
fixed interest charges.
margin of safety available to the suppliers of funds bearing
Fixed Interest bearing Securities
) Formula: Capital Gearing Ratio Equity Shareholders' Fund

d) Components :
of interest. It includes
The numerator consists of the funds
that carry fixed rate
bonds and other loans on which a company
debentures, Preference share capital,
pays fixed rate of interest.
+ Reserves and surplus
Equity shareholders' Fund consists of Equity share capital
- Fictitious Assets.