Chapter 16. Accounting Ratios – Financial Accounting

Chapter 16

Accounting Ratios

LEARNING OBJECTIVES

After studying this chapter, you would be able to understand

  1. Meaning of Ratio and Ratio Analysis

  2. Objective of Ratio Analysis

  3. Advantages and Uses of Ratio Analysis

  4. Limitations of Ratio Analysis

  5. Classification of Ratios

  6. Liquidity Ratios – Computations

  7. Solvency Ratios – Computations

  8. Profitability Ratios – Computations

  9. Activity Ratios – Computations

  10. Ratios

INTRODUCTION

Usually the accounting goal in preparing financial statements is to provide valuable information to its different types of users. They mainly concentrate on collecting financial data and preparing financial statements — Balance Sheet and Income Statement. These statements provide only certain figures for its components. In order to make the information more useful, these financial statements are analysed by applying different techniques. One such technique or tool employed for analysing financial statements is “Ratio Analysis”, the corner stone of financial analysis is the use of ratios. As ratios capture critical dimension of the economic performance of business entities, the study of ratio analysis has gained much importance now-a-days. Numbers depicted in financial statements are hard to understand out of context. For example, “Profit Rs 2,50,000” — shown in income statement cannot reveal the exact real meaning unless it is analysed with other items (components), that is, how much capital is employed to achieve this profit. Likewise, this may be analysed by comparing with other components — sales, total assets, selling expenses, administration expenses and so on. Role of ratio analysis is vital, in such scenario. A financial ratio is computed by dividing one number (component/item) by another number. For a set of financial statements, a number of ratios can be computed. Only such ratio analysis can help give true meaning to the numbers in the Balance Sheet as well as income statements. The basic financial ratios help us to put numbers in perspective. By relating one part of the financial statements to another, they facilitate to answer a number of questions. In this chapter, important ratios, namely Liquidity Ratios, Solvency Ratios, Activity Ratios and Profitability Ratios are dealt with in analysis of financial statements.

OBJECTIVE 1: MEANING OF RATIO ANALYSIS–A SYSTEMATIC USE OF RATIOS TO INTERPRET THE PERFORMANCE OF ENTITIES

1.1 Meaning of Ratio and Ratio Analysis

A “Ratio” is described as arithmetical expression of relationship between two related items. Here, items represent the various components that constitute the financial statements. As these components have cause and effect relationship, arithmetical relationship between such components attains much significance. Accounting Ratios are nothing but ratios that are compared on the basis of accounting information provided by financial statements.

Ratio Analysis is a tool or technique employed to analyse the financial statements. Ratio Analysis is a process of interpreting relationship between the components (item) of financial statements thereby extending a meaningful information about business entities. Ratio Analysis is an accounting tool utilised in analysis, interpreting the various items in financial statements and reporting in understandable terms to its users. Myers explained it as, “Ratio Analysis is a study of relationship among various financial factors in a business”.

Ratio Analysis is a systematic use of ratios to interpret the financial statements in order to determine the performance and financial condition of the business enterprises. The term Accounting Ratios refers to the numerical relationship between two components/items/variables of the financial statements. This relationship can be expressed as

  1. Proportion say, for example the relationship between two variables – current assets and current liabilities (assuming current assets of Rs 1,50,000 and current liabilities of Rs 50,000). Current assets/Current liabilities

    = Rs 1,50,000/Rs 50,000 = 3:1.

    The relationship between two variables is expressed in the ratio form as 3:1 (proportion of numbers).

  2. The relationship can be expressed in terms of percentage say, net profits are 20 percent of sales (assuming net profit of Rs 20,000 and sales of Rs 1,00,000).

    Net Profit/Sale× 100 = Rs 20,000/Rs 1,00,000×100 = 20%

    (or)

  3. The same relationship can be expressed in fraction:

    Net Profit is 1/5th of Sale = 20,000/1,00,000 =1/5 (or) 0.2

    (or)

  4. The relationship can be expressed in “a number of times” – say the relationship between two items, net sales and current assets (assuming net sales of current assets turnover ratio) = Net Sales/Current Assets = 1,00,000/20,000 is expressed in “a number of times” as 5.

These alternative methods of expressing variables which are related to each other (interdependent) are referred to as Ratio Analysis. Such analysis facilitates to make better decisions on the overall performance of business organisations.

1.2 Ratio Analysis

The main objectives are:

  1. To judge the earning capacity of enterprises
  2. To ascertain the financial position (liquidity and solvency) and
  3. To determine the operating efficiency of business entities.

One would be able to understand broad objectives from the advantages of Ratio Analysis.

OBJECTIVE 2: ADVANTAGES AND USES OF RATIO ANALYSIS

1. Effective Tool in Analysis of Financial Statements: Final accounts of any enterprise is analysed by means of ratios, thereby all of them – bankers, investors, creditors etc.,are in a position to understand the financial position of such enterprises.

2. Easy and Simple in Application: These ratios summarise briefly the results of detailed and complicated accounting computation.

3. Liquidity Position: Ratios are an effective tool in assessing the firm‘s ability to meet its short-term obligations. Liquidity Ratios play an important role.

4. Long-term Solvency: Ratio Analysis is useful in analysing the long-term financial strengthness of a business entity. Profitability Ratio‘s role is significant in determining such capacity of a firm.

5. Judging Operating Efficiency: Activity Ratios are very useful in assessing the operating efficiency of a business concern. Sales revenue mobilised by effective utilisation of assets –is best ascertained by using Activity Ratios.

6. Tools for Forecasting: Ratios are very much useful in planning, execution and forecasting of any business related activities. Trend Ratios facilitate these tasks.

7. Overall Profitability: The management of any business enterprise is interested in the overall capability, i.e. (i) ability to meet its short-term and long-term needs to its creditors (ii) to ensure a reasonable return to its owners and (iii) to secure optimum and effective utilisation of the assets of the firm. All the ratios play an effective role in assessing the overall profitability of a concern.

8. Diagnosis and Remedial Measures: Even though the overall profitability is said to be normal, these ratios act effectively in spotting out the weak spots in the business components and suggesting measures to be taken to plug the loop-holes.

9. Intra-firm Comparison: The performance of different units belonging to the same business firm can be easily compared with Ratio Analysis. In an unit of the same firm, progress can be motivated and slackness can be averted by such intra-firm comparisons.

10. Inter-firm Comparison: Comparison of a firm‘s performance with other business firms is called inter-firm comparison. Such comparison exposes a firm‘s position against its competitors. Adverse results will help to rectify and modify its planning to achieve the desired results in the industry.

11. Trend Analysis: To sail among the other industries, to know the direction of movement, this trend analysis can render the necessary assistance.

OBJECTIVE 3: LIMITATIONS OF RATIO ANALYSIS

1. Results not Reliable: Reliability of ratio and its analysis depends on the correctness of financial statements. So the results obtained on the basis of any defective financial statements may also be not reliable.

2. Difficulty in Comparison: Various firms may adopt different procedures for the various activities of the enterprise. Differences may be due to

  1. Method of inventory valuation (First-In-First-Out (FIFO), Last-In-First-Out (LIFO) etc.)
  2. Method of computing depreciation (WDV, Straight Line)
  3. Working life of assets estimation
  4. Amortisation of intangible assets (goodwill, patents)
  5. Capitalisation of certain items
  6. Treatment of extraordinary items etc.
  7. Different accounting period, procedures

Due to such variations among the industries, comparisons may not be easy, reliable and accurate.

3. Price Level Changes: Frequent changes in price level will affect the compatibility of ratios. At times of inflation, such comparison will not yield the desired results.

4. Different Concepts: There are always different opinions about accounting concepts and computation techniques of various ratios. This conceptual diversity affects the effectiveness of Ratio Analysis. Different meanings and different approaches affect comparison.

5. Not Qualitative Analysis: As Accounting Ratios are tools of quantitative analysis, qualitative factors are ignored or over-rided.

6. Window Dressing: Manipulation of values are always in practice by concealing the real facts. Ratios are affected by window dressing of figures.

7. Not a Standard Yardstick: There is no standard ratio in practice to compare any of the components of business enterprise. It is difficult to evolve a common standard ratio, which is acceptable by all and at all times.

8. Insignificant Factors: Even if the figures of a business entity are not really significant, Accounting Ratios are computed. Such ratios may not be of much use for any financial analyst.

9. Personal Bias: While preparing financial statements, personal judgment plays a crucial role and as such these ratios are also not free from this limitation. So, such conclusions based on personal bias will be a standard one.

OBJECTIVE 4: CLASSIFICATION OF RATIOS OR TYPES OF RATIOS

Ratios may be classified as:

  • Liquidity Ratios (Short-term solvency)
  • Solvency Ratios
  • Profitability Ratios
  • Activity Ratios
OBJECTIVE 5: LIQUIDITY RATIOS

These ratios measure the short-term solvency of a concern. These ratios measure the firm‘s ability to pay off current dues (i.e., repayable in a year). In other words, liquidity means the ability to meet short-term obligations. (A liquid asset is one that can very easily be converted in to assets.) Liquidity Ratios may further be classified as:

  • Current Ratio
  • Liquid Ratio
  • Absolute Liquid Ratio

5.1 Current Ratio – Relationship of Current Assets to Current Liabilities

  1. The relationship of current assets to current liabilities is termed as “Current Ratio”.
  2. Short-term financial position is assessed by computing this ratio.
  3. Current Ratio serves also as an indicator to assess short-term obligations of a concern.
  4. This is calculated at a particular date and NOT for a particular PERIOD.
  5. The ratio is computed as: Current Ratio = Current Assets/Current Liabilities.
  6. Current Assets: The assets, which are in the form of cash or cash equivalents or can be converted into cash in a short time are current assets. These are
    1. Cash and Bank balance
    2. Sundry debtors (after deducting provision)
    3. Bills receivable (after deducting provision)
    4. Stock
    5. Short-term investment
    6. Marketable securities
    7. Prepaid expenses
    8. Advance payment
  7. Current Liabilities: Liabilities, which are repayable in short time. These are:
    1. Sundry creditors
    2. Bills payable
    3. Overdraft (Bank/Bills)
    4. Short-term loans
    5. Outstanding expenses
    6. Provision for Tax
    7. Unclaimed Dividend
  8. Any enterprise should have a reasonable Current Ratio, satisfactory level is 2:1. A higher ratio indicates poor investment policy, and a lower ratio reveals lack of liquidity and shortage of working capital.
  9. The excess of current assets over current liabilities is known as working capital.

Computation of Current Ratio

Illustration: 1

From the following, compute Current Ratio.

 

 

 

Rs

 

Stock

36,500

 

Sundry Debtors

63,500

 

Cash-in-hand and Cash in Bank

10,000

 

Bills Receivable

9,000

 

Short-term Investments

30,000

 

Prepaid Expenses

1,000

 

Bank Overdraft

20,000

 

Sundry Creditors

25,000

 

Bills Payable

16,000

 

Outstanding Expenses

14,000

Solution

 

Step 1:

Students have to classify and list out the Current Assets. They are: Stock, Sundry Debtors, Cash-in-hand/Bank, Bills Receivable, Short-term Investments, Prepaid Expenses.

Step 2:

Value of all these Current Assets have to be added and total value of Current Assets is calculated.

Step 3:

Now, Current Liabilities have to be sorted out. They are: Bank Overdraft, Sundry Creditors, Bills Payable and Outstanding Expenses.

Step 4:

Value of all these Current Liabilities have to be added together and total value of Current Liabilities is arrived at.

Step 5:

Current Assets/Current Liabilities = Current Ratio

(a)Total value computed as in Step 2 and Step 4 to be taken into account.

 

 

Here, value of Current Assets

=

Rs 1,50,000

 

         Current Liabilities

=

Rs 75,000

 

         Current Ratio

=

Rs 1,50,000/Rs 75,000

 

 

=

2:1

 

Step 6:

Conclusion: Current Ratio is at normal level.

Computation of Current Ratio from Balance Sheet

Illustration: 2

From this Balance Sheet of Prasadh and Co. Ltd, compute the Current Ratio.

 

Balance Sheet as on Mar 31, 2006

Solution

 

Step 1:

Total value of all Current Assets have to be calculated first.

Step 2:

Here, if Balance Sheet is given, students have to pick up from the assets side, items belonging to current assets.

Step 3:

Here, except Fixed Assets, all the other items, that is, Stock, Debtors and Cash are Current Assets. Its total value = Rs 12,000 + Rs 7,500 + Rs 10,500 = Rs 30,000/-

Step 4:

Next step is to pick up the Current Liabilities alone from the Liabilities side of the Balance Sheet. Here Bank Overdraft and Creditors are Current Liabilities. Its total value = Rs 7000 +Rs 8000 = Rs 15,000

Step 5:

Current Ratio: Current Assets/Current Liabilities
= 30,000/15,000
= 2:1

Step 6:

Conclusion: The Current Ratio is at normal level.

Current Ratio from Working Capital

Illustration: 3

From the following, calculate the Current Ratio.

 

 

 

 

Rs

 

Liquid Assets

:

40,000

 

Stock

:

30,000

 

Prepaid Expenses

:

10,000

 

Debtors

:

20,000

 

Working Capital

:

75,000

Solution

Here, working capital is given.

Step 1: So, students have to find out the value of Current Liabilities by using the formula:

 

(As Working Capital

=

Current Assets – Current Liabilities)

Current Liabilities

=

Current Assets – Working Capital

Value of Current Assets

=

Liquid Assets × Stock Debtors × Prepaid Expenses

 

=

Rs 40,000 × Rs 30,000 × Rs 20,000 × Rs 10,000 = Rs 1,00,000

 

Step 2: Current Liabilities

=

Current Assets — Working Capital

 

=

Rs 1,00,000−Rs 75,000 (given)

 

=

Rs 25,000

 

Step 3: Current Ratio

=

Current Assets/Current Liabilities

 

=

1,00,000/25,000

 

=

4:1

 

Step 4:

Conclusion: Current Ratio is at a higher level. It indicates poor investment policy of the concern, as huge amount of assets lie idle.

Current Ratio from Capital Employed

Illustration: 4

A company has Total Assets of Rs 3,00,000, Fixed Assets: Rs 1,50,000, Capital Employed: Rs 2,70,000. Calculate the Current Ratio.

Solution

Step 1: Total assets and fixed assets are given. So Current Assets have to be worked out.

 

    Current Assets

=

Total Assets − Fixed Assets

 

=

Rs 3,00,000 − Rs 1,50,000

 

=

Rs 1,50,000

Step 2: From the value of capital employed and total assets, Current Liabilities have to be computed.

 

    Current Liabilities

=

Total Assets − Capital Employed

 

=

Rs 3,00,000 − Rs 2,70,000

 

=

Rs 30,000

 

Step 3: Current Ratio

=

Current Assets/Current Liabilities

 

=

1,50,000/30,000

 

=

5:1

Step 4: Conclusion: Current Ratio is 5:1. It is above normal level.

Current Ratio from Debts

Illustration: 5

Calculate Current Ratio from the following:

 

 

 

Rs

    Working Capital

:

80,000

    Total Debt

:

60,000

    Long-term Debt

:

40,000

Solution

Step 1: Value of current liabilities is to be calculated first, if these datas alone are given.

 

    Current Liabilities

=

Total Debt − Long-term Debt

    (i.e., Short-term Debt)

 

=

Rs 60,000 − Rs 40,000

 

=

Rs 20,000

Step 2: Next step is to find the value of Current Assets.

 

    Current Assets

=

Working Capital + Current Liabilities

 

=

Rs 80,000 + Rs 20,000

 

=

Rs 1,00,000

 

Step 3: Current Ratio

=

Current Assets/Current Liabilities

 

=

1,00,000/20,000

 

=

5:1

Step 4: Current Ratio is at a higher level.

Treatment of Value of Goods Purchased

Illustration: 6

A company has Current Assets of Rs 2,50,000 and Current Liabilities Rs 1,50,000. Afterwards it purchased goods for Rs 50,000 on credit. Calculate Current Ratio after the purchase.

Solution

Note: Value of Current Assets and Current Liabilities, value of goods purchased are given.

* Value of goods purchased is on credit.

Important: So, it comes under both Current Assets and Current Liabilities.

* So, this value has to be added with liabilities and assets.

 

   So Current Assets

=

Rs 2,50,000 + Rs 50,000

   Current Liabilities

=

Rs 1,50,000 + Rs 50,000

       Current Ratio

=

3,00,000/2,00,000

 

=

3:2

Treatment of Creditors

Illustration: 7

Current Liabilities of a company are Rs 2,00,000/-, Current Ratio = 2.5:1. After this, it paid to X, a creditor of Rs 50,000. Calculate Current Ratio after payment to the creditor.

Solution

 

Step 1:

Current Ratio and Current Liabilities are given. From this, Current Assets have to be calculated.

 

    Current Ratio

=

Current Assets/Current Liabilities

    Current Assets

=

Current Ratio × Current Liabilities

 

=

2.5 × Rs 2,00,000

 

=

Rs 5,00,000

 

Step 2:

Payment of Rs 50,000 is given to the creditor. This has to be adjusted on both Current Assets and Current Liabilities.

 

    So, after payment

    Current Assets = Rs 5,00,000 − Rs 50,000 = Rs 4,50,000

    Current Liabilities = Rs 2,00,000 − Rs 50,000 = Rs 1,50,000

 

Step 3: Current Ratio

=

4,50,000/1,50,000

 

=

3:1

Treatment of Value of Current Assets

Illustration: 8

The ratio of Current Assets to Current Liabilities is 3:1, value being Rs 3,00,000 and Rs 1,00,000 respectively. The accountant of that firm is firm to maintain Current Ratio at 2:1 by acquiring Current Assets on credit being standard levels. You are required to assist him by suggesting the amount of Current Assets to be bought.

Solution

Step 1: Let the value of Current Assets to be required be = X (assumed)

 

Step 2: Current Ratio

=

Current Assets /Current Liabilities

 

 
=

 

=

(1,00,000 + X) 2 = (3,00,000 + X) 1

 

=

2,00,000 + 2X = 3,00,000 + X

                    2X − X

=

3,00,000 − 2,00,000

                            X

=

1,00,000

Current Assets to be acquired to maintain 2:1 Current Ratio = Rs 1,00,000.

5.2 Liquid Ratio or Quick Ratio or Acid Test Ratio

  1. Liquid Ratio is a relationship of liquid assets with current liabilities.
  2. This ratio is used to assess the firm‘s short-term liquidity. (Solvency)
  3. Liquid Assets = Current Assets – (Stock + Prepaid Expenses)
  4. This ratio is an indicator to assess the short-term debt paying capacity of a concern.
  5. This ratio is of high importance for Banks and other financial institutions.
  6. Liquid Ratio is computed as:
  7. Liquid Ratio = Liquid Assets/Current Liabilities
  8. Liquid Ratio of 1:1 is generally taken as a favourable one.
  9. A high Liquid Ratio indicates understocking.
  10. A low Liquid Ratio indicates overstocking.

Treatment of Liquid Assets

Illustration: 9

Calculate “Liquid Ratio” from the following:

 

 

 

Rs

 

Current Liabilities

80,000

 

Current Assets

1,20,000

 

Stock

30,000

 

Prepaid Expenses

10,000

 

Sundry Debtors

50,000

Solution

Step 1: First, Liquid Assets have to be calculated

  1. Liquid Assets

    =

    Current Assets − (Stock + Prepaid Expenses)

     

    =

    Current Assets − (Stock + Prepaid Expenses)

     

    =

    Rs 1,20,000 − (Rs 30,000 + Rs 10,000)

     

    =

    Rs 1,20,000 − Rs 40,000

     

    =

    Rs 80,000

    or

  2. It may also be deducted one by one from current assets, as

Current Assets – Stock – Prepaid Expenses. [Students may choose whichever is easier for them, either (i) or (ii).]

 

Step 2: Liquid Ratio

=

Liquid Assets/Current Liabilities

 

=

Rs 80,000/Rs 80,000

 

=

1:1

Conclusion: Liquid Ratio is said to be at a normal and satisfactory level.

Computation of Current Ratio and Liquid Ratio

Illustration: 10

Sonali Ltd furnished the following information regarding its Current Assets and Current Liabilities:

 

 

Current Assets

Rs

 

Cash

5,000

 

Sundry Debtors

35,000

 

Bills Receivable

10,000

 

Marketable Securities

20,000

 

Prepaid Expenses

8,000

 

Stock

62,000

 

Total

1,40,000

 

 

Current Liabilities

 

 

Sundry Creditors

40,000

 

Bills Payable

25,000

 

Outstanding Expenses

5,000

 

Total

70,000

You are required to compute

  1. Current Ratio,
  2. Liquid Ratio,
  3. And as an accountant, pass your opinion on the result of these ratios.

Solution

Step 1: First Current Ratio is to be calculated.

 

Current Ratio

=

Current Assets/Current Liabilities

 

=

Rs l,40,000/Rs 70,000 = 2:1

Step 2: Liquid Ratio is to be calculated.

So, Liquid Assets have to be computed.

 

    Liquid Assets

=

Current Assets − Stock − Prepaid Expenses

 

=

Rs 1,40,000 − Rs 62,000 − Rs 8,000 = Rs 70,000

    Liquid Ratio

=

Liquid Assets/Current Liabilities

 

=

1:1

Opinion

  1. Current Ratio is 2:1 which is ideal one.
  2. Liquid Ratio is 1:1 which is also ideal.

So, the position of Sonali Ltd is said to be satisfactory and ideal, based on liquidity point of view.

Treatment of Value of Stock

Illustration: 11

Current Liabilities of a company: Rs 2,50,000

Current Ratio: 2:1

Liquid Ratio: 1:1

Compute the value of stock assuming there are no other current assets.

Solution

Step 1: First, value of Liquid Assets has to be calculated, as Liquid Ratio is given.

 

    Liquid Ratio: 1:1

 

 

 

=

Liquid Assets/Current Liabilities = 1/1

 

=

Liquid Assets/Rs 2,50,000 = 1/1

    ∴ Liquid Assets

=

Rs 2,50,000

Step 2: Value of Current Assets to be calculated, as Current Ratio is given.

 

    Current Ratio

=

Current Assets/Current Liabilities = 2/1

 

=

Current Assets/2,50,000 = 2/1

    (Current Assets × 1)

=

(2 × 2,50,000)

 

=

Rs 5,00,000

Step 3: Value of stock is to be found out.

Value of Stock = Current Assets − Liquid Assets (Stock-in-trade)

Because, stock is the only current asset, as per the assumption given in the problem.

      = Rs 5,00,000 – Rs 2,50,000

      = Rs 2,50,000

Computation of Current Liabilities from Ratios

Illustration: 12

The Current Ratio of a company is 3:1 and Liquid Ratio is 1:1. Stock is Rs 5,00,000. Compute Current Liabilities.

Solution

Step 1: Since two various ratios are given, from that ratio, Current Liabilities is to be calculated.

 

    Current Ratio

=

Current Assets/Current Liabilities

 

=

3/1

    Liquid Ratio

=

Liquid Assets/Current Liabilities = 1/1

    Current Assets − Liquid Assets

=

Stock

                                    3 − 1

=

Stock

                                        2

=

Stock

    Current Liabilities = 5,00,000/2

=

Rs 2,50,000

Computation of Current Assets and Current Ratio

Illustration: 13

Total Current Liabilities of a company is Rs 3,00,000, Liquid Ratio is 4:1, Stock is Rs 3,00,000. Find the Current Assets and Current Ratio.

Solution

Step 1: Current Liabilities = Rs 3,00,000 (Given)

Liquid Ratio = 4:1 (Given)

Step 2: Liquid Ratio = Liquid Assets/Current Liabilities

         = 4:1

That means Liquid Assets are 4 times as that of Current Liabilities

 

∴ Liquid Assets

=

4 × Rs 3,00,000

 

=

Rs 12,00,000

 

Step 3: Current Assets

=

Liquid Assets + Stock

 

=

Rs 12,00,000 + Rs 3,00,000

 

=

Rs 15,00,000

 

Step 4: Current Ratio

=

Current Assets/Current Liabilities

 

=

Rs l5,00,000/Rs 3,00,000

 

=

5:1

Illustration: 14

Sharma Ltd has Liquid Ratio 2:1, stock is Rs 50,000. Total Current Liabilities is Rs 1,00,000. Compute Current Ratio.

Solution

Step 1: Liquid Ratio = 2:1 (Given)

        Liquid Ratio = Liquid Assets/Current Liabilities = 2/1

This means that the value of Liquid Assets is twice as that of Current Liabilities.

 

    Liquid Assets

=

2 – Rs 1,00,000

 

=

Rs 2,00,000

Step 2: Value of Current Assets has to be calculated.

 

    Current Assets

=

Liquid Assets + Stock

 

=

Rs 2,00,000 + Rs 50,000

 

=

Rs 2,50,000

 

Step 3: Current Ratio

=

Current Assets/Current Liabilities

 

=

Rs 2,50,000/Rs 1,00,000

 

=

2.5:1

Computation of Value of Stock

Illustration: 15

Liquid Ratio: 2:1; Current Assets: Rs 2,50,000; Current Liabilities: Rs 60,000. Compute the value of stock.

Solution

Step 1: Liquid Ratio = 2:1 (Given)

 

    Liquid Ratio

=

Liquid Assets/Current Liabilities = 2/1

    Liquid Assets

=

Current Liabilities × 2

 

=

Rs 60,000 × 2

 

=

Rs 1,20,000

 

Step 2: Value of stock

=

Current Assets − Liquid Assets

 

=

Rs 2,50,000 − Rs 1,20,000

 

=

Rs 1,30,000

Relationship of Working Capital with Current Ratio and Liquid Ratio

Illustration: 16

Working capital of a limited company is Rs 1,20,000. Current Ratio is 3:1, Stock is Rs 60,000. Compute (a) Current Liabilities (b) Current Assets (c) Liquid Ratio

Solution

From Working Capital and Current Ratio, other values are computed as follows:

Step 1: Working Capital = Current Assets – Current Liabilities

   Rs 1,20,000 = Current Assets − Current Liabilities

Step 2: Current Ratio = Current Assets/Current Liabilities = 3/1

Step 3: Assume Current Liabilities = X

        Then, Current Assets = 3 × X (as ratio is = 3:1)

Step 4: Go to first step,

 

i.e., Current Assets – Current Liabilities

=

1,20,000

                                              3X – X

=

1,20,000

                                                    2X

=

1,20,000

                                                       X

=

Rs 60,000 (Current Liabilities)

 

Step 5: Current Assets

=

Rs 60,000 × 3

 

=

Rs 1,80,000

 

Step 6: Liquid Assets

=

Current Assets − Stock

 

=

Rs 1,80,000 − Rs 60,000

 

=

Rs 1,20,000

 

Step 7: Liquid Ratio

=

Liquid Assets/Current Liabilities

 

=

1,20,000/60,000 = 2/1

 

=

2:1

5.3 Absolute Liquid Ratio – Relationship of Absolute Liquid Assets to Liquid Liabilities

The relationship of absolute liquid assets to liquid liabilities is termed as “Absolute Liquid Ratio”. It is calculated as:

Absolute Liquid Ratio = Absolute Liquid Assets/Liquid Liabilities

Absolute Liquid Assets = Cash, Bank and Short-term Investments.

Liquid Liabilities = Current Liabilities – Bank overdraft. Satisfactory level of ratio is 1:1.

Computation of Absolute Liquid Ratio

Illustration: 17

A limited company has Current Liabilities of Rs 1,00,000. It has Cash-in- hand Rs 5,000, Cash at Bank Rs 45,000, Short-term Investments Rs 50,000. Further Bank Overdraft is Rs 25,000. Compute Absolute Liquid Ratio.

Solution

Step 1: First, value of absolute Liquid Assets has to be calculated.

 

    Absolute Liquid Assets

=

Cash + Bank + Short-term Investment

 

=

Rs 5,000 + Rs 45,000 + Rs 50,000

 

=

Rs 1,00,000

Step 2: Value of Liquid Liabilities has to be calculated, now.

 

    Liquid Liabilities

=

Current Liabilities − Bank Overdraft

 

=

Rs 1,00,000 − Rs 25,000

 

=

Rs 75,000

 

Step 3: Absolute Liquid Ratio

=

Absolute Liquid Assets/Liquid Liabilities

 

=

Rs 1,00,000/Rs 75,000

 

=

1 : 0.75

OBJECTIVE 6: SOLVENCY RATIOS (LONG-TERM SOLVENCY)
  • Solvency Ratios deals with entity’s ability to meet its long-term obligations.
  • Solvency refers to the firm’s ability to meet its long-term indebtedness.
  • The following are important Solvency Ratios:
    1. Debt Equity Ratio
    2. Total Assets to Debt Ratio
    3. Proprietary Ratio

6.1 Debt Equity Ratio

6.1.1 Debt Equity Ratio – Relationship between Debt and Equity

  1. This ratio is computed to ascertain the soundness of the long-term financial position of the concern.
  2. This ratio indicates the proportion between debt (external equities) and the equity (internal equities).
  3. Debt Long-term loans: Debentures, long-term loans from Banks and financial institutions. Equity: Shareholder’s funds: Equity Share capital, Preference share capital, Reserves and surplus loss, Losses and fictitious assets (e.g.: Preliminary expenses).
  4. This ratio is calculated as:

    Debt Equity Ratio = Debt (Long-term Loans)/Equity (Shareholder’s Funds)

  5. If it is 2:1, then the concern is said to be at a satisfactory level.
  6. A higher ratio than this normal level, i.e. 2:1 then the concern is facing a risky financial position, where as a lower ratio indicates safer financial position.
  7. It also indicates the extent to which the concern depends upon outsiders for its existence.

Computation of Debt Equity Ratio

Illustration: 18

From the following, compute Debt Equity Ratio:

 

 

Equity Share Capital

1,00,000

 

General Reserve

80,000

 

6¼% Debentures

75,000

 

Current Liabilities

90,000

 

Preliminary Expenses

30,000

Solution

Debt Equity Ratio = Debt/Equity

Step 1: Debt = Rs 75,000

(∴ Debentures only here)

 

Step 2: Equity

=

Equity Share Capital + General Reserve − Preliminary Expenses

 

=

Rs 1,00,000 + 80,000 − Rs 30,000

 

=

Rs 1,50,000

 

Step 3: Debt Equity Ratio

=

Rs 75,000/Rs 1,50,000

 

=

1:2

6.2 Total Assets to Debt Ratio

6.2.1 Total Assets to Debts Ratio – Relationship between Total Assets and Debt

The components of this ratio:

(i) Total Assets and (ii) Debt

  1. Total Assets: This include both Fixed and Current Assets. But this does not include fictitious assets as preliminary expenses, underwriting commission discount on issue of shares/debentures etc. and debit balance of Profit and Loss A/c.
  2. Debts: Long-term debts, which usually gets matured after 1 year. This includes bonds, debentures and other loans from financial institution.
    • Total Assets to Debt Ratio = Total Assets/Long-term Debts
    • Normal level is said to be at 2:1 ratio.
    • A higher ratio indicates higher security to lenders.
    • A low ratio indicates a risky financial position.

Computation of Total Assets to Debt Ratio

Illustration 19

Following is the Balance Sheet of a company as on Mar 31, 2006:

You are required to compute Total Assets to Debt Ratio.

Solution

Step 1: Total Assets = Rs 5,00,000

Step 2: Debt (Long term) = Rs 2,00,000 (Debentures only)

 

Step 3: Total Assets to Debt Ratio

=

Total Assets/Long-term Debt

 

=

Rs 5,00,000/Rs 2,00,000

 

=

5:2

6.3 Proprietary Ratio

6.3.1 Proprietary Ratio – Relationship between Proprietor’s Funds and Total Assets

  1. This ratio establishes the relationship between Proprietor’s funds and total tangible assets.
  2. This ratio reflects the general financial position of a concern.
  3. This is computed as:

    Proprietor’s Funds Proprietary Ratio = (Shareholder’s Fund)/Total Assets

  4. Proprietor’s Funds: Share capital, Reserves and surplus (loss to be deducted, payment to others not included)
  5. Tangible Assets: Good will, Preliminary expenses etc.
  6. Normal level = 100
  7. A high level indicates safety to creditors.
  8. A low (usually < 50) level assets the (investors) creditors.

Illustration: 20

From the following, calculate Proprietary Ratio:

  Rs

Equity Share Capital

1,00,000

reference Share Capital

30,000

Reserves and Surplus

20,000

Debentures

2,00,000

Sundry Creditors

50,000

 

3,00,000

Fixed Assets

2,00,000

Current Assets

30,000

Investments

70,000

 

3,00,000

Solution

  1. Shareholder’s Funds: Rs 1,00,000 + Rs 30,000 + Rs 20,000= Rs 1,50,000 (excluding debentures and creditors)
  2. Total Assets = Rs 3,00,000
  3. Proprietary Ratio = Rs l,50,000/Rs 3,00,000 = 1/2 = 0.5 or 5:1 (or) 0.5 × 100 = 50%

Computation of Proprietary Ratio from Balance Sheet

Illustration: 21

Balance Sheet of Dabar Ltd as on Mar 31, 2006 is given. From this, compute (a) Debt Equity Ratio, (b) Proprietary Ratio and (c) Total Assets to Debt Ratio

Solution

 

(a) Value of Debentures = Rs 5,00,000

    Shareholder’s Funds (Equity)

=

Equity Share Capital + General Reserve

 

=

Rs 12,00,000 + Rs 8,00,000 (Debentures)

    Debt Equity Ratio

=

Long-term Debts/Shareholder’s Funds

 

=

Rs 5,00,000/Rs 20,00,000=0.25:1

(b) Proprietary Ratio

=

Shareholder’s Funds/Total Assets

 

=

Rs 20,00,000/Rs 40,00,000 = 0.5:1 or 0.5% = 50%

(c) Total Assets to Debt Ratio

=

Total Assets/Long-term Debt

 

=

Rs 40,00,000/Rs 5,00,000

 

=

8:1

OBJECTIVE 7: PROFITABILITY RATIOS
  • Efficiency of a concern is measured by profitability.
  • Profit as compared to the capital employed indicates profitability of a concern.
  • Some important Profitability Ratios are: Gross Profit Ratio, Net Profit Ratio, Operating Profit Ratio and Operating Ratio.

7.1 Gross Profit Ratio

7.1.1 Gross Profit Ratio – Relationship of Gross Profit to Sales

  1. The relationship of gross profit to sales is termed as Gross Profit Ratio.
  2. This ratio is calculated as:

    Gross Profit Ratio = Gross Profit/Net Sales × 100

  3. Gross Profit is taken from Trading Account of an enterprise.

     

         Gross Profit

    =

    Sales − Cost of Goods Sold

       Cost of Goods Sold

    =

    Opening Stock × Purchases − Closing Stock (or)

     

    =

    Sales − Gross Profit

            Net Sales

    =

    Gross Sales (Cash Sale × Credit Sale) − Sales Returns

  4. This ratio is a good indicator to maintain the correct selling price and efficiency of trading activities.
  5. It may also be compared to previous years, which will assist the management to take vital policies.

Illustration: 22

From the following, calculate Gross Profit Ratio.

 

 

 

Rs

 

Cash Sales

50,000

 

Credit Sales

60,000

 

Sales Return

10,000

 

Gross Profit

50,000

Solution

Step 1: Value of Net Sales to be computed.

 

    Net Sales

=

Cash Sale + Credit Sale − Sales Return

 

=

Rs 50,000 + Rs 60,000 − Rs 10,000

 

=

Rs 1,00,000

Step 2: Gross Profit = Rs 50,000 (Given)

 

Step 3: Gross Profit Ratio

=

Gross Profit/Net Sales × 100

 

=

Rs 50,000/ Rs l,00,000 × 100 = 50%

Illustration: 23

From the following data, compute Gross Profit Ratio.

  2008 Rs 2009 Rs

Sales

2,00,000

2,40,000

Gross Profit

50,000

80,000

Solution

 

Gross Profit Ratio = Gross Profit/Net Sales × 100

                    Year

            Year

                    2008

            2009

Gross Profit Ratio = Rs 50,000/Rs 2,00,000 × 100

= Rs 20,000/Rs 2,40,000 × 100

                    = 25% →

= 33 1/3%

Conclusion = Profit rose from 25% to 33 1/3% this year.

Treatment of Cost of Goods Sold and Gross Profit (G.P.)

Illustration: 24

Sales of a company is Rs 7,20,000.

Gross Profit is 20% on cost. Compute Gross Profit Ratio.

Solution

Step 1: Cost of goods sold has to be calculated as:

 

        Let the cost be

=

Rs 100

            Then Sales

=

Rs 120 (100 + 20%)

    Cost of Goods Sold

=

100/120 × Rs 7,20,000

 

=

Rs 6,00,000

Step 2: Next, Gross Profit has to be calculated.

 

    Gross Profit

=

Sales − Cost of Goods Sold

 

=

Rs 7,20,000 − Rs 6,00,000

 

=

Rs 1,20,000

 

Step 3: Gross Profit Ratio

=

Gross Profit/Net Sales × 100

 

=

Rs 1,20,000/Rs 7,20,000 × 100

 

=

16.66%

7.2 Net Profit Ratio

7.1.2 Net Profit Ratio – The Relations hip of Net Profit to Net Sales

  1. The relationship of Net Profit to Net Sales is termed as “Net Profit Ratio”.
  2. Net Profit Ratio is calculated as

    Net Profit Ratio = Net Profit/Net Sales ×100

  3. This ratio reflects the overall efficiency of a concern.
  4. This ratio also helps to determine operational efficiency of an enterprise.
  5. Higher the Net Profit Ratio, better the efficiency of a concern.
  6. At times, Net Profit Ratio is calculated either Profit Before Tax (P.B.T.) (or) Profit After Tax (P.A.T.), then Net Profit Ratios will be

    P.B.T./Net Sales × 100 (or) P.A.T./Net Sales×100

  7. Net Profit is taken from P and L Account or to Gross profit less administration expenses, selling and distribution expenses, financial expenses, non-operating expenses and adding non-operating incomes.

Computation of Net Profit Ratio

Illustration: 25

Compute Net Profit Ratio from these.

   Net Profit = Rs 75,000

          Sales = Rs 3,00,000

Solution

Net Profit Ratio= Net Profit/Net Sales × 100

 

= Rs 75,000/Rs 3,00,000 × 100 = 25%

Illustration: 26

Gross Profit Ratio of a company is 20%. Its cash sales are Rs 5,00,000 and its credit sales are 80% of total sales. The indirect expenses are Rs 50,000. Calculate Net Profit Ratio.

Solution

Step 1: Total sales have to be computed.

 

    Total Sales

=

Cash Sales + Credit Sales

 

=

Rs 5,00,000 + 80% of Total Sales

    This means cash sales = 20% (100% − 80%) of Total Sales

    ∴ Total Sales

=

Cash Sales ×100/20

 

=

Rs 5,00,000 × 100/20

 

=

Rs 25,00,000

Step 2: Next, value of Gross Profit is to be computed.

 

    Gross Profit

=

Rs 25,00,000 × 20/100

 

=

Rs 5,00,000

Step 3: Value of Net Profit is to be computed.

 

    Net Profit

=

Gross Profit − Indirect Expenses

 

=

Rs 5,00,000 − Rs 50,000

 

=

Rs 4,50,000

 

Step 4: Net Profit Ratio

=

Net Profit/Net Sales × 100

 

=

Rs 4,50,000/Rs 25,00,000 × 100

 

=

18%

7.3 Operating Profit Ratio

7.3.1 Operating Profit Ratio – Relationship between Operating Profit and Net Sales

  1. This ratio measures the relationship between operating profit and net sales.
  2. This ratio helps in determining the operational efficiency of an enterprise.
  3. This ratio is calculated as:

    Operating Profit Ratio = Operating Profit/Net Sales × 100

  4. Operating Profit = Net Profit+ Non-operating Expenses –Non-operating Income

    Non-operating Expenses = Interest on Loan and Loss on sale of assets

    Non-operating Income = Dividend, Interest received and Profit on sale of asset

    Or
  5. Operating Profit = Gross Profit –Operating Expenses
  6. Net Sales = Gross Sales = Cash Sales + Credit Sales – Sales Revenue

Computation of Operating Profit Ratio

Illustration: 27

Compute Operating Profit Ratio from the following:

 

 

 

Rs

 

Net Profit

6,00,000

 

Loss on Sale of Furniture

20,000

 

Profit on Sale of Investments

60,000

 

 

Rs

 

Interest paid on Loan

60,000

 

Interest from Investment

40,000

 

Sales

11,60,000

Solution

Step 1: Non-operating expenses have to be calculated.

 

Non-operating Expenses

=

Interest on Loan + Loss on Sale of Furniture

 

=

Rs 60,000 + Rs 20,000

 

=

Rs 80,000

Step 2: Non-operating income to be computed.

 

Non-operating Income

=

Interest received from Investments + Profit on Sale of Investment

 

=

Rs 40,000 + Rs 60,000

 

=

Rs 1,00,000

Step 3: Operating profit is to be computed.

 

Operating Profit

=

Net Profit + Non-operating Expenses − Non-operating Income

 

=

Rs 6,00,000 + 80,000 − 1,00,000

 

=

Rs 5,80,000

 

Step 4: Operating Profit Ratio

=

Operating Profit/Net Sales × 100

 

=

5,80,000/11,60,000 × 100

 

=

50%

Treatment of G.P. with Sales

Illustration: 28

Calculate Operating Profit Ratio if

Case (a) Net sales Rs 10,00,000, Gross profit 20%on Sales and Operating expenses Rs 20,000

Case (b) Net sales Rs 6,00,000, Gross profit 20% on Sales and Operating expenses Rs 20,000

Solution

 

Case (a): Operating Profit

=

Gross Profit—Operating Cost

 

=

Rs 2,00,000−Rs 20,000

 

=

Rs 1,80,000

    Operating Profit Ratio

=

Operating Profit/Net Sales × 100

 

=

Rs 1,80,000/Rs 10,00,000 × 100 = 18%

Case (b): Operating Profit

=

Gross Profit—Operating Expenses

                    Gross Profit

=

20% of Sales

 

=

20/100 × Rs 6,00,000

 

=

Rs 1,20,000

            ∴ Operating Profit

=

Rs 1,20,000−Rs 20,000

 

=

Rs 1,00,000

Operating Profit Ratio

=

Operating Profit/Net Sales × 100

 

=

Rs 1,00,000/Rs 6,00, 000 × 100 = 16.66%

7.4 Operating Ratio

7.4.1 Operating Ratio – Relationship between Operating Cost and Net Sales

  1. This ratio establishes relationship between operating cost and net sales.
  2. This measures the operating efficiency of the enterprise.
  3. This ratio measures the amount of expenditure incurred in production, sales and distribution of output.
  4. Operating Ratio = Cost of Goods Sold + Operating Expenses/Net Sales × 100

     

    or

     

    Operating Ratio = Operating Cost/Net Sales × 100

  5. Cost of Goods Sold =Opening Stock + Purchases + Direct Expenses + Manufacturing Expenses – Closing Stock (or) Sales – Gross Profit
  6. Operating Expenses = Administrative Expenses + Selling and Distribution Expenses
  7. Operating Ratio and Net Profit Ratio are interrelated.

    Operating Ratio + Net Profit Ratio = 100

    Example:

20% + 80% = 100

 

 

 

or

 

40% + 60% = 100

 

 

 

or

 

70% + 30% = 100

 

 

  • Higher Operating Ratio indicates poor performance, so lower the better.
  • It is an indicator to determine the cost content, and which element of cost has gone up.

Computation of Operating Ratio

Illustration: 29

From the following, compute Operating Ratio:

 

 

 

Rs

 

Cost of Goods Sold

4,50,000

 

Operating Expenses

50,000

 

Sales

10,60,000

 

Sales Returns

60,000

Solution

Step 1: Add Cost of Goods Sold and Operating Expenses

        = Rs 4,50,000 + Rs 50,000

        = Rs 5,00,000

Step 2: Value of Net Sales has to be calculated.

 

    Net Sales

=

Sales — Sales Return

 

=

Rs 10,60,000 − Rs 60,000

 

=

Rs 10,00,000

Step 3: Operating Ratio is to be found out.

 

    Operating Ratio

=

Cost of Goods Sold + Operating Expenses/Net Sales × 100

 

=

Rs 5,00,000/Rs l0,00,000 × 100

 

=

50%

OBJECTIVE 8: ACTIVITY RATIOS
  • Activity Ratios measure the effectiveness of entities.
  • These ratios are also called as “Performance or Turnover Ratios”.
  • These ratios measures the effectiveness of a business concern.
  • It can also be known how effectively a concern utilises its resources, by using these ratios.
  • The following are some important Activity Ratios:
    1. Capital Turnover Ratio
    2. Fixed Assets Turnover Ratio
    3. Inventory (Stock) Turnover Ratio
    4. Debtors Turnover Ratio (Receivables)
    5. Creditors Turnover Ratio
    6. Working Capital Turnover Ratio

8.1 Inventory Turnover Ratio

8.1.1 Inventory Turnover Ratio – Relationship between the Cost of Goods Sold and Average Inventory

  1. This ratio establishes relationship between the cost of goods sold (during a given period) and the average amount of inventory carried (during that period).
  2. This indicates whether stock has been efficiently used or not.
  3. The ratio is calculated as follows:

    Inventory or Stock Turnover Ratio

        = Cost of Goods Sold/Average Inventory (or) Stock

  4. Cost of Goods Sold = Opening Stock + Purchase + Direct Expenses – (Less) Closing Stock

     

    or

     

    Cost of Goods Sold =Sales– Gross Profit

    Average Stock = (Opening Stock + Closing Stock)/2

    Note: If information to calculate average stock is not given in the problem then students are expected to take the closing stock as average stock.

     

  5. Higher ratio indicates the unit functions on a comparatively low margin of profit. More sales are on with (that unit of investment in stocks) a rupee of investment in stocks.
  6. This ratio also helps to invest minimum in stock.
  7. It helps business enterprises to earn a reasonable margin of profits.

Computation of Inventory Turnover Ratio

Illustration: 30

From the following, compute Inventory Turnover Ratio.

 

 

 

Rs

 

Cost of Sales

9,00,000

 

Stock at the beginning of the year

2,50,000

 

Stock at the end of the year

3,50,000

Solution

Step 1: First, average stock is to be calculated.

Average Stock

Step 2: Cost of Goods Sold = Cost of Sales = Rs 9,00,000

Step 3: Inventory Turnover Ratio = Rs 9,00,000/Rs 3,00,000 = 3 times

Computation of Stock Turnover Ratio from Trading A/c

Illustration: 31

Following is the Trading A/c of Jam Ltd. Compute Inventory Turnover Ratio.

Solution

Step 1: Cost of goods sold has to be calculated.

 

    Cost of Goods Sold

=

Sales — Gross Profit

 

=

Rs 3,00,000 − Rs 1,00,000

 

=

Rs 2,00,000

Step 2: Average stock is to be calculated.

Average Stock

Step 3: Stock Turnover Ratio

=

Cost of Goods Sold/Average Stock

 

=

Rs 2,00,000/Rs 25,000 = 8 times

Treatment of Cost of Sales

Illustration: 32

From the following, calculate Stock Turnover Ratio.

Total Sales: Rs 10,00,000, Opening Stock: Rs 2,20,000 and Closing Stock: Rs 1,80,000.

Loss Ratio = 20%.

Solution

Step 1: From Sales, Cost of Sales is to be computed.

Sales = Rs 10,00,000

Gross Loss: 20%

20% of Sales (10,00,000) = Rs 2,00,000

 

    ∴ Cost of Sales

=

Sales + Gross Loss

 

=

Rs 10,00,000 + Rs 2,00,000

 

=

Rs 12,00,000

Step 2: Average Stock has to be calculated.

Average Stock

Step 3: Inventory Turnover Ratio

=

Cost of Sales/Average Stock

 

=

Rs 12,00,000/Rs 2,00,000 = 6 times

Illustration: 33

From the following, calculate Inventory Turnover Ratio.

 

 

Rs

Opening Stock

1,00,000

Purchases

3,50,000

Sales

5,00,000

Gross Profit Ratio

20% on Sales

Solution

Step 1: First, cost of sales has to be computed.

 

    Cost of Sales

=

Sales − Gross Profit

 

=

Rs 5,00,000 − (20% of 5,00,000)

 

=

Rs 5,00,000 − Rs 1,00,000

 

=

Rs 4,00,000

Step 2: Value of Closing Stock has to be calculated.

 

    Closing Stock

=

Opening Stock + Purchases + Gross Profit − Sales

 

=

Rs 1,00,000 + Rs 3,50,000 + Rs 1,00,000 − Rs 5,00,000

 

=

Rs 5,50,000 − Rs 5,00,000

 

=

Rs 50,000

Step 3: Value of Average Stock

Step 4: Inventory Turnover Ratio

=

Cost of Goods Sold/Average Stock

 

=

Rs 4,00,000/Rs 75,000

 

=

5.33 times

8.2 Debtors Turnover Ratio or Receivables Turnover Ratio

8.2.1 Debtors Turnover Ratio –Relationship between Net Credit Sales and Average Debtors

  1. This ratio indicates the relationship between net credit sales and average debtors or receivables in a year.
  2. This ratio is calculated as:

    Debtors Turnover Ratio = Net Credit Sales/Average Accounts Receivable

  3. Accounts Receivable includes “Trade Debtors” and “Bills Receivables”.
  4. Average Debtors
  5. Doubtful debts are not deducted from total debtors.
  6. If details regarding opening and closing receivables and credit sales are not given in the problem, the Debtors Turnover Ratio =Total Sales/Accounts Receivable
  7. This ratio is calculated to determine the number of times the receivables are turned over in a period in relation to sales.
  8. It indicates how quickly debtors are converted into cash.
  9. A high ratio indicates the quickness of debts collected. Lower ratio would mean otherwise.

Debtors Turnover Ratio — Computation

Illustration: 34

The following data are taken from Shah Ltd.

 

 

Rs

Total Sales for the year 2009

4,00,000

Cash Sales for the year 2009

1,00,000

Debtors as on Jan 1, 2009

45,000

Debtors as on Dec 31, 2009

55,000

Compute Debtors Turnover Ratio.

Solution

Step 1: First, Credit Sales have to be calculated.

 

    Credit Sales

=

Total Sales − Cash Sales

 

=

Rs 4,00,000 − Rs 1,00,000

 

=

Rs 3,00,000

Step 2: Next, average debtors have to be computed.

Average Debtors

Step 3: Finally,

 

    Debtors Turnover Ratio

=

Credit Sales/Average Debtors

 

=

Rs 3,00,000/Rs 50,000 = 6 times

8.3 Working Capital Turnover Ratio

8.3.1 Working Capital Turnover Ratio – Relationship between Sales and Working Capital

  1. This ratio indicates the efficiency of working capital of a concern.
  2. This also indicates if there is over trading.
  3. This ratio is calculated as:
  4. Working Capital Turnover Ratio = Sales/Working Capital

    Working Capital = Current Assets − Current Liabilities

  5. This ratio is better than Stock Turnover Ratio.
  6. It measures the rate of working capital utilisation.

Illustration: 35

Compute Working Capital Turnover Ratio.

 

 

Rs

Cost of Goods Sold

2,80,000

Current Assets

2,05,000

Current Liabilities

1,65,000

Solution

First, working capital is to be calculated.

 

    Working Capital

=

Current Assets — Current Liabilities

 

=

Rs 2,05,000 − Rs 1,65,000

 

=

Rs 40,000

Note: As no sales figures are given, ratio is to be calculated on the basis of cost of sales.

 

   So Working Capital Turnover Ratio

=

Cost of Sales/Net Working Capital

 

=

Rs 2,80,000/Rs 40,000

 

=

7 times

Computation of Working Capital Turnover Ratio from Balance Sheet

Illustration: 36

Following is the Balance Sheet of Chopra Ltd. Compute Working Capital Turnover Ratio.

Further Information

  1. Total Sales during the year = Rs 46,00,000
  2. Sales Returns during the year = Rs 6,00,000

Solution

Step 1: First, Net Sales (or) turnover is to be computed.

 

    Net Sales

=

Total Sales − Sales Return

 

=

Rs 46,00,000 − Rs 6,00,00

 

=

Rs 40,00,000

Step 2: Next, Current Assets have to be added.

 

Current Assets

=

Short-term Investment + Stock + Debtors + Bills Receivable + Cash at Bank + Cash-in-hand

Current Assets

=

Rs 2,30,000 + Rs 1,80,000 + Rs 2,20,000 + Rs 1,10,000 + Rs 60,000 + Rs 1,00,000

 

=

Rs 9,00,000

Step 3: Next, Current Liabilities should be added together.

 

    Current Liabilities

=

Creditors + Bills Payable + Provision for Income Tax

 

=

Rs 2,80,000 + Rs 80,000 + Rs 40,000

 

=

Rs 4,00,000

 

Step 4: Working Capital

=

Current Assets — Current Liabilities

 

=

Rs 9,00,000 − Rs 4,00,000

 

=

Rs 5,00,000

Step 5: Finally,

 

   Working Capital Turnover Ratio

=

Net Sales/Working Capital

 

=

Rs 40,00,000/Rs 5,00, 000

 

=

8 times

Notes

* Both Operating Profit Ratio and Operating Ratio are complementary to each other.

* If one such ratio is deducted from 100, the other ratio can easily be obtained.

* Post-mortem Analysis: Ratio Analysis is based on past records, i.e. what happened on a particular date. Nothing is revealed in the interim period. No facts about the future is disclosed.

* Not conclusive result: A single ratio cannot be relied upon to take decisive action. Inter-related and overall analysis of all the concerned ratios can only yield the desired result to some extent. Ratios obtained by a single ratio analysis is not reliable and conclusive.

OBJECTIVE 9: RATIOS: ADVANCED LEVEL

9.1 Turnover Ratio

The ratios to determine how quickly certain current assets are converted into cash are termed as Turnover Ratios.

Some important Turnover Ratios are:

  1. Inventory Turnover Ratio
  2. Debtors Turnover Ratio
  3. Creditors Turnover Ratio

9.1.1 Inventory Turnover Ratio

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

Remember

Cost of Goods Sold = Sales – Gross Profit

Average Inventory

This ratio is expressed by………times.

High ratio indicates status of liquidity of a concern.

Low ratio indicates that the inventory stays for a long time in the warehouse, which is not advisable.

Computation of Inventory Turnover Ratio

Illustration: 37

A firm has sold goods worth Rs 4,00,000 with a gross profit margin of 25%. The stock at the beginning and at the end of the period are Rs 45,000 and Rs 55,000 respectively. Compute the Inventory Turnover Ratio.

Solution

Step 1: Cost of Goods Sold = Sales – Gross Profit

 

Sales

=

Rs 4,00,000 (Given)

Gross Profit (G.P.)

=

25% of Rs 4,00,000

 

=

Rs 1,00,000 (Profit)

 

=

(Rs 4,00,000 – Rs 1,00, 000) = Rs 3,00,000

Step 2: Average Inventory = (Rs 45,000 + Rs 55,000)/2→(Stock in the beginning + Stock at the end)/2

Step 3: Inventory Turnover Ratio = Rs 3,00,000/Rs 50,000 =6 times

Step 4: Inventory Holding Period = 12 Months/Inventory Turnover Ratio
                                                      = 12/6 = 2 months

 

9.1.2 Debtors Turnover Ratio

Formula

 

Debtors Turnover Ratio

=

Net Credit Sales/Average Debtors

Net Credit Sales

=

Gross Credit Sales – Sales Returns

Average Debtors

=

Note: Debtors include Bills Receivable.

High ratio indicates short time lag between credit sales and cash collection. A low ratio shows the slackness in debt recovery.

Computation of Debtors Turnover Ratio

Illustration: 38

A firm has made credit sales of Rs 2,00,000 during the year. The outstanding amount of debtors at the beginning and at the end of the year were Rs 20,000 and Rs 30,000 respectively. What is the Debtors Turnover Ratio?

Solution

Formula

 

Debtors Turnover Ratio

=

Net Credit Sales/Average Debtors

 
    Average Debtors

 
=

 

 
=

 
    Debtors Collection Period

 
=

9.1.3 Creditors Turnover Ratio

It is a ratio between net credit purchases and the average amount of creditors outstanding during the year.

Formula

 

Creditors Turnover Ratio

=

Net Credit Purchases/Average Creditors

Net Credit Purchases

=

Gross Credit Purchases – Returns

 
    Average Creditors

 
=

Creditors include bills payable.

A low ratio shows the liberal credit policy.

A high ratio shows the speedy settlement of credit.

Computation of Creditors Turnover Ratio

Illustration: 39

A firm has made credit purchases of Rs 3,00,000. The amount payable to the creditors at the beginning and the end of the year is Rs 70,000 and Rs 80,000 respectively. Compute the Creditors Turnover Ratio.

Solution

 

Creditors Turnover Ratio

=

Net Credit Purchases/Average Creditors

 
    Average Creditors

 
=

 

 
=

 
    ∴ Creditors Payment Period

 
=

9.2 Cash Cycle – Combined Effect of Turnover Ratios

Cash cycle shows the inter-relationships of sales, collections from debtors and payment to creditors. It reveals the combined effect of all these Turnover Ratios.

Assume that in the above three illustrations, the data showed relate to a single and same firm, then cash cycle.

 

Inventory Holding Period

= 2 months

Add: Debtors Collection Period

Less: Creditor s Payment Period

Shorter the cash cycle,, better the liquidity status.

 

[The liquidity position of a firm, now-a-days, at international level, is also examined in relation to its ability to meet projected daily expenditure from operations. Such ratios – Defensive Interval Ratio (a ratio between quick assets and projected daily cash recruitments), Cash Flow from operations ratios are not dealt with here.]

9.3 Leverage Ratios

The other category of financial ratios is also termed as Leverage Ratios or Capital Structure Ratios. A modern approach is to express Debt Equity Ratio in terms of the relative proportion of long-term debt and shareholder’s equity.

Debt Equity Ratio = Long-term Debt/Shareholder’s Equity

In this approach, Current Liabilities are excluded in long-term debt. So, by including the Current Liabilities in the debt structure, Debt Equity Ratio is computed differently as

Debt Equity Ratio = Total Debt/Shareholder’s Equity

The Debt Equity Ratio has wider implications, affecting the creditors, owners and even the firm itself. Do judicious combination of Creditors Funds and Owners Funds, that is, the proportion of debt in the financial structure plays a crucial role in determining financial status of a firm. Technically this is termed as Leverage or Trading on Equity %.

This is further inter-related to Coverage Ratios, which measure the firm’s ability to pay certain fixed charges. The Coverage Ratios measure the relation between what is normally available from operations of the firms and the claims of outsiders. Coverage Ratios –interest coverage, dividend coverage, total fixed charge coverage, total cash flow coverage, capital expenditure ratio, debt–service coverage ratio are not dealt with here.

9.4 Profitability Ratios

9.4.1 Profitability Ratios relating to Sales

We have discussed Profitability Ratios in the earlier part of the chapter. Now a slight advance step on Profitability Ratios is to be seen here. Profitability Ratios relating to sales is termed as Expense Ratio. There are different variants of Expense Ratios, depending upon the nature of expense. They are

  1. Cost of Goods Sold = Cost of Goods Sold/Net Sales × 100
  2. Operating Expenses Ratio = Administrative Expenses + Selling Expenses/Net Sales ×100
  3. Administrative Expenses Ratio = Administrative Expenses/Net Sales × 100
  4. Selling Expenses Ratio = Selling Expenses/Net Sales× 100
  5. Operating Ratio = Cost of Goods Sold + Operating Expenses/Net Sales × 100
  6. Financial Expenses Ratio=Financial Expenses/Net Sales × 100

Note: Expenses on taxes, dividends and extraordinary losses (theft, stock devasted by natural calamities) are not included.

Thus, specific Expenses Ratio for each of such items may be calculated. These Expense Ratios are interrelated with Profit Margin Ratio (G.P. Ratio, N.P. Ratio etc.). The Profitability Ratios based on sales (Expenses Ratio) is a very important tool for ana1ysing the operational efficiency – the profitability of a manufacturing concern.

9.4.2 Profitability Ratios relating to Investments

Return on Investment Ratio: Profitability Ratios relating to Investments, measures the relationship of the profit of the firm to its Investments. These ratios are termed as Return on Investments (ROI).

Return on Assets: (based on assets) measure the relationship between net profit assets. The net profit may be (a) net profits after taxes (b) net profits after taxes + interest and (c) net profits after taxes + interest – tax savings and the assets may be (a) total assets (b) fixed assets and (c) tangible assets. As such, there are different variants in computation of return on assets.

Formulae for computing different return on assets:

  1. Return on Assets (ROA) = Net Profit after Taxes/Average Total Assets × 100
  2. ROA = Net Profit after Taxes + Interest/Average Total Assets × 100
  3. ROA = Net Profit after Taxes + Interest/Average Tangible Assets × 100
  4. ROA = Net Profit after Taxes + Interest/Average Fixed Assets ×100

The above formulae can be substituted by the following to ascertain the operating performance of a business entity.

Return on Capital Employed (ROCE): Here the capital employed is the base to test the profitability of a concern, relating to sources of long-term funds.

As the concepts of profits and capital employed vary, ROCE also can be computed in various ways:

  1. ROCE = Earnings Before Interest and Taxes (EBIT) /Average Total Capital Employed + 100
  2. ROCE = Net Profit after Taxes + Interest – Tax advantage on Interest/Average Total Capital Employed ×100
  3. ROCE = Net Profit after Taxes + Interest – Tax advantage on Interest/Average Total Capital Employed – Average Intangible Assets × 100

ROCE, in total, assess the firm’s profitability, taking owners’ funds and lenders’ funds together.

9.4.3 Return on Shareholder’s Equity

Profit is based on return on shareholder’s equity and its different variants. Moving one step up, profitability of firm may be ascertained by computing Return on Shareholder’s Equity.

There are different variants of the Return on Shareholder’s equity. They are:

  1. Rate of return on:
    1. Total Shareholders’ Equity
    2. Equity of Ordinary Shares
  2. Earnings Per Share (EPS)
  3. Dividend Per Share (DPS)
  4. Dividend Payout Ratio (D/P Ratio)
  5. Dividend and Earnings Yield
  6. Price Earnings Ratio (P/E Ratio)
  7. Return on Investment (ROI) and (h) Computing of ROI Ratio

9.4.3.1a Return on Total Shareholders’ Equity: Return on Total Shareholders’ Equity = Net Profit after Taxes/ Average Total Shareholders’ Equity × 100

Total Shareholders’ Equity = Preference Share Capital + Ordinary Shareholders’ Equity (equity share capital + share premium +reserves and surplus – accumulated loss)

This ratio indicates how profitably the owners’ funds have been utilised by the business entities.

9.4.3.1b Rate of Return on Equity of Ordinary Shareholders: It is also called as Net Worth. This ratio measures the return on the total equity funds of ordinary shareholders.

Return on Equity Funds

This is the most essential and vital ratio for equity shareholders of a company. Since equity shareholders are real owners, this ratio plays a crucial and significant role in industries.

9.4.3.2 Earnings Per Share (EPS):This measures the extent of profit available to the equity shareholders. Profit is computed as per share basis.

Earnings Per Share = Net Profit (after taxes and dividend on performance shares)/No. of Ordinary Shares Outstanding × 100

These ratios can be analysed by (i) intra-firm results (past records) (ii) inter-firm comparisons and (iii) overall industry results.

Besides these,

  1. Cash Earnings Per Share,
  2. Book Value Per Share and
  3. Price to Book Value Shares

are also useful in analysing and predicting future returns from Stock.

9.4.3.3 Dividend Per Share (DPS):DPS = Dividend paid to ordinary shareholders/No. of Ordinary Shares Outstanding

DPS may be a better indicator than EPS, as it shows the distribution of net profit to ordinary shareholders.

9.4.3.4 Dividend Payout Ratio (D/P Ratio):This ratio measures the proportion of dividends paid to earning available to shareholders.

From this, Retention Ratio is computed.

Retention Ratio = 100 − D/P Ratio

This is useful to measure how much is retained in the business from the net profits earned.

These two ratios, i.e. EPS and DPS are generally based on book value of shares (per share).

9.4.3.5 Earnings and Dividend Yield: Yield of a firm may also be expressed on the basis of market value of shares (per share). These are (i) Earnings Yield (ii) Dividend Yield

They are computed as:

  1. Earnings Yield = EPS/Market Value Per Share × 100
  2. Dividend Yield = DPS/Market Value Per Share × 100

9.4.3.6 Price Earnings Ratio (P/E Ratio):This ratio measures the amount that investors are willing to pay for each rupee of earnings.

  • This ratio measures investors’ expectations and the market appraisal of the performance of a business entity.
  • As investors on firm’s performance is assessed, this is very useful to the investors.
  • Further advanced concepts such as Return on Equity (ROE), Growth Rates, Internal Growth Rate (IGR) and Sustainable Growth Rates (SGR) are not dealt with here.

9.4.3.7 Return on Investment (ROI):This ratio measures the relationship of profit with capital employed.

Formula:

  • This ratio is expressed in percentage.
  • This is useful to ascertain how much income the use of Rs 100 of Capital generates.
  • This ratio measures how efficiently the sources entrusted to the business are used.
  • This ratio also ascertains the efficiency of different units within a business concern.

9.4.3.8 Computation of ROI Ratio: Capital employed is to be computed, first. For this, any of the following methods can be adopted.

Method 1: Sum of (1) Share Capital (includes preference and equity) (2) Reserves and (3) Long-term loans has to be done.

From this total, the following items have to be deducted: (1) Fictious Assets (e.g. preliminary expenses) and (2) Non-operating assets.

Net result will be the Capital employed.

Method 2: Capital employed will be ascertained by adding all the fixed assets (less depreciation) and the working capital of a concern.

Illustration: 40

Following is the Balance Sheet of Raj Ltd as on Mar 31, 2009: Compute ROI:

Solution

Step 1: Profit before interest has to be computed.

 

 

Rs

Profit (as shown in the question)

4,00,000

Add: Interest (10% on Rs 10,00,000)

1,00,000

Profit before interest

5,00,00

Step 2: Capital employed is to be computed.

 

Method 1:Fixed Assets (Net)

25,00,000

Add: Working Capital

 

Current Assets –Current Liabilities

5,00,000

(Rs 15,00,000 – Rs 10,00,000)

 

Capital Employed

________
30,00,000

This can be ascertained by another way.

 

Method 2: Share Capital

10,00,000

Add: (Reserves + Profits)

 

Rs 7,00,000 + Rs 4,00,000

11,00,000

 

21,00,000

Add: Loans

10,00,000

 

31,00,000

Less: Underwriting Commission

1,00,000

Capital Employed

30,00,000

 

Step 3: → ROI

=

Profit before Interest/Capital Employed × 100

 

=

Rs 5,00,000/Rs 30,00,000 × 100

 

=

16.66%

Calculation of Capital Employed

Illustration: 41

The Balance Sheet of X Ltd as on Mar 31, 2009.

 

 

Additional Information

Net profit for the year was Rs 1,00,000 after charging interest of Rs 20,000 on secured term loan, but before tax.

Calculate Return on Capital Employed for the year.

Solution

[Note: As Net profit and interest are shown in additional information they may straight away be taken for the computation of the Profit Before Interest (PBI).

Step 1: Here profit is shown after charging interest. So profit is added to interest here to arrive at Profit Before Interest.

Therefore, Profit Before Interest = Rs 1,00,000 + Rs 20,000 = Rs 1,20,000

Step 2: Capital Employed is now calculated.

Method 1: Fixed Assets

 

(Rs 1,00,000 + Rs 1,00,000 + Rs 1,77,500 + Rs 37,500 + Rs 25,000)

=

Rs 4,40,000

Add → Working Capital (C.A.. C.L.)

=

Rs 60,000

(Rs 4,70,000 – Rs 4,10,000)

 

__________
Rs 5,00,000

Method 2

 

 

   Rs

Share Capital

2,50,000

Preference Share Capital

1,00,000

Add: Reserves and Surplus

1,25,000

Add: Long-term Loan

1,50,000

 

6,25,000

Less: Miscellaneous Expenditure

25,000

 

6,00,000

Less: Investment

1,00,000

Capital Employed

5,00,000

Step 3: Return on Capital Employed: PBI/Capital Employed × l00
              = 1,20,000/5,00,000 × 100 = 24%

Note: Investments not taken into account here assuming it is not exclusively for the business concern.

Computation of EPS

Illustration: 42:

Calculate the Earnings Per Share from the following data.

 

 

      Rs

Net Profit after Tax

  6,00,000

10% Preference Share Capital (Rs 10 each)

10,00,000

Equity Share Capital (Rs 10 per share)

10,00,000

Solution

 

 

  Rs

Preference Dividend: 10% of Rs 10,00,000

1,00,000

   Number of Equity Shares

10,00,000/10

 

1,00,000

  Net Profit after Tax

6,00,000

Substitute the figures in the equation or formula:

Earnings Per Share

Computation of DPS

Illustration: 43

Net Profit after interest and tax Rs 5,00,000. Profit distributed as dividend 50%. Equity Share Capital (25,000 equity shares Rs 100 per share) Rs 25,00,000. Calculate Dividend Per Share.

Solution

 

DPS

=

Profit distributed as Dividend/No. of Equity Shares

 

=

(50% of Rs 5,00,000)/25,000 = Rs 2,50,000/25,000

 

=

Rs 10

DPS

=

Rs 10 per Share

Illustration: 44

Earnings per share Rs 25. Market Price per share Rs 400. Calculate Price Earning Ratio.

Solution

Illustration: 45

The Capital of Vasanth Co. Ltd is as follows:

 

 

      Rs

10% Preference Share of Rs 10 each

  5,00,000

Equity Shares of Rs 10 each

20,00,000

 

________
25,00,000

Further Information

 

 

      Rs

Profit after Tax

2,50,000

Equity Dividend Paid

1,00,000

Market price per Equity Share

          50

Calculate: (i) Earnings Per Share and (ii) Price Earning Ratio.

Solution

  1. EPS
  2.  

    P/E Ratio

    =

    Market Price per Share/Earning per Share

     

    =

    Rs 50/Re. 1 = 50 : 1

(Combining these two ratios, that is, EPS and P/E, market value of share in future may be computed, which means forecast.)

 

[Here Market Price per Share

=

EPS × P/E

 

=

1 × 50 = Rs 50]

Illustration: 46

 

 

      Rs

Equity Share Capital (Rs 10 per Share)

25,00,000

Reserves and Surplus

   2,50,000

Secured Loan (15%)

12,50,000

10% Unsecured Loan

   6,25,000

Fixed Assets

15,00,000

10% Investments

   2,50,000

Operating Profit

12,50,000

Income Tax Rate

         50%

Market Price per Share

           50

Calculate Price Earning Ratio (P/E)

 

Solution

Step 1: First, EPS has to be ascertained.

 

 
Rs

Operating Profit

12,50,000

Less:

  1. Interest on 15% loan: Rs 1,87,500
  2. Interest on 10% loan: Rs 62,500
2,50,000

Profit before Tax

10,00,000

Less: Income Tax 50%

5,00,000

Profit after Tax

5,00,000

Step 2: No. of Equity Shares

             = Rs 25,00,000/Rs 10 = 2,50,000 shares

Step 3: EPS = Profit after Tax/No. of Equity Shares

                      = Rs 5,00,000/2,50,000 = Rs 2

Step 4: Calculation of P/E Ratio

 

 

P/E Ratio

=

Market Price per Share/EPS

 

 

 
=

SOLVED PROBLEMS FOR PROFESSIONAL COURSES – COMPREHENSIVE

Construction of Trading and Profit A/c

Illustration: 47

You are given the following information for the year 2008–09 from the books of a firm engaged in trading operations.

Average monthly sales for the year amounted to Rs 30,000

Goods are sold at cost plus 25%

Stock-in-trade on Mar 31,2009: Rs 29,000

Stock Turnover Ratio: 10

Operating Ratio: 85% Turnover

Depreciation charged on fixed assets for the year: Rs 10,000

Non-operating income for the year consisted of Bank Interest Rs 1,500 and Dividends received from investments Rs 2,500.

Non-operating expenses amounted to Rs 2,500 towards the sale of fixed assets.

You are required to construct the Trading and Profit and Loss Account of the firm for the year ended Mar 31, 2009.

 

(ICWA Inter – Modified)

Solution

The following have to be computed in the order of sequence: (1) G.P. (2) Opening Stock (3) Purchases (4) Net Operating Profit (5) Total Operating Expenses to construct the Trading and Profit and Loss A/c.

Step 1: Calculation of Gross Profit

 

Gross Profit

=

25% of Sales

 

=

25/100 × (Rs 30,000 × 12)

 

=

1/4 × Rs 3,60,000

 

=

Rs 90,000

Step 2: Calculation of Opening Stock

 

Cost of Goods Sold

=

Sales – G.P.

 

=

Rs 3,60,000 – Rs 90,000)

 

=

Rs 2,70,000

Stock Turnover

=

Cost of Goods Sold/Average Stock

10 (Given)

=

Rs 2,70,000/Average Stock

Let Average Stock be X.

 

 

Then 10

=

Rs 2,70,000/X

10 × X

=

Rs 2,70,000

X = Rs 2,70,000/10 = Rs 27,000

 

 

Average Stock

=

(Opening Stock + Closing Stock)/2

Rs 27,000

=

(Opening Stock + Closing Stock)/2

(Opening Stock + Closing Stock)/2

=

Rs 27,000

Let Opening Stock be taken as “Y”

 

 

Y + Closing Stock

=

Rs 27,000 × 2

Y + Rs 29,000

=

Rs 54,000

(Given)

 

 

Y

=

Rs 54,000 – Rs 29,000

Therefore, Opening Stock

=

Rs 25,00

Step 3

 

Purchases

=

C.G.S. + Opening Stock – Closing Stock

Purchases

=

Rs 2,70,000 + Rs 29,000 – Rs 25,000

 

=

Rs 2,74,000

Step 4: Calculation of Net Operating Profit

 

 
Operating Ratio

   85

(Given)

 

Therefore, Total Operating Expenses

=

85 × 3,60,000/100

 

=

Rs 3,06,000

Therefore, Net Operating Profit

=

Sales – Total Operating Expenses

 

=

Rs 3,60,000 – Rs 3,06,000

 

=

Rs 54,000

Step 5: Calculation of Operating Expenses

Operating Expenses other than Depreciation = Total Operating Expenses — C.G.S. — Depreciation

Step 6: Construction of Trading and Profit and Loss Account

 

Trading and Profit and Loss Account
For the Year Ending Mar 31, 2009

Construction of Balance Sheet

Illustration: 48

From the particulars furnished here under, you are required to prepare the Balance Sheet: Stock Velocity: 6; Gross Profit Margin = 20%; Capital Turnover Ratio: 2; Fixed Assets Turnover Ratio: 4; Debt Collection Period: 2 months; Creditors Payment Period: 73 days; Gross Profit was Rs 3,00,000; Excess of Closing Stock over Opening Stock was Rs 25,000; Difference in Balance Sheet represents Bank balance.

 

C.A. Inter – Modified)

Solution

(Assumption: The entire sales and purchases were made on credit.)

Note: Missing figures which are inter-related with other items are to be ascertained in the following sequences.

Step 1: Computation of Sales

 

Gross Profit Margin

=

20%

Gross Profit (Given)

=

Rs 3,00,000

Therefore, Sales

=

100/20 × Rs 3,00,000

 

=

Rs 15,00,000

Step 2: Cost of Goods Sold has to be computed.

 

Cost of Goods Sold

=

Sales – Gross Profit

 

=

Rs 15,00,000 − Rs 3,00,000

 

=

Rs 12,00,000

Step 3: Calculation of Opening Stock and Closing Stock.

 

Stock Velocity

= 6 (Given)

Remember: Average Stock = Cost of Goods Sold/Stock Velocity

 

 

=

Rs 12,00,000/6 = Rs 2,00,000

Let Opening Stock be taken as X Rs

Then Closing Stock

=

Rs (X + 25,000)

Remember another Equation:

 
    Average Stock

 
=

 
    Rs 2,00,000

 
=

 
    Rs 2,00,000

 
=

2X + Rs 25,000

=

Rs 2,00,000 × 2

2X

=

Rs 4,00,000 − Rs 25,000

 

=

Rs 3,75,000

X

=

Rs 3,75,000/2 = Rs 1,87,500

Therefore, Opening Stock

=

Rs 1,87,500

Closing Stock

=

Rs 1,87,500 + Rs 25,000

 

=

Rs 2,12,500

Step 4: Computation of Capital

Remember: Capital = Sales/Capital Turnover Ratio

                                  = Rs 15,00,000/2 = Rs 7,50,000

Step 5: Computation of Fixed Assets

Remember: Fixed Assets = Sales/Fixed Assets Turnover Ratio

                                            = Rs 15,00,000/4 = Rs 3,75,000

Step 6: Calculation of Debtors

 

Debt Collection Period

=

2 months

Debtors

=

Credit Sales × 2/12

 

=

Rs (15,00,000) × (2/12)

 

=

Rs 2,50,000

Step 7: Computation of Purchases

 

Purchases

=

Cost of Goods Sold + Excess of Closing Stock over Opening Stock

 

=

Rs 12,00,000 + Rs 25,000

 

=

Rs 12,25,000

Step 8: Computation of Creditors

 

Creditors Payment Period

=

73 days

Creditors

=

(Credit Purchases) × 73/365

 

=

(Rs 12,25,000) × 73/365

 

=

Rs 2,45,000

Step 9: Finally, Preparation of Balance Sheet

 

Balance Sheet as on….

Calculation of Missing Figures

Illustration: 49

Complete the following annual financial statements on the basis of ratios provided as under.

 

Profit and Loss Account for the Year Ended Mar 31, 2009

  1. Net Profit to Sales 5%
  2. Current Ratio 1.5
  3. Return on Net worth 20%
  4. Inventory Turnover 15 times

    (based on Cost of Goods Sold)

  5. Share Capital to Reserves 4:1
  6. Rate of Income Tax 50%

(C.A. Inter – Modified)

Solution

Missing figures have to be ascertained in the following sequence (as the particulars relating to ratio are inter-related).

Step 1: Profit after Tax (PAT)

 

PAT

=

Sales × Net Profit Ratio

 

=

10,00,000 × 5% = Rs 50,000

Step 2: Provision for Tax

Income Tax Rate is 50%

Income Tax 50% of PBIT and

Profit after Tax = Balance 50%

          (PAT)

Therefore PAT and Income Tax are equal

Hence Income Tax = (same as PAT) Rs 50,000 (Step 1)

Step 3: Debentures

 

Debentures

= Interest on Debentures/Rate of Interest
= Rs 5,000 (Given)/10% = Rs 50,000

Step 4: EBIT

 

EBIT

= Net Profit after Tax + Provision for Tax + Debentures interest
= Rs 50,000 + Rs 50,000 + Rs 5,000
= Rs 1,05,000

Step 5: Net Worth

 

Net Worth

= Return/Rate of Return on Net Worth
= Rs 50,000/20% = Rs 2,50,000

Step 6: Share Capital

 

Share Capital

= Net Worth × 4/5
= Rs 2,50,000 × 4/5 = Rs 2,00,000

Step 7: Reserves

 

Reserves

= Net Worth – Share Capital
= Rs 2,50,000 – Rs 2,00,000 = Rs 50,000

Step 8: Current Assets

 

Current Assets = Current Liabilities × 1.5
  = (Given as Sundry Creditors)Rs 30,000 × 1.5 = Rs 45,000

Step 9: Closing Stock

 

Closing Stock

= Cost of Goods Sold/Inventory Turnover Ratio
= Rs 3,00,000/15 = Rs 20,000

 

Profit and Loss Account for the Year Ended Mar 31, 2009

Balance Sheet as on Mar 31, 2009

Preparation of Final Accounts

Illustration: 50

From the following ratios and further information, you are required to prepare a Trading and Profit and Loss Account:

  1. Fixed Assets/Capital = 5/4
  2. Fixed Assets Rs 2,50,000
  3. Capital/Liabilities = 1/2
  4. Net Profit/Capital = 1/5
  5. Gross Profit Ratio 20%
  6. Stock Turnover Ratio = 10
  7. Fixed Assets/Total Current Assets = 5/7
  8. Net Profit to Sales 20%
  9. Closing Stock Rs 25,000

Out of Current Assets, Sundry Debtors are Rs 3,00,000.

The balance represents Cash.

(CA – Modified)

Solution

Note: In ratio analysis, the particulars are inter-related. As such, missing figures have to be computed in the sequence as follows:

Step 1: Calculation of Capital

Fixed Assets/Capital = 5/4

Rs 2,50,000/Capital = 5/4

Capital × 5 = 4 × Rs 2,50,000

Therefore, Capital = 4 × Rs 2,50,000/5 = Rs 2,00,000

Step 2: Liabilities value is to be computed

 

Capital/Liabilities

=

1/2

Rs 2,00,000/Liabilities

=

1/2

2 × Rs 2,00,000

=

1 × Liabilities

Therefore, Liabilities

=

Rs 4,00,000

Step 3: Computation of Net Profit

 

Net Profit/Capital

=

1/5

Net Profit/2,00,000

=

1/5

Net Profit × 5

=

1 × Rs 2,00,000

Net Profit

=

Rs 2,00,000/5

 

=

Rs 40,000

Step 4: Computation of Sales

 

Net Profit/Sales × 100

=

20 (Given: Particular No. (viii))

Rs 40,000/Sales × 100

=

20

Therefore, Sales

=

Rs 40,000 × 100/20 = Rs 2,00,000

Step 5: Computation of Gross Profit

 

Gross Profit Ratio

=

20% (Given)

Gross Profit/Sales × 100

=

20

Gross Profit/Rs 2,00,000 × 100

=

20

Therefore, Gross Profit

=

Rs 2,00,000 × 20/100 = Rs 40,000

Step 6: Computation of Opening Stock

Take the equation,

 

Cost of Goods Sold

=

Sales – Gross Profit

 

=

Rs 2,00,000 – Rs 40,000 = Rs 1,60,000

Going to other related equation:

 

Cost of Goods Sold/Average Stock

=

Stock Turnover Ratio

Rs 1,60,000/Average Stock

=

10 (Given)

Rs 1,60,000

=

10 × Average Stock

Average Stock = Rs 1,60,000/10

=

Rs 16,000

 
=

 
Average Stock

Opening Stock + Closing Stock

=

2 × Average Stock

 

=

2 × Rs 16,000

 

=

Rs 32,000

Opening Stock + Rs 25,000

=

Rs 32,000

Therefore, Opening Stock

=

Rs 32,000 − Rs 25,000

 

=

Rs 7,000

Step 7: Cash Balance

 

Fixed Assets/Total Current Assets

=

5/7

Rs 2,50,000/Total Current Assets

=

5/7

5 × Total Current Assets

=

7 × Rs 2,50,000

Total Current Assets

=

7 Rs 2,50,000/5

 

=

7 × Rs 50,000

 

=

Rs 3,50,000

But Total Current Assets

=

Closing Stock + Debtors + Cash

Cash

=

Total Current Assets – Closing Stock – Debtors

 

=

Rs 3,50,000 – Rs 25,000 – Rs 3,00,000

 

=

Rs 25,000

Step 8: Finally, after obtaining all the figures, we have to prepare first, Trading and Profit and Loss Account and then the Balance Sheet.

 

Trading and Profit and Loss Account for the Year Ended

 

Balance Sheet as at

Construction of a Proforma Balance Sheet

Illustration: 51

From the following information, compute the Proforma Balance Sheet of a public limited company:

Sales = Rs 20,00,000

Sales to Net Worth = 2 times

Current liabilities to Net Worth = 40%

Total liabilities to Net Worth= 60%

Current Ratio= 3 times

Sales to Closing Inventory =5 times

Average Collection Period = 73 days

 

Proforma Balance Sheet

(C.A. Inter, Modified)

Solution

Note: Proforma Balance Sheet itself is a hint to ascertain the missing figures. It is done as follows:

Step 1: Computation of Net Worth

 

Sales to Net Worth

=

2 times (given)

Rs 20,00,000/Net Worth

=

2

Net Worth × 2

=

Rs 20,00,000

Net Worth

=

Rs 20,00,000/2

 

=

Rs 10,00,000

Step 2: Computation of Current Liabilities

 

Current Liabilities to Net Worth

=

40% (given)

Current Liabilities/Net Worth

=

40/100

Current Liabilities/Rs 10,00,000

=

40/100

100 × Current Liabilities

=

40 × Rs 10,00,000

Current Liabilities

=

40 Rs 10,00,000/100

 

=

Rs 4,00,000

Step 3:Computation of Long-term Liabilities

 

Total Liabilities to Net Worth

=

60% (given)

Total Liabilities/Net Worth

=

60/100

100 × Total Liabilities

=

60 × Rs 10,00,000

Total Liabilities

=

60 × Rs 10,00,000/100

 

=

Rs 6,00,000

Therefore, Long-term liabilities

=

Total Liabilities – Current Liabilities

 

=

Rs 6,00,000 – Rs 4,00,000

 

=

Rs 2,00,000

Step 4: Computation of Current Assets

 

Current Ratio

=

Current Assets/Current Liabilities = 3 (Given)

 

=

Current Assets/Rs 4,00,000 = 3 (Given)

Therefore, Current Assets

=

3 × Rs 4,00,000

 

=

Rs 12,00,000

Step 5: Calculation of Stock

 

Sales to Closing Inventory

=

5 times (Given)

Sales/Stock

=

5 times

Rs 20,00,000

=

5 × Stock

Therefore, Stock

=

Rs 20,00,000/5

 

=

Rs 4,00,000

Step 6: Computation of Sundry Debtors

 

Average Collection Period

=

73 days

Sundry Debtors/Sales/365

=

73

Therefore, Sundry Debtors

=

Rs 20,00,000 × 73/365

 

=

Rs 4,00,000

Step 7: Computation of Cash

 

Cash

=

Current Assets – Stock – Debtors

 

=

Rs 12,00,000 – Rs 4,00,000 – Rs 4,00,000

 

=

Rs 4,00,000

Step 8: Finally, Proforma Balance Sheet has to be drawn.

 

Proforma Balance Sheet

SOLVED PROBLEMS (COMPREHENSIVE)

Comprising different ratios

Illustration: 52

Net Profit Ratio of a business concern is 20%. The indirect expenses are Rs 80,000 and cash sales are Rs 3,00,000. The credit are 80% of total sales. Calculate the Gross Profit Ratio.

Solution

Step 1: Value of Total Sales has to be calculated.

Credit Sales                   = 80% of total sales (given in the question)

∴ Cash Sales = 100% – 80%

(Total Sales – Credit Sales)

Step 2: After this, we have to calculate Net Profit..

Formula: Net Profi t Ratio = Net Profi t/Net Sales × 100

Substitute the values in the formula:

 

20%

=

Net Profit/Rs 15,00,000

i.e., 20/100

=

Net Profit/Rs 15,00,000

Net Profit × 100

=

20 × Rs 15,00,000

Net Profit

=

20 × 15,00,000/100

∴ Net Profit

=

Rs 3,00,000

Step 3: Next, Gross Profit has to be found out.

Remember: Gross Profit = Net Profit + Indirect Expenses

 

 

=

Rs 3,00,000 + Rs 80,000 (given)

 

=

Rs 3,80,000

Step 4: Finally, Gross Profit Ratio has to be computed.

Formula: Gross Profit Ratio = Gross Profit/Net Sales × 100

Substitute the values in the formula:

 

Gross Profit Ratio

=

Rs 3,80,000/Rs 15,00,000 × 100

 

=

25.33%

Illustration: 53

From the following information, calculate

(i) Stock Turnover Ratio (ii) Operating Ratio and (iii) Capital Turnover Ratio

 

 

   Rs

Opening Stock

28,000

Closing Stock

22,000

Purchases

46,000

Sales

90,000

Sales Returns

10,000

Carriage Inwards

   4,000

Office Expenses

   4,000

Selling and Distribution Expenses

   2,000

Capital Employed

2,00,000

Solution

(i) Computation of Stock Turnover Ratio

Step 1: Formula: Stock Turnover Ratio = Cost of Goods Sold/Average Stock

  • From the given information, we have to calculate Cost of Goods Sold.
  • Remember: Cost of Goods Sold = Opening Stock × Purchases × Carriage Inwards – Closing Stock
  • Substitute the figures in the equation from the information given in the question.
  • Cost of Goods Sold = Rs 28,000× Rs 46,000 × Rs 4,000– Rs 22,000 = Rs 56,000

Step 2: Then Average Stock has to be computed.

 

 
    Remember: Average Stock

 
=

 

 
=

Average Stock

=

Rs 25,000

Step 3: Final Step

 

Formula: Stock Turnover Ratio

=

Cost of Goods Sold/Average Stock

 

=

Rs 56,000/Rs25,000

∴ Stock Turnover Ratio

=

2.24 times

(ii) Computation of Operating Ratio

For this, Operating Expenses have to be computed.

Step 1: Here, Operating Expenses = Office Expenses + Selling and Distribution Expenses

 

 

=

Rs 4,000 + Rs 2,000

 

=

Rs 6,000

Step 2: Cost of Goods Sold (As worked out in Step 1) = Rs 56,000

Step 3: Net Sales = Sales – Sales Returns

 

 

=

Rs 90,000 − Rs 10,000 (Given)

 

=

Rs 80,000

Step 4: Formula: Operating Ratio

 

 

=

Rs 56,000 + Rs 6,000/Rs 80,000 × 100

∴ Operating Ratio

=

77.5%

(iii) Computation of Capital Turnover Ratio

 

Formula

=

Net Sales/Capital Employed × 100

 

=

Rs 80,000/Rs 2,00,000 × 100

 

=

40%

Illustration: 54

Rs 2,40,000 is the Cost of Goods Sold.

Inventory Turnover is 8 times.

Stock at the beginning is 1.5 times more than the stock at the end.

Calculate the value of opening and closing stock.

Solution

Step 1: Let the Closing Stock be X. (Assumption)

Then Opening Stock will be = 1.5X (As per question)

i.e., Opening Stock is 1.5 times more than Closing Stock.

Step 2: Formula: Inventory Turnover Ratio = Cost of Goods Sold/Average Stock

 

  8

=

Rs 2,40,000/(X + l.5X/2)

(Average Stock = (Opening Stock + Closing Stock)/2)

  8

=

Rs 2,40,000 × 2/(X + l.5X)

  8(X + 1.5X)

=

Rs 2,40,000 × 2

  8(2.5X)

=

Rs 4,80,000

  20X

=

Rs 4,80,000

  X

=

Rs 4,80,000/20 = Rs 24,000

  Closing Stock

=

Rs 24,000

Step 3: Opening Stock = Rs 24,000 × 1.5

                                = Rs 36,000

Illustration: 55

  1. The ratio of Current Assets (Rs 3,00,000) to Current Liabilities (Rs 2,00,000) is 1.5:1. The accountant of the business concern is interested in maintaining a Current Ratio at the level 2:1 by paying off a part of Current Liabilities. Compute the amount of current liabilities that should be paid off in order to maintain the Current Ratio at the level 2:1.
  2. Compute the Gross Profit Ratio. Sales: Rs 6,00,000; Gross Profit 25% on Cost.

Solution

(A) Let the Current Liabilities that should be paid off be Y (assumed).

Substitute the figure in the formula :

 

 

2(2,00,000 − Y)

=

1(3,00,000 − Y)

4,00,000 − 2Y

=

3,00,000 − Y

      −2Y + Y

=

3,00,000 − 4,00,000

      −Y

=

−1,00,000

      Y

=

Rs 1,00,000

So Current Liabilities that should be paid to maintain the Current Ratio at the level 2:1 will be Rs 1,00,000.

 

(B) Step 1: Let the Cost of Goods Sold be Rs 100 (assumed).

Then Sales = Rs 100 + 25 (Given) = 125

If Sales are Rs125, Cost of Goods Sold is Rs 100.

Step 2: If Sales are Rs 6,00,000 (given in question),

 

Cost of Goods Sold will be

=

100/125 × 6,00,000

 

=

Rs 4,80,000

Step 3: Gross Profit = Sales – Cost of Goods Sold

 

 

=

Rs 6,00,000 – Rs 4,80,000

 

=

Rs 1,20,000

Step 4: Formula: Gross Profit Ratio = Gross Profit/Net Sales × 100

Substitute the values in the formula:

Gross Profi t Ratio = Rs l,20,000/Rs 6,00,000 × 100

 

=

20%

Illustration: 56

Net Sales: Rs 4,00,000; Cost of Goods Sold: Rs 2,00,500; Administrative Expenses: Rs 45,000; Selling Expenses: Rs 57,000; Share Capital: Rs 8,50,000; Reserves and Surplus: Rs 3,00,000; Long-term Loans: Rs 8,20,000; Fixed Assets (Net): Rs 4,62,000; Investments: Rs 2,42,500; Debtors: Rs 72,000; Opening Stock; Rs 2,40,000; Closing Stock: Rs 2,10,000; and Bank Balance: Rs 3,00,000.

From the above details, you are required to compute:

  1. Gross Profit Ratio
  2. Stock Turnover Ratio
  3. Proprietary Ratio

Solution

(a) Computation of Gross Profit Ratio

 

Remember: Gross Profit

=

Net Sales – Cost of Goods Sold

 

=

Rs 4,00,000 – Rs 2,00,500

 

=

Rs 1,99,500

  • Formula: Gross Profit Ratio = Gross Profit/Net Sales × 100

 

=

Rs l,99,500/Rs 4,00,000 × 100

 

=

49.87%

(b) Computation of Stock Turnover Ratio

Step 1: First, Average Stock is to be calculated.

 

 
     Average Stock

 
=

 

 
=

 

=

Rs 4,50,000/2 = Rs 2,25,000

Step 2: Formula = Stock Turnover Ratio = Cost of Goods Sold/Average Stock

Substitute the values in the formula,

    = Rs 2,00,500/Rs 2,25,000 = 0.89 times

(c) Calculation of Proprietary Ratio

Step 1: Shareholder’s Funds should be calculated.

 

Remember: Shareholder’s Funds

=

Share Capital + Reserves and Surplus

 

=

Rs 8,50,000 + Rs 3,00,000 (Given)

 

=

Rs 11,50,000

Step 2: Total Assets should be calculated.

Remember: Total Assets: Sum of all assets given in question

 

Here, Total Assets

=

Fixed Assets + Investments + Debtors + Closing Stock + Bank Balance

 

=

Rs 4,62,000 + Rs 2,42,500 + Rs 72,000 + Rs 2,10,000 + Rs 3,00,000

 

=

Rs 12,86,500

Step 3: Formula:

 

Proprietary Ratio

=

Shareholder’s Funds/Total Assets

 

=

Rs l1,50,000/Rs 12,86,000

 

=

0.89

 

 

Or

 

=

89.42%

Illustration: 57

On the basis of the following information, you are required to calculate the following ratios:

  1. Gross Profit Ratio
  2. Debt Equity Ratio
  3. Working Capital Turnover Ratio

Net Sales: Rs 5,65,000; Bank Loan; Rs 1,25,000; Cost of Goods Sold: Rs 3,75,000.00; Current Assets: Rs 3,25,000; Current Liabilities: Rs 1,75,000; Equity Share Capital: Rs 3,95,000; Debentures: Rs 1,29,000.

Solution

(a) Calculation of Gross Profit Ratio

Step 1: Gross Profit has to be worked out first.

 

Remember: Gross Profit

=

Net Sales – Cost of Goods Sold

 

=

Rs 5,65,000 – Rs 3,75,000

 

=

Rs 1,90,000

Step 2: Now, Gross Profit Ratio = Gross Profit/Net Sales × 100

 

 

=

Rs 1,90,000/Rs 5,65,000 × 100

 

=

33.62%

(b) Calculation of Debt Equity Ratio

Step 1: Total Long-term Debts have to be determined first.

 

Remember: Total Long-term Debts

=

Debentures + Loan

 

=

Rs 1,29,000 + Rs 1,25,000

 

=

Rs 2,54,000

Step 2: Formula:

Debt Equity Ratio = (Total) Long-term Debts/Shareholder’s Funds

Remember: Shareholder’s Funds = Equity Share Capital

 

∴ Ratio

=

Rs 2,54,000/Rs 3,95,000

 

=

0.64:1

(c) Calculation of Working Capital Turnover Ratio

Step 1: First Net Working Capital has to be ascertained.

 

Remember: Working Capital

=

Current Assets – Current Liabilities

 

=

Rs 3,25,000 – Rs 1,75,000

 

=

Rs 1,50,000

Step 2: Formula:

 

Working Capital Turnover Ratio

=

Net Sales/Net Working Capital

 

=

Rs 5,65,000/Rs 1,50,000

 

=

3.76 times

Illustration: 58

Calculate the Cost of Goods Sold from the following information:

Sales: Rs 12,00,000; Sales Returns: Rs 80,000;

Operating Expenses: Rs 1,82,000; Operating Ratio: 92%

Solution

Formula:

Operating Ratio = Cost of Goods Sold + Operating Expenses/Net Sales × l00

Substitute the values

92/100 = Cost of Goods Sold + Rs 1,82,000/Rs 11,20,000

 

100 × (Cost of Goods Sold + Rs 1,82,000)

=

92 × Rs 11,20,000

Cost of Goods Sold + Rs 1,82,000

=

92 × Rs l1,20,000/100

 

=

Rs 10,30,400

Cost of Goods Sold

=

Rs 10,30,400 − Rs 1,82,000

 

=

Rs 8,48,400

Illustration: 59

Calculate the amount of Gross Profit from the following information:

 

Average Stock

=

Rs 80,000

Stock Turnover Ratio

=

6 times

Selling Price

=

25% above cost

Solution

This problem can be solved in either of the following two methods:

Method 1

Step 1: Formula: Stock Turnover Ratio = Cost of Goods Sold/Average Stock

 

6

=

Cost of Goods Sold/Rs 80,000

6 × Rs 80,000

=

Cost of Goods Sold

Rs 4,80,000

=

Cost of Goods Sold

Step 2: Selling Price is given 25% above cost.

 

∴ Gross Profit

=

25% of Cost of Goods Sold

 

=

25/100 – Rs 4,80,000

 

=

Rs 1,20,000

Method 2

Let the Cost Price be taken as Rs 100 (assumption)

 

Sale Price

=

25% above cost

 

=

Rs 100 + 25 = Rs 125

If Sale Price is Rs 125, Cost Price = 100

If Sale Price is Rs 4,80,000, Cost Price = 125/100 × Rs 4,80,000

(Cost Price) Sales Cost = Rs 6,00,000

Gross Profit = Sales – Cost of Goods Sold

 

=

Rs 6,00,000 – Rs 4,80,000

 

=

Rs 1,20,000

Note: Depending on the particulars provided in the problem, students can choose any of the above methods to ascertain Gross Profit.

Illustration: 60

Calculate Opening Stock and Closing Stock from the following information:

Total Sales = Rs 6,00,000

Gross Profit = 25% on Sales

Stock Turnover Ratio = 5 times

Closing Stock is Rs 12,000 more than the Opening Stock

Solution

The following stages has to be followed one by one to compute the Opening Stock and Closing Stock.

Step 1: First, Gross Profit has to be ascertained.

Step 2: From Gross Profit value, Cost of Goods Sold has to be worked out.

Step 3: From Cost of Goods Sold, value of Average Stock is ascertained by applying Stock Turnover Ratio.

Step 4: From the Stock Turnover Ratio, that is, after knowing Average Stock, Opening Stock and Closing Stock amounts have to be ascertained, finally.

Note: The factors are inter-related. So we have to unlock the secret information, i.e. indirect particulars to solve the problem.

Step 1: First Gross Profit is to be ascertained.

 

Gross Profit

=

25% on Sales

(Given in Problem)

 

=

25/100 × Rs 6,00,000

 

=

Rs 1,50,000

Step 2: From this value, Cost of Goods Sold has to be found out.

 

Remember: Cost of Goods Sold

=

Sales – Gross Profit

 

=

Rs 6,00,000 – Rs 1,50,000

 

=

Rs 4,50,000

Step 3: After computing the value of Cost of Goods Sold, value of Average Stock is to be ascertained by applying the Stock Turnover Ratio.

Formula:

 

Stock Turnover Ratio

=

Cost of Goods Sold/Average Stock

5

=

Rs 4,50,000/Average Stock

Average Stock × 5

=

Rs 4,50,000

Average Stock

=

Rs 4,50,000/5

 

=

Rs 90,000

Step 4: Finally, the value of Opening and Closing Stock has to be ascertained.

Let Opening Stock be Z (assumption).

Then Closing Stock = (Z + Rs 12,000)

(Given in the problem, i.e. Closing Stock is Rs 12,000 more than Opening Stock)

Remember:

 

=

Average Stock

 

Z + (Z + Rs 12,000)

=

Average Stock × 2

 

Z + (Z + Rs 12,000)

=

Rs 90,000 × 2 (From Step 3)

 

2Z + Rs 12,000

=

Rs 1,80,000

 

2Z

=

Rs 1,80,000 − Rs 12,000

 

 

=

Rs 1,68,000

 

Z

=

Rs l,68,000/2 = Rs 84,000

 

i.e., Opening Stock

=

Rs 84,000

 

Closing Stock

=

(Rs 84,000 + Rs 12,000)

 

 

=

Rs 96,000

Illustration: 61

  1. Calculate Stock Turnover Ratio from the following information: Sales: Rs 2,00,000; Gross Profit Ratio: 25%

    Opening Stock was 1/4th value of Closing Stock. Closing Stock was 40% of Sales.

  2. A business firm has a Current Ratio of 4:1 and a Quick Ratio of 1.2:1. Working Capital: Rs 1,80,000. Compute the Total Current Assets and Stock.

Solution

On the basis of information, the following has to be computed one by one:

Step 1: Gross Profit from Gross Ratio.

Step 2: Cost of Goods Sold from Gross Profit.

Step 3: Closing Stock, Opening Stock and Average Stock have to be worked out.

Step 4: Finally, Stock Turnover Ratio is to be found out.

Step 1: Gross Profit = 25% on Sales (Given)

 

 

=

25/100 × Rs 2,00,000

 

=

Rs 50,000

Step 2: Remember: Cost of Goods Sold = Sales – Gross Profit

 

 

=

Rs 2,00,000 – Rs 50,000

 

=

Rs 1,50,000

Step 3: Closing Stock = 40% of Sales (Given)

 

 

=

40/100 × Rs 2,00,000

 

=

Rs 80,000

Opening Stock is ¼th value of Closing Stock.

(Given in the Problem)

 

∴ Opening Stock

=

¼ Rs 80,000

 

=

Rs 20,000

Average Stock

=

 

=

 

=

Rs 50,000

Step 4: Only after computing values for the above, Stock Turnover Ratio can be ascertained.

 

Formula: Stock Turnover Ratio

=

Cost of Goods Sold/Average Stock

 

=

Rs 1,50,000/Rs 50,000

 

=

3 times

Computation of Total Current Assets

Step 1: Current Ratio is 4:1 (Given)

 

Remember: Current Ratio

=

Current Assets/Current Liabilities

4/1

=

Current Assets/Current Liabilities

* 1 × Current Assets

=

4 × Current Liabilities

Working Capital

=

Rs 1,80,000 (Given)

 

Remember: Current Assets – Current Liabilities

=

Working Capital

Current Assets – Current Liabilities

=

Rs 1,80,000

4 × Current Liabilities – Current Liabilities

=

Rs 1,80,000

         (As worked out in *)

 

 

 

3 Current Liabilities

= Rs 1,80,000

Current Liabilities

= Rs 1,80,000/3

 

= Rs 60,000

∴ Current Assets

= 4 × Current Liabilities

 

= 4 × Rs 60,000

Total Current Assets

= Rs 2,40,000

(ii) Computation of Stock

Quick Ratio formula is applied to compute Quick Assets first.

 

Remember: Quick Ratio

= Quick Assets/Current Liabilities

1.2/1

= Quick Assets/Rs 60,000

Quick Assets

= Rs 60,000 × 1.2

 

= Rs 72,000

 

Remember: Stock

= Current Assets – Quick Assets

 

= Rs 2,40,000 – Rs 72,000

 

= Rs 1,68,000

Summary

 

Part A: Theory

  • Accounting Ratio – Meaning and uses
  • Ratio Analysis – Advantages – Limitations of Accounting Ratios
  • Classification of Ratios:
  • Various Ratios – Significance – Calculation (Refer the summarised form attached separately)

Part B:

  • Remember formula to calculate various ratios.
  • Once again remember various items included for each such category.

    For example: Liquid Assets: Various items to be included in this: Cash-in-hand, Bank, Sundry Debtors, Bills Receivable, Short-term investments etc.

    Note: The author does not want to repeat once again here. Students are asked to refer the main part of the chapter and remember the steps involved in the calculation of various ratios.

  • Remember also, the standard parameter for each ratio. Based on that, suggest your ideas on the basis of results obtained.

Key Terms

Current Assets: Assets that can be converted to cash or sold or consumed within a year.

Current Liabilities: Liabilities that fall due within a year.

Current Ratio: Relationship between Current Assets and Current Liabilities.

Debt Equity Ratio: Common dividends per share divided by market price per share.

Earning Per Share (EPS): Net income divided by average no. of outstanding common share.

Inventory: Stock or Goods held by an entity for sale.

Inventory Turnover: The Cost of Goods Sold divided by the average inventory held during the period.

Owner’s Fquity: The residual interest in the company’s assets after deducting liabilities.

Price Earning (P/E) Ratio: Market Price per Share divided by Earning per Share.

Return on Sales Ratio: Net income divided by sales.

Short-term liquidity: A business entity’s ability to meet current liabilities on maturity date.

Shareholder’s Equity: Equity Assets over liabilities of company.

Total Assets Turnover: Sales divided by Average Total Assets.

Working Capital: The excess of Current Assets over Current Liabilities.

References

 

White Gerald I, “The analysis and use of financial statements”, John Wiley & Sons, New York 1998.

Helbert E.A., “Techniques of financial analysis”, Richard. D. Irwin, Homewood 911, 1972.

Horngreen, Sundem & Elliott, “Introduction to Financial Accounting”, Pearson Education, New Delhi, 2005.

A Objective-type Questions

 

I Fill in the blanks with opt terms

  1. Ratio is a ___________ relationship between two items expressed in a quantitative form.
  2. Ratio Analysis is a study of relationship among various ________ factors in a business.
  3. Ratio Analysis is a useful device for analyzing __________ statements.
  4. Ratio Analysis is a __________ device to spot out weak areas and take remedial measures quickly.
  5. Liquidity Ratios measure the _____________ solvency of a concern.
  6. The relationship of current assets to current liabilities is termed as _______ Ratio.
  7. By computing Current Ratio ______________ solvency of a concern is assessed.
  8. Satisfactory level of Current Ratio is _____________
  9. The excess of current assets over current liabilities is known as __________
  10. Liquid Ratio is a relationship of liquid assets with ________.
  11. Liquid Ratio is an indicator to assess the short-term _______ paying capacity of a concern.
  12. Favourable level of Liquid Ratio is __________
  13. ___________ Ratio studies the concern’s ability to meet its long-term financial position.
  14. ___________ Ratio indicates the proportion between debt and equity.
  15. Satisfactory level of Debt Equity Ratio is _________.
  16. Components of Total Assets to Debts Ratio are Total Assets and _________.
  17. Normal level of Total Assets to Debts Ratio is __________.
  18. Proprietary Ratio establishes the relationship between ______ and Total Tangible Assets.
  19. Normal level of Proprietary Ratio is ________.
  20. The relationship of Gross Profit to Sales is termed as _________.
  21. The relationship of Net Profit to Net Sales is termed as ________.
  22. Operating Profit Ratio measures the relationship between ___________ and Net Sales.
  23. Operating Ratio establishes relationship between __________ and Net Sales.
  24. Activity Ratios are also known as __________.
  25. __________ Ratios establish relationship between the Cost of Goods Sold and the average amount of inventory carried during the period.
  26. Debtors Turnover Ratio is also called as _______.
  27. __________ Ratio indicates how quickly debtors are converted into cash.
  28. Working Capital Turnover Ratio studies the relationship between _________ and working capital.
  29. Both Operating Profit Ratio and Operating Ratio are _________ to each other.
  30. Net result of Probability Ratios are expressed in __________.

Answers

  1. Mathematical
  2. Financial
  3. Financial
  4. Diagnostic
  5. Short-term
  6. Current
  7. Short-term
  8. 2:1
  9. Working Capital
  10. Current Liabilities
  11. Debt
  12. 1:1
  13. Solvency
  14. Debt Equity
  15. 2:1
  16. Debt
  17. 2:1
  18. Proprietor’s Funds
  19. 100
  20. Gross Profit Ratio
  21. Net Profit Ratio
  22. Operating Profit
  23. Operating Cost
  24. Turnover
  25. Inventory Turnover
  26. Receivables Turnover
  27. Debtors Turnover
  28. Sales
  29. complementary
  30. percentage

II State whether the following statements are True or False

  1. Ratio Analysis helps in financial forecasting.
  2. Liquidity Ratios measure the long-term solvency of a concern.
  3. A liquid asset is one that can very easily be converted into asset.
  4. Current Ratio is calculated for a particular period.
  5. Marketable securities are Current Assets.
  6. Overdraft (Bank/Bills) is current liability.
  7. Current Liabilities = Working Capital – Current Assets
  8. Liquid Ratio is used to assess the firm’s short-term solvency.
  9. A high Liquid Ratio indicates under stocking.
  10. Solvency Ratios study the concern’s ability to meet short-term indebtedness.
  11. A higher Debt Equity Ratio indicates safer financial position of an equity.
  12. In computing Solvency Ratios, fictitious assets do not form part of total assets.
  13. Long-term Debts, generally get matured after 1 year.
  14. A higher Total Assets to Debts Ratio indicates a risky financial position of the concern.
  15. In proprietor’s funds, payments to others are not included.
  16. A high level Proprietary Ratio indicates safety to creditors.
  17. Higher the Net Profit Ratio, better the efficiency of a concern.
  18. Loss on sale of assets is operating expenses.
  19. Higher Operating Ratio indicates poor performance of a concern.
  20. Higher Inventory Ratio indicates the concern’s high margin of profit.

Answers

 

1. True

2. False

3. True

4. False

5. True

6. True

7. False

8. True

9. False

10. False

11. False

12. True

13. True

14. False

15. True

16. True

17. True

18. False

19. True

20. False

B Multiple Choice Questions

 

III Choose the correct answer

  1. Ratio which measures the short-term solvency of a concern is
    1. Gross Profit Ratio
    2. Operating Ratio
    3. Proprietary Ratio
    4. Current Ratio
  2. Ratio to assess the short-term debt paying capacity of a concern is
    1. Liquid Ratio
    2. Debt Equity Ratio
    3. Creditors Turnover Ratio
    4. None of the above
  3. The ratio which is used to ascertain the soundness of the long-term financial position is
    1. Debt Equity Ratio
    2. Current Ratio
    3. Absolute Liquid Ratio
    4. Gross Profit Ratio
  4. Normal level for Proprietary Ratio is expected to be at
    1. 1:1
    2. 2:1
    3. 100
    4. 50
  5. If the Current Assets and Working Capital of a concern are Rs 80,000 and Rs 50,000 respectively then Current Liabilities will be
    1. Rs 1,00,000
    2. Rs 70,000
    3. Rs 1,30,000
    4. Rs 30,000
  6. The ratio which is a good indicator to maintain the correct selling price and efficiency of trading activities is
    1. Net Profit Ratio
    2. Gross Profit Ratio
    3. Current Ratio
    4. Liquid Ratio
  7. The relationship of Net Profit to Net Sales is termed as
    1. Gross Profit Ratio
    2. Net Profit Ratio
    3. Operating Profit Ratio
    4. None of the above
  8. If the value of Gross Profit and Indirect Expenses of a concern are Rs 4,00,000 and Rs 1,00,000 respectively the value of Net Profit will be
    1. Rs 5,00,000
    2. Rs 4,00,000
    3. Rs 3,00,000
    4. None of the above
  9. The Operating Profit and Net Sales of a firm are Rs 2,00,000 and Rs 10,000 respectively, then Operating Profit Ratio will be
    1. 20%
    2. 5%
    3. 50%
    4. 10%
  10. The ratio which indicates how quickly debtors are converted into cash is
    1. Receivables Turnover Ratio
    2. Inventory Turnover Ratio
    3. Working Capital Turnover Ratio
    4. Creditors Turnover Ratio

Answers

  1. (d),
  2. (a),
  3. (a)
  4. (c),
  5. (d),
  6. (b),
  7. (b),
  8. (c),
  9. (a),
  10. (a)

C Short Answer Questions

  1. What do you mean by “Ratio”?
  2. What is Ratio Analysis?
  3. Enlist the important objectives of Ratio Analysis.
  4. Enumerate the significance of Ratio Analysis.
  5. Mention the broad classification of ratios.
  6. How can Liquidity Ratios be classified?
  7. What do you mean by Current Ratio?
  8. How can Current Ratio be computed?
  9. Give examples for Current Assets.
  10. Mention items relating to Current Liabilities.
  11. What is the satisfactory level of Current Ratio?
  12. How can Working Capital be computed?
  13. Current Assets and Current Liabilities of a firm are Rs 3,00,000 and Rs 1,50,000. Calculate the Current Ratio and interpret the result.
  14. What is meant by Absolute Liquid Ratio?
  15. What are the Solvency Ratios?
  16. How can Debt Equity Ratio be calculated?
  17. How can Liquid Ratio be computed?
  18. How will you calculate Total Assets to Debts Ratio?
  19. What is the formula to compute Proprietary Ratio?
  20. What are the components of Proprietor’s funds?
  21. How can Gross Profit Ratio be computed?
  22. How will you calculate Net Profit Ratio?
  23. How Operating Profit Ratio can be found out?
  24. Write down the formula to calculate Operating Ratio.
  25. Mention the classification of Turnover Ratios.
  26. How Inventory Turnover Ratio can be computed?
  27. Mention the formula to compute Debtors Turnover Ratio.
  28. How can Working Capital Turnover Ratio be calculated?

D Essay-type Questions

  1. Explain Ratio Analysis. Enlist the objectives of Ratio Analysis. Explain its significance.
  2. What are the advantages and disadvantages of Ratio Analysis?
  3. Explain Liquidity Ratio. How are they useful in financial accounting? How the results of various Liquidity Ratios may be interpreted?
  4. How “Solvency” of a concern is determined? Explain the significance of various “Solvency Ratios”. Discuss their role in a concern to take important decisions.
  5. Enumerate the important role of some “Profitability Ratio”. Explain how they are helpful in determining the profit aspects of a concern.
  6. Mention some important “Activity Ratios”. Explain each of their role in decision making process of a growing concern.

E Exercises

 

1. The Current Assets of a company are Rs 1,26,000 and the Current Ratio is 3:2 and the value of inventories is Rs 2,000. Find out the Liquid Ratio.

Answer: 1.48:1

2. Inventory Turnover Ratio is 3 times sales are Rs 1,80,000. Opening Stock is Rs 2,000 more than the Closing Stock. Calculate the Opening and Closing Stock when goods are sold at 20% profit on cost.

Answer: Opening Stock: Rs 51,000

         Closing Stock: Rs 49,000

3. A company had a Liquid Ratio of 1.5 and Current Ratio of 2 and Inventory Turnover Ratio 6 times. It had total Current Assets of Rs 8,00,000 in the year 2008. Find out the annual sales if goods are sold at 25% profit on cost.

Answer: Sales: Rs 15,00,000

4. A company earns a gross profit of 20% on cost. Its credit sales are thrice its cash sales. It credit sales are Rs 4,00,000. Calculate the Gross Profit Ratio of the company.

Answer: 16.67%

5. A company earns a gross profit of 25% on cost. Its credit sales are twice its cash sales. If the credit sales are Rs 8,00,000, compute the Gross Profit Ratio of the company.

Answer: 20%

6. Current Liabilities of a company are Rs 5,60,000, Current Ratio is 5:2, Quick Ratio is 2:1. Find the value of stock.

Answer: Rs 2,80,000

7. Calculate the Current Assets of a company from the following information:

  1. Stock Turnover: 4 times
  2. Gross Profit 20% on sales
  3. Stock in the end is Rs 20,000 more than stock in the beginning
  4. Sales: Rs 3,00,000
  5. Current Liabilities: Rs 40,000
  6. Quick Ratio: 0.75

Answer: Rs 1,00,000

8. X Ltd has a Liquid Ratio 7:3, value of stock is Rs 25,000 and its Current Liabilities Rs 75,000. Compute the Current Ratio.

Answer: 8:3

9. Cost of Goods Sold is Rs 2,00,000. Inventory Turnover is 8 times. Stock at the beginning is 1.5 times more than stock at the end. Compute the value of opening and closing stocks.

Answer: Opening Stock: Rs 20,000

          Closing Stock: Rs 30,000

10. The ratio of Current Assets (Rs 6,00,000) to Current Liabilities (Rs 4,00,000] is 1.5:1. The accountant of the firm is interested in maintaining Current Ratio at 2:1 by paying off a part of Current Liabilities. Compute the Current Liabilities that should be paid off so as to maintain the Current Ratio at the level of 2:1.

Answer: Rs 2,00,000

11. Sales: Rs 4,00,000
Gross Profit: 25% on cost
Compute Gross Profit Ratio.

Answer: 20%

12. Rs 3,00,000 is the Cost of Goods Sold. Inventory Turnover is 8 times. Stock at the beginning is 2 times more than the stock at the end. Calculate the value of opening and closing stock.

Answer: Closing Stock: Rs 25,000

          Opening Stock: Rs 50,000

13. Rs 4,00,000 is the Cost of Goods Sold. Inventory Turnover is 5 times. Stock at the beginning is 1.5 times more than the stock at the end. Calculate the values of opening and closing stock.

Answer: Opening Stock: Rs 25,000

         Closing Stock: Rs 16,667

14. Compute the Gross Profit Ratio:
Sales: Rs 5,00,000; Gross Profit: 25% on cost

Answer: Gross Profit: Rs 1,00,000

          Gross Profit Ratio: 20%

15. The Current Liabilities of a company are Rs 3,50,000. Its Current Ratio is 3 and Liquid Ratio is 1.75. Calculate (i) Current Assets (ii) Liquid Assets and (iii) Inventory

Answer:

  1. Current Assets: Rs 10,50,000
  2. Liquid Assets: Rs 6,12,500
  3. Inventory: Rs 4,37,500

16.

 

 

Rs

Net Sales

3,75,000

Cost of Goods Sold

2,50,000

Current Liabilities

1,20,000

Loan

60,000

Current Assets

4,25,000

Equity Share Capital

1,90,000

Debentures

75,000

From the above information calculate (i) Gross Profit Ratio (ii) Debt Equity Ratio and (iii) Working Capital Turnover Ratio.

Answer:

  1. Gross Profit Ratio: 33 1/3%
  2. Debt Equity Ratio: 27:38
  3. Working Capital

    Turnover Ratio: 1.22 times

17. The Current Assets of a company are Rs 15,00,000. Its Current Ratio is 3.00 and Liquid Ratio is 1.25. Calculate the amount of (i) Current Liabilities (ii) Liquid Assets and (iii) Inventory.

Answer:

  1. Current Liabilities: Rs 5,00,000
  2. Liquid Assets: Rs 6,25,000
  3. Inventory: Rs 8,75,000

18. The Current Ratio of a company is 3.0 and its Liquid Ratio is 1.15. Its Current Liabilities are Rs 3,00,000. Compute (i) Current Assets (ii) Liquid Assets and (iii) Inventory.

Answer:

  1. Current Assets Rs 9,00,000
  2. Liquid Assets: Rs 3,45,000
  3. Inventory: Rs 5,55,000

19. The Current Assets of a company are Rs 17,00,000. Its Current Ratio is 2.50 and Liquid Ratio is 0.95. Calculate (i) Current Liabilities (ii) Liquid Assets and (iii) Inventory.

Answer:

  1. Current Liabilities: Rs 6,80,000
  2. Liquid Assets: Rs 6,46,000
  3. Inventory: Rs 10,54,000

20. From the following details, compute (i) Gross Profit Ratio (ii) Stock Turnover Ratio and (iii) Operating Ratio:

 

 

Rs

Sales

1,50,000

Cost of Goods Sold

1,20,000

Opening Stock

29,000

Closing Stock

31,000

Debtors

16,000

Net Fixed Assets

1,10,000

Answer:

  1. Gross Profit Ratio: 20%
  2. Stock Turnover Ratio: 4 times
  3. Operating Ratio: 90.66%

21. From the following information, calculate (i) Current Ratio (ii) Quick Ratio and (iii) Working Capital Turnover Ratio:

 

 

Rs

Sundry Debtors

4,00,000

Stock

1,60,000

Marketable Securities

80,000

Cash

1,20,000

Prepaid Expenses

40,000

Bills Payable

80,000

Sundry Creditors

1,60,000

Debentures

2,00,000

Expenses Payable

1,60,000

Net Sales

20,00,000

Answer:

  1. Current Ratio: 2:1
  2. Quick Ratio: 1.5:1
  3. Working Capital Turnover Ratio = 5 times

22. From the particulars given below, calculate (i) Current Ratio (ii) Acid Test Ratio (iii) Working Capital Turnover Ratio:

 

 

Rs

Fixed Assets

1,00,000

Stock

37,200

Debtors

19,200

Cash

39,600

Prepaid Expenses

10,000

Creditors

36,000

Bank Overdraft

17,000

Reserves

10,000

Net Sales

31,800

Answer:

  1. Current Ratio: 2:1
  2. Acid Test Ratio: 1.11:1

23.

  1. From the given information, calculate the Stock Turnover Ratio.

    Sales: Rs 2,00,000; G.P.: 25% on Cost; Operating Stock: 1/3rd of the value of closing stock; Closing Stock: 30% of Sales.

  2. A business has a Current Ratio of 3:1 and Quick Ratio of 1.2:1. The Working Capital is Rs 1,80,000. Compute the Total Current Assets and Stock.

Answer:

  1. 4 times
    1. Rs 2,70,000
    2. Rs 1,62,000

24. From the given information, calculate the Stock Turnover Ratio:

Sales: Rs 2,00,000; G.P.: 25%; Opening Stock was 1/4th value of closing stock. Closing Stock was 20% of Sales.

Answer: 6 times

25. A business has a Current Ratio of 2:1 and a Quick Ratio of 1.2:1. Working Capital is Rs 1,50,000. Calculate Total Current Assets and Stock.

Answer:

  1. Total Current Assets: Rs 3,00,000
  2. Stock: Rs 1,20,000

26. On the basis of the particulars given below, calculate (i) Operating Ratio (ii) Liquid Ratio and (iii) Proprietary Ratio.

Cash Sales: Rs 3,00,000; Credit Sales: Rs 2,80,000; Sales Returns: Rs 20,000; Cost of Goods Sold: Rs 4,00,000; Selling and Distribution Expenses: Rs 7,000; Administrative Expenses: Rs 8,000; Current Liabilities: Rs 2,30,000; Current Assets: Rs 4,00,000; Closing Stock: Rs 40,000; Equity Share Capital: Rs 5,00,000; 8% Preference Share Capital: Rs 2,00,000; Fixed Assets: Rs 5,50,000.

Answer:

  1. Operating Ratio: 74.1%
  2. Liquid Ratio: 36:23
  3. Proprietary Ratio: 73.68%

27. On the basis of the following information you are required to calculate (i) Operating Ratio (ii) Liquid Ratio and (iii) Proprietary Ratio. Cash Sales: Rs 4,00,000; Credit Sales: Rs 2,75,000; Sales Returns: Rs 27,000; Cost of Goods Sold: Rs 3,90,000; Selling and Distributive Expenses: Rs 7,000; Administrative Expenses: Rs 3,000; Current Liabilities: Rs 1,95,000; Current Assets: Rs 3,94,000; Closing Stock: Rs 23,000; Equity Share Capital: Rs 4,37,000; Preference Share Capital: Rs 1,74,000; Fixed Assets: Rs 4,30,000.

Answer:

  1. Operating Ratio: 61.72%
  2. Liquid Ratio: 1.9:1
  3. Proprietary Ratio: 74.15%
EXERCISES (CONTINUED – MODELWISE)

Model 1: Current Ratio

 

28.

  1. From the following, calculate the Current Ratio:

     

     

    Rs

    Cash-in-hand

    2,50,000

    Sundry Debtors

    1,50,000

    Stock-in-trade

    2,00,000

    Sundry Creditors

    2,00,000

    Bills Payable

    1,00,000

     

  2. From the following, compute Current Ratio:

     

     

    Rs

    Stock

    30,000

    Sundry Debtors

    20,000

    Cash or Bank

      8,000

    Bills Receivable

    15,000

    Short-term Investments

    25,000

    Prepaid Expenses

      2,000

    Bank Overdraft

    15,000

    Sundry Creditors

    20,000

    Bills Payable

    10,000

    Outstanding Expenses

      5,000

Answer:

  1. 2:1
  2. 2:1

Model 2: Liquid Ratio or Acid Test Ratio or Quick Ratio

 

29. Calculate Liquid Ratio from the following:

 

 

Rs

Cash

15,000

Bills Receivable

20,000

Stock

22,000

Creditors

17,000

Outstanding Expenses

2,000

 

 

Rs

Debtors

20,000

Short-term Investment

20,000

Prepaid Expenses

3,000

Bills Payable

6,000

Answer: 47:26

30. Calculate Current Ratio and Liquid Ratio from the following balance sheet:

 

Balance Sheet of Swarna Ltd as on Mar 31, 2007

Answer:

  1. Current Ratio = 8:5
  2. Liquid Ratio = 5:7

Model 3: Absolute Liquid Ratio

 

31. Calculate Absolute Liquid Ratio.

 

 

Rs

Cash-in-hand

  2,000

Cash at Bank

  3,000

Short-term Investments

  5,000

Current Liabilities

30,000

Bank Overdraft

10,000

Answer: 5:1

Model 4: Debt Equity Ratio

 

32. Calculate Debt Equity Ratio from the following:

 

 

Rs

Debentures

3,00,000

Loan from Banks

2,00,000

Equity Share Capital

1,75,000

Reserves and Surpluses

  75,000

Answer: 2:1

Model 5: Proprietary Ratio

 

33. Calculate Proprietary Ratio from the following:

 

 

Rs

Equity Share Capital

2,00,000

Preference Share Capital

1,00,000

Reserves and Surpluses

1,00,000

Machinery

1,00,000

Goodwill

  40,000

Cash at Bank

  40,000

Stock

  60,000

Answer: 16.66%

Model 6: Gross Profit Ratio

 

34. Calculate Gross Profit Ratio from the following:

 

 

Rs

Purchases

3,15,000

Opening Stock

15,000

Closing Stock

30,000

Sales

4,00,000

Answer: 25%

Model 7: Net Profit Ratio

 

35. Calculate Net Profit Ratio from the following:

 

 

Rs

Net Profit

50,000

Sales

2,50,000

Answer: 20%

36. From the given data, calculate

  1. Gross Profit Ratio
  2. Net Profit Ratio
  3. Current Ratio

 

Rs

Sales

6,00,000

Net Profit

60,000

Current Liabilities

60,000

Cost of Goods Sold

4,00,000

Current Assets

1,20,000

Answer:

  1. 33⅓%
  2. 10%
  3. 2:1

Model 8: Operating Profit Ratio

 

37. From the following data, compute the Operating Profit Ratio:

 

 

Rs

Net Profit

2,00,000

Loss on Sale of Machine

10,000

Profit on Sale of Investment

40,000

Interest Paid on Loan

40,000

Interest from Investments

60,000

Sales

3,00,000

Answer: 50%

38. Calculate Operating Profit Ratio from the following:

 

 

Rs

Gross Profit

1,50,000

Sales

9,07,500

Operating Expenses

60,000

Sales Return

7,500

Answer: 10%

Model 9: Operating Ratio

 

39. Calculate Operating Ratio from the following:

 

 

Rs

Cost of Goods Sold

4,50,000

Operating Expenses

50,000

Sales

10,12,500

Sales Returns

12,500

Answer: 50%

40. From the following, calculate Operating Ratio:

 

 

Rs

Cost of Goods Sold

6,25,000

Operating Expenses

75,000

Sales

14,13,900

Sales Returns

13,900

Answer: 50%

Model 10: Capital Turnover Ratio

 

41. Compute Capital Turnover Ratio, from the following:

 

 

Rs

Cash Sales

2,40,000

Credit Sales

2,72,000

Sales Return

12,000

Equity Share Capital

1,00,000

Long-term Loan

90,000

Reserves and Surpluses

60,000

Answer: 2 Times

42. From the following, compute Capital Turnover Ratio:

 

 

Rs

Cash Sales

3,10,000

Credit Sales

3,97,600

Sales Return

7,600

Equity Share Capital

2,00,000

Long-term Loan

1,00,000

Reserves and Surpluses

50,000

Answer: 2 Times

Model 11: Fixed Assets Turnover Ratio

 

43. Compute Fixed Assets Turnover Ratio from the following:

 

 

Rs

Fixed Assets

5,50,000

Depreciation on Fixed Assets

50,000

Sales

10,08,750

Sales Return

8,750

Answer: 2 Times

44. Calculate Fixed Assets Turnover Ratio from the following:

 

 

Rs

Sales

16,19,875

Sales Return

19,875

Fixed Assets

4,60,000

Depreciation on Fixed Assets

60,000

Answer: 4 Times

Model 12: Stock Turnover Ratio

 

45. Calculate Stock Turnover Ratio from the following:

 

 

Rs

Cost of Goods Sold

6,00,000

Opening Stock

1,00,000

Closing Stock

2,00,000

Answer: 4 Times

46. Compute Stock Turnover Ratio from the following:

 

 

Rs

Sales

4,50,000

Gross Profit

50,000

Stock

75,000

Answer: 5.3 Times

Model 13: Debtors Turnover Ratio

 

47. Calculate Debtors Turnover Ratio from the following data:

 

 

Rs

Cash Sales

60,000

Total Sales

2,20,000

Debtors at the beginning of the year

75,000

Debtors at the closing of the year

85,000

Answer: 2 Times

48. Compute Debtors Turnover Ratio from the following:

 

 

Rs

Total Sales

12,50,000

Sales Return

50,000

Opening Debtors

1,05,000

Closing Debtors

95,000

Answer: 12 Times

Model 14: Creditors Turnover Ratio

 

49. Compute Creditors Turnover Ratio from the following:

 

 

Rs

Credit Purchases

4,80,000

Opening Creditors

55,000

Closing Creditors

65,000

Answer: 8 Times

50. Compute Creditors Turnover Ratio from the following:

 

 

Rs

Total Purchases

2,05,000

Cash Purchases

40,000

Purchases Return

5,000

Opening Creditors

55,000

Closing Creditors

25,000

Answer: 4 Times

Model 15: Miscellaneous (Comprehensive) (Combination of Ratios)

 

51. From the following balance sheet, calculate Current Ratio and Proprietary Ratio: Balance Sheet of Felix Ltd as on Mar 31, 2007.

  1. Current Ratio = 0.8:1
  2. Proprietary Ratio = 2.3:3.5

52. The following is the Profit and Loss Account of a company for the year ending Mar 31, 2007.

You are required to prepare

  1. Gross Profit Ratio
  2. Net Profit Ratio
  3. Operating Ratio
  4. Stock Turnover Ratio

Answer:

  1. 28.5%
  2. 57%
  3. 71.4%
  4. 5 Times

53. From the following balance sheet of X Ltd, you are required to calculate

  1. Debt Equity Ratio
  2. Proprietary Ratio
  3. Current Ratio
  4. Fixed Assets Turnover Ratio
  1. 1:8
  2. 4:5
  3. 2:1

54. From the following, calculate

  1. Operating Profit Ratio
  2. Operating Ratio
  3. Gross Profit Ratio
  4. Net Profit Ratio

 

Rs

Sales

2,00,000

Gross Profit

40,000

Administrative Expenses

3,000

Selling Expenses

2,000

Loss on Sale of Investments

2,000

Dividend Received

1,000

Net Profit

30,000

Answer:

  1. 15.5%
  2. 82.5%
  3. l20%

55. Following is the summarised Trading and Profit and Loss A/c for the year ending Mar 31, 2007 and the Balance Sheet as on that date:

Balance Sheet as on Mar 31, 2007

Calculate :

  1. Gross Profit Ratio
  2. Operating Ratio
  3. Return on Capital Employed

Answer:

  1. 60%
  2. 67.5%
  3. 50%

56. Calculate the amount of Gross Profit:

Average Stock: Rs 50,000

Stock Turnover Ratio: 10 times

Selling Price: 20% above Cost

Answer: Rs 1,00,000

57. Calculate Cost of Goods Sold:

Sales: Rs 15,00,000; Sales Return: Rs 1,00,000

Operating Expenses: Rs 50,000; Operating Ratio = 90%

Answer: Rs 12,10,000

58. Calculate Opening Stock and Closing Stock:

Total Sales: Rs 10,00,000

Gross Profit: 20% on Sales

Stock Turnover Ratio: 5 times

Closing Stock is Rs 20,000 more than Opening Stock

Answer:

  1. Cost of Goods gold: Rs 8,00,000
  2. Opening Stock: Rs 1,50,000
  3. Closing Stock: Rs 1,70,000

59. A trader carries an average stock of Rs 20,000. His Stock Turnover is 5 times. If he sells goods at a profit of 25% on sales, calculate the profit.

Answer: Rs 25,000

60. Debt collection period of X Ltd is 36 days. Sales affected during the year were Rs 5,00,000. Assuming 360 days in a year, calculate Debtors Turnover Ratio; Average Debtors; Debtors on Jan 01, 2006 and Dec 31, 2006, if the debtors at the end are Rs 20,000 more than those in the beginning.

Answer:

  1. Debtors Turnover Ratio = 10 Times
  2. Debtors on 1. 1. 2006: Rs 40,000
  3. Debtors on 31. 12. 2006: Rs 60,000

61. Current Liabilities are Rs 50,000; Liquid Ratio is 2:1; Current Ratio is 3:1. Calculate Quick Assets, Stock-in-trade and Current Assets.

Answer:

  1. Quick Assets: Rs 1,00,000
  2. Stock-in-trade: Rs 50,000
  3. Current Assets: Rs 1,50,000

62. Calculate Return on Equity:

 

 

Rs

Equity Share Capital

1,50,000

10% Prof. Share Capital

1,00,000

Reserves and Surpluses

5,00,000

Net Profit after Tax

2,10,000

Answer: 28%

63.

 

 

Rs

Share Capital

1,00,000

General Reserve

50,000

12% Loan

50,000

Sales for the year

2,00,000

Tax paid

10,000

Profit after Tax and Dividend

20,000

From the above information, you are required to calculate:

  1. Debt Equity Ratio
  2. Capital Turnover Ratio
  3. Interest Coverage Ratio
  4. Return on Equity
  5. Debt to Total Fund Ratio

Answer:

  1. Debt Equity Ratio = 1:2
  2. Capital Turnover Ratio = 2 Times
  3. Interest Coverage Ratio = 6 Times
  4. Return on Equity = 30%
  5. Debt to Total Fund Ratio = 1:3

64. The following data relates to Shree Ltd.

 

 

2008 (Rs)

2009 (Rs)

Sales

20,00,000

25,00,000

Cost of Goods Sold

10,00,000

12,00,000

Gross Profit

2,00,000

2,50,000

The Manager claims that he has worked more efficiently during the year 2006 because the Gross Profit has increased by Rs 50,000 and should be rewarded for his efficiency of service.

Give your opinion to the management to decide upon manager’s claim.

65. From the following information, comment on the efficiency of the working of the company:

  2008 (Rs) 2009 (Rs)

Sales

4,00,000
6,00,000

Cost of Goods Sold

3,00,000
4,00,000

Gross Profit

2,00,000
2,50,000

Operating Expenses

50,000
1,00,000

Operating Profit

1,00,000
1,00,000