Significance

The earning per share helps in determining the market price of the equity share of the company. A
comparison of EPS of the company with another will also help in deciding whether the equity share
capital is being effectively used or not. It also helps in estimating the company's capacity to pay dividend
to its equity shareholders.

3. Price Earning (P/E) Ratio

This ratio indicated the number of times the earning per share is covered by its market price. This is
calculated according to the following formula:
Market price per equity share
Earning per share
Significance
Price-Earning ratio helps the Investor in deciding whether or not to buy the shares of a company at a
particular market price.

4. Gross Profit Ratio

This ratio expresses relationship between the gross profit and net sales. Its formula is:
Gross profit
-xlOO
Net sales
Significance
This ratio indicates the degree to which the selling price of goods per unit may decline without resulting
in losses, from operations, to the firm. It also helps in ascertaining whether the average percentage of
mark up on the goods is maintained.
There is no norm for judging the 'Gross Profit Ratio'. Therefore, the evaluation of the business on its
basis is a matter of judgment. However, the gross profits should be adequate to cover operating expenses
and to provide for fixed charges, dividends and building up of reserves.

5. Net Profit Ratio

atio

dicates net margin earned on a sale of Rs. 100. It is calculated as

i
n

follows: Net operating profit

-xlOO
Net sales

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Significance
This ratio helps in determining the efficiency with which affairs of the business are being managed. An
increase in the ratio, over the previous period, indicates improvement in the operational efficiency of
the business, provided the gross profit ratio is constant. The ratio is thus, an effective measure to check
the profitability of a business.
An investor has to judge the adequacy or otherwise of this ratio by taking into account the cost of
capital, the return in the industry as a whole and, market conditions, such as boom or depression period.
No norms can be laid down. However, constant increase in the above ratio year after year is a definite
indication of improving conditions of the business.
B. Solvency Ratios
A company is considered to be solvent or financially sound if it is in a position to carry on its business
smoothly and meet all obligations, both long-term as well as short-term, without strain. The following
are the important ratios for measuring the long-term and short-term solvency of a firm.

1. Long-term Solvency Ratios

In order to determine the long-term solvency of a business, the following ratios will be useful: (i)
Fixed Assets Ratio: This ratio is expressed as follows:
Fixed assets Longterm funds
The ratio should not be more than 1. If it is less than 1, it shows that a part of the working capital
has been financed through long-term funds. This is desirable to some extent because a part of
working capital, termed as 'core working capital', is more or less of a fixed nature. The ideal ratio
is 0.67.
Fixed assets include 'net fixed assets' (i.e. original cost-depreciation to date) and trade investments
including shares in subsidiaries. Long-term funds include share capital, reserves, and long-term
loans.
(ii) Debt-equity Ratio. The debt-equity ratio is calculated to ascertain the soundness of the long-term
financial policies of the company. It is also known as the 'External-Internal' equity ratio. It may
be calculated as follows:
Debt-equity ratio =

External equities Internal equities

The term 'external equities' refers to total outside liabilities, and the term 'internal equities' refers
to shareholders' funds or the tangible net worth. In case the ratio is 1 (i.e. outsiders' funds are
equal to shareholders' funds), it is considered to be quite satisfactory.
In case debt-equity ratio is to be calculated as a long-term financial ratio, it may be calculated as
follows:
Total long-term debt (i)
Debt-equity ratio = Total long_term
(ii) Debt-equity ratio

Total long-term debt Shareholds' funds

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Method (ii) is most popular.
Ratio (i) gives the proportion of the long-term debt to the total long-term funds (including borrowed
as well as owned funds), while the Ratio (ii) indicates the proportion of the long-term debt to the
shareholders' funds (i.e. tangible net worth) .
Ratio (i) may be taken as ideal if it is 0.5 while the ratio (ii) may be taken as ideal if it is 1. In other
words, the investor may take debt-equity ratio as quite satisfactory if shareholders' funds are
equal to long-term borrowed funds. However, a higher ratio, say, two-thirds borrowed funds and
one-third owned funds, may also not be considered as unsatisfactory if the business needs heavy
investment in fixed assets and has an assured return on its investment, e.g. the case of public
utility concerns.
It is to be noted that preference shares, redeemable within a period of twelve years from the date
of their issue, should be taken as a part of debt.
Significance
The ratio indicates the proportion of owners' stake in the business. Excessive liabilities tend to
cause insolvency. The ratio indicates the extent to which the firm depends upon outsiders for its
existence. The ratio provides a margin of safety to the creditors. It tells the owners the extent to
which they can borrow, to increase the profits, with a limited investment.
2. Short-term Solvency Ratios
The following ratios will be useful for determining the short-term solvency of a business: (i) Current
Ratio: This ratio is an indicator of the firm's commitment to meet its short-term liabilities. It is
expressed as follows:
Current assets
Current liabilities
Current assets include cash and other assets convertible or meant to be converted into cash during
the operating cycle of the business (which is of not more than a year). Current liabilities mean
liabilities payable within a year's time either out of existing current assets or by creation of new
current liabilities.
Book debts outstanding for more than six months and loose tools should not be included in
current assets. Prepaid expenses should be taken into current assets.
An ideal current ratio is 2. A very high current ratio is also not desirable since it means less
efficient use of funds.
Significance
The current ratio is an index of the concern's financial stability since it shows the extent of the
working capital, which is the amount by which the current assets exceed the current liabilities. As
stated earlier, a higher current ratio would indicate inadequate employment of funds while a poor
current ratio is a danger signal to the management. Poor current ratio shows that the business is
trading beyond its resources.
(ii) Liquidity Ratio : This ratio is also termed as 'acid test ratio' or 'quick ratio'. This ratio is ascertained
by comparing the liquid assets (i.e. assets which are immediately convertible into cash without
much loss) to current liabilities. Prepaid expenses and stock are not taken as liquid assets. The
ratio may be expressed as:
Liquid assets
Current liabilities

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The ideal ratio is 1.
Significance
The ratio is also an indicator of short-term solvency of the company.
A comparison of the current ratio to quick ratio shall indicate the inventory hold-ups. For example,
if the two concerns have the same current ratio but a different liquidity ratio, it indicates overstocking by the concern having a low liquidity ratio as compared to the concern which has a
higher liquidity ratio.
C. Turnover Ratios

1. Stock Turnover Ratio : This ratio indicates whether the investment in inventories is efficiently
used or not. It, therefore, explains whether investment in inventories is within proper limits or
not. The ratio is calculated as follows:
Cost of goods sold during the year
Average inventory
Average inventory is calculated by taking stock levels of raw materials, work-in-process, finished
goods, at the end of each month, adding them up and, dividing by twelve.
The average inventory may also be computed on the basis of the average of inventory at the
beginning and at the end of the accounting period.
Significance
The inventory turnover ratio signifies the liquidity of the inventory. A high inventory turnover
ratio indicates brisk sales. The ratio is, therefore, a measure to discover the possible trouble in the
form of overstocking or overvaluation. The stock position is known as the graveyard of the balance
sheet. If the sales are quick, such a position would not arise unless the stocks consist of unsaleable
items. A low inventory turnover ratio results in the blocking of funds in inventory, which may
ultimately result in heavy losses due to inventory becoming obsolete or deteriorating in quality.
2. Debtors' Turnover Ratio (Debtors' Velocity)-: Debtors are an important constituent of current
assets and, therefore, the quality of debtors, to a great extent, determines a firm's liquidity. Two
ratios are used by financial analysts to judge this. They are:
(i) Debtors, turnover ratio, and
(ii) Debt collection period ratio.
Debtors' turnover ratio is calculated as under:
Credit sales
Average accounts receivable
The term 'Accounts Receivable' includes 'Trade Debtors' and 'Bills Receivable'.
In case, details regarding opening and closing receivables and credit sales are not available, the
ratio may be calculated as follows:
Total sales
Accounts receivables
Significance
'Sales to Accounts Receivable Ratio' indicates the efficiency of the staff entrusted with collection
of book debts. The higher the ratio, the better it is, since it would indicate that debts are being

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collected more promptly. For measuring the efficiency, it is necessary to set up a standard figure;
a ratio lower than the standard will indicate inefficiency.
The ratio helps in cash budgeting since the flow of cash from customers can be worked out on the
basis of sales.
Debt Collection Period Ratio : The ratio indicates the extent to which the debts have been
collected in time. It gives the average debt collection period. The ratio is very helpful to the
lenders because it explains to them whether their borrowers are collecting money within a reasonable
time. An increase in the period will result in greater blockage of funds in debtors. The ratio may
be calculated by any of the following methods:

(0-

Months (or days) in a year Debtors' turnover

Average accounts receivable x Months (or days) in a year Credit sales for the year

(ii)
(iii)

Accounts receivable
Average monthly or daily credit sales
Significance
Debtors' collection period measures the quality of debtors since it measures the rapidity or slowness
with which money is collected from them. A shorter collection period implies prompt payment by
debtors. It reduces the chances of bad debts. A longer collection period implies too liberal and
inefficient credit collection performance. However, in order to measure a firm's credit and collection
efficiency, its average collection period should be compared with the average of the industry. It
should be neither too liberal nor too restrictive. A restrictive policy will result in lower sales
which will reduce profits.
It is difficult to provide a standard collection period of debtors. It depends upon the nature of the
industry, seasonal character of the business and, credit policies of the firm. In general, the amount
of receivables should not exceed three to four months' credit sales.

21.6 DIFFERENT USERS AND THEIR USE OF RATIOS

(i) Accounting ratios used by a long-term creditor:
Income before interest and tax
Interest charges
(a) Fixed charges cover =
_ Cash profit available for debt service (b) Debt service coverage
ratio = Interest + Principal payments instalment
(ii) Accounting ratios used by a bank granting a short-term loan: Quick assets
Current liabilities
(a) Quick ratio =

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Current
assets
(b) Current ratio =
Current liabilities (iii) Accounting ratios used by shareholders:
Pr ofit available for equity shareholders
No. of equity shares

(a) Earnings per share =

Dividend per share (b)
Dividend yield ratio = Market price per share
Illustration

Assuming current ratio is 2, state in each of the following cases, whether the current ratio will improve or
decline or will have no change:
(i) Payment of a current liability
(ii) Purchase of fixed assets (iii)
Cash collected from customers (iv)
Bill receivable dishonoured
(v) Issue of new shares
Solution
When the current ratio is 2 : 1 or say the current assets are Rs. 20,000 and the current liabilities Rs.
10,000, the effect of the transaction given in the problem on current ratio will as follows:
(i) Payment of current liability: On payment of a current liability out of current assets, working
capital will remain unchanged. However, current ratio will improve. For instance, if out of above
current liabilities Rs. 5,000 is paid, resultant current assets will be Rs. 15,000 and current liabilities
Rs. 5,000. This will give a current ratio of 3:1.
(it) Purchase of fixed assets: On purchase of fixed assets in cash, current assets will decrease without
any change in current liabilities. Thus, the transaction will result in decline of current ratio from
2: 1
'
'
(iii) Cash collected from customers: Collection of debtors, results in the conversion of one current
asset, viz., debtors into another current asset, viz., cash. Hence, amount of current assets and
current liabilities remain unchanged, the current ratio will, therefore, remain at 2:1.
(iv) Bills receivable dishonoured: When a bill receivable is dishonoured, it cannot always be presumed
that the customer has become insolvent. Hence, if the customer is solvent, the amount of bills
receivable will get reduced and the amount due from debtors will increase. There will be no
change in the amount of current liabilities. Hence, on this assumption current ratio will continue
to be 2:1.
However, if it is anticipated that the debt becomes bad and it is recorded as such, it will result in the
reduction of current assets resulting in fall in the current ratio from 2:1.
(v) Issue of new shares: If issue of new shares is for cash it will result in an increase in the current
assets. Hence, there will be consequential improvement in current ratio as there will be no change
in current liabilities.

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However, if issue is in consideration of purchase of fixed assets or conversion of debentures, there will
be no change in current assets or current liabilities and, therefore, no change in current ratio.
21.7 LET US SUM UP
Ratios are important tools for financial analysis and are used by owners, investors, bankers, creditors, rating
agencies and other interested persons. For calculating ratios, figures, provided in the financial statements, i.e.
the P & L a/c and the Balance sheet, are used. Ratios can be used for inter-firm or intra-firm comparison in order
to know the trends and position of various financial parameters. While using the ratios, we should be careful
about the various situations in which the firms operate and also methods used in arriving at the figs, in the
financial statements. The main ratios are the profitability ratios, solvency ratios and, the turnover ratios.
21.8 KEYWORDS
Financial Statements, P&L a/c, Balance Sheet, Tangible Net Worth (TNW), Profitability, Solvency, Turnover,
Earning Per Share(EPS), P/E ratio, DSCR, Operating Profit, Net Profit, Current Assets, Current Liabilities.
Long-term debts, Working Capital, Window-dressing.