Ratios: Classification and Computation

In this article we will discuss about the classification and computation of ratios.

Classification of Ratios:

Ratios may be classified from various stand points and they are:

(A) Classification by Statements:

This classification is based on those statements from which information’s are obtained for calculating ratios since accounting information’s are obtained mostly from two statements i.e. Balance Sheet and Profit and Loss Account.

The following are included in this classification:

(1) Balance Sheet Ratios or Financial Ratios:

These include:

(i) Liquidity Ratio,

(ii) Current Ratio,

(iii) Stock Ratio,

(iv) Proprietary Ratio, and

(v) Capital Gearing Ratio.

(2) Profit and Loss Account Ratios or Operating Ratios:

These include:

(i) Gross Profit Ratio,

(ii) Expense Ratio,

(iii) Operating Ratio,

(iv) Net Profit Ratio, and

(v) Profit Cover of Interest and Dividend.

(3) Balance Sheet and Profit and Loss Account Ratios:

These include:

(i) Return on Capital Employed,

(ii) Return on Shareholders Fund,

(iii) Stock Turnover,

(iv) Debtors Turnover,

(v) Creditors Turnover,

(vi) Working Capital Turnover,

(vii) Current Assets Turnover,

(viii) Total Turnover,

(ix) Fixed Assets Turnover, and

(x) Net Sales to Tangible Assets.

(B) Classification by Users:

This classification is based on the parties who are interested in making the use of these ratios.

These include:

(1) Ratios for Management:

These are also known as Management Efficiency Ratios and include:

(i) Operating Ratio

(ii) Return on Capital Employed

(iii) Stock Turnover

(iv) Debtors Turnover

(v) Solvency Ratio

(2) Ratios for Creditors:

These include:

(i) Current Ratio

(ii) Solvency Ratio

(iii) Creditors Turnover

(iv) Fixed Asset Ratio

(v) Assets Cover

(vi) Interest Cover or Debt Service Ratio

(3) Ratios for Shareholders:

These include:

(i) Return on Shareholders Fund,

(ii) Capital Gearing Ratio,

(iii) Dividend Cover,

(iv) Yield Rate,

(v) Proprietory Ratio,

(vi) Dividend Ratio, and

(vii) Assets Cover of Share.

(C) Classification by Relative Importance:

It includes the following:

(1) Primary Ratios or Explanatory Ratios

These include:

(i) Return on Capital Employed.

(ii) Asset Turnover.

(iii) Profit Ratio.

(2) Secondary Ratios:

These include:

(i) Working Capital Turnover.

(ii) Stock to Current Assets.

(iii) Current Assets to Fixed Assets.

(iv) Stocks to Fixed Assets.

(v) Fixed Assets to Total Assets.

(3) Secondary Credit Ratios:

These include:

(i) Creditors Turnover.

(ii) Debtors Turnover.

(iii) Liquidity Ratio.

(iv) Current Ratio.

(v) Average Collection Period.

(4) Growth Ratios:

These include:

(i) Growth Rate in Sales.

(ii) Growth Rate in Net Assets.

(D) Classification to Accounting Significance:

These include:

(i) Solvency Ratio.

(ii) Earning Ratio.

(iii) Capitalisation Ratio.

(iv) Credit Ratio.

(v) Management Ratio.

(E) Classification by Nature:

These include:

(i) Inventory Ratio.

(ii) Debtors and Creditors Ratio.

(iii) Sales Ratio.

(iv) Earnings and Dividend Ratio.

(v) Cost Ratio.

(F) Classification by Purpose:

These include:

(i) Profitability Ratio.

(ii) Activity Ratio.

(iii) Financial Ratios.

(iv) Miscellaneous Ratios.

Computation of Ratios:

1. Gross Profit Ratio:

This ratio expresses the relationship between Gross Profit and Sales.

The formula for computing this ratio is:

Gross Profit Ratio = Gross Profit/Sales x 100

2. Operating Ratio:

This ratio establishes the relationship between total operating expenses and sales. The total operating expenses include cost of goods sold, administrative expenses, financial expenses and selling and distribution expenses.

Operating Ratio = Cost of Sales + Other Operating Expenses/Sales x 100

3. Expenses Ratio:

There are several sub-divisions of this ratio.

Some of the important are:

(a) Cost of goods sold to net sales ratio:

This ratio is established between the cost of goods sold to the net sales.

Ratio = Cost of goods sold/Net Sales

(b) Each item of expenses to net sales ratio:

Each item of the expenses is compared to net sales and ratios are established such as

(i) Factory cost to sales.

(ii) Administrative expenses to sales.

(iii) Distribution expenses to sales.

4. Net Profit Ratio:

It measures the relationship between Net Operating Profit and Sales and as such is expressed as percentage to sales.

Net Profit Ratio = Net Operating Profit/Sales x 100

5. Return on Capital Employed:

It measures the relationship between profit before interest and tax to capital employed.

Return on Capital Employed = Profit before Interest and Tax/ Capital Employed x 100

6. Earning Per Share:

It is calculated by dividing net profit after tax and preference share dividend by number of equity shares.

EPS = Net Profit after Tax and Preference Share Dividend/Number of Equity Shares

7. Price Earning Ratio:

This ratio indicates the number of times earning per share is covered by its market price.

P.E.R = Market Price Per Share/Earning Per Share

8. Dividend Per Share:

It is calculated by dividing the amount of dividend distributed by the number of equity shares.

D.P.S = Dividends to Equity Shareholders/Number of Equity Shares

9. Pay-Out Ratio:

It is calculated by dividing rate of dividend by net profit

Pay – Out Ratio = Equity Dividend/Net Profit after Tax and Preference Dividend x 100

10. Earning Yield Ratio:

This is the reciprocal of price earning ratio and it is obtained by

E.Y.R = Earning Per Share/Market Price Per Share x 100

11. Dividend Yield Ratio:

In some cases the amount of dividend is related to market value of shares. In this case the resultant relationship is known as Dividend Yield Ratio.

D.Y.R = Dividend Per Share/Market Price Per Share x 100

12. Ratio of Revenue Reserves to Paid Up Capital:

This ratio is calculated by establishing the relationship between revenue reserves and paid up capital.

Ratio of Revenue Reserves to Paid up Capital = Revenue Reserves/Paid up Capital x 100

13. Interest Cover:

It explains the relationship between profit before interest and tax and fixed interest charges.

Interest Cover = Profit before Interest and Tax/Fixed Interest Charges

14. Dividend Cover:

It is the reciprocal of pay-out ratio.

Dividend Cover = Profit after Interest and Tax/Dividend

15. Inventory Turnover:

Inventory turnover is the number of times obtained by dividing cost of sales by average stock.

Inventory Turnover = Cost of Goods Sold/Average Stock

16. Receivables Turnover:

Receivables turnover measures the number of times the receivables rotate in a year in terms of sales.

Receivable Turnover = Net Sales/Average Receivables

17. Payables Turnover:

Payables turnover shows the relationship between net purchases for the whole year and total payables.

Payable Turnover = Payables/Net Purchases

18. Assets Turnover:

This ratio shows the relationship between total assets of the concern and sales of the concern.

Assets Turnover = Net Sales/Total Assets

19. Capital Turnover:

It is the ratio between capital employed and sales.

Capital Turnover = Sales/Capital Employed

20. Fixed Asset Ratio:

Fixed asset ratio is the ratio of capital and long term funds to fixed assets.

Fixed Asset Ratio = Capital + Long Terni Liabilities/Fixed Assets

21. Current Ratio:

The ratio of current assets to current liabilities is called current ratio.

Current Ratio = Current Assets/Current Liabilities

22. Stock to Current Asset Ratio:

It expresses the relationship between stock and current assets.

Stock to Current Asset Ratio = Stock/Current Assets

23. Acid Test Ratio/Quick Ratio:

This ratio is the relationship between quick assets and current liabilities.

Quick Ratio = Quick Assets/Current Liabilities

24. Super Quick Ratio:

It is obtained by dividing the super quick current assets by current liabilities.

Super Quick Ratio = Super Quick Assets/Current Liabilities

25. Solvency Ratio:

It is obtained by dividing total assets by total liabilities.

Solvency Ratio = Total Assets/Total Liabilities

26. Debt Equity Ratio:

Debt equity ratio relates all recorded creditor’s claims on assets to owners recorded claims in order to measure the firms obligations to creditors in relation to funds provided by the owners.

Debt Equity Ratio = Outsiders Fund/Shareholders Fund

27. Ratio of Tangible Assets to Total Assets:

It explains the relation between tangible assets and total debts.

Ratio of Tangible Assets to Total Assets = Tangible Assets/Total Debt

28. Capital Gearing Ratio:

This ratio attempts to measure the capital gearing or capital leverage in the scheme of capitalisation.

Capital Gearing Ratio = Equity Share Capital + Reserves/Preference Share Capital + Debentures