 Accounting Basics Tutorial
 Accounting  Home
 Accounting  Overview
 Accounting  Process
 Accounting  Basic Concepts
 Accounting  Conventions
 Accounting  Accounts' Classification
 Accounting  Systems
 Financial Accounting
 Financial Accounting  Journal
 Financial Accounting  Ledger
 Financial Accounting  Books
 Financial Accounting  Depreciation
 Cost Accounting
 Cost Accounting  Introduction
 Cost Accounting  Advantages
 Cost Accounting  vs. Financial A/c
 Cost Accounting  Cost Classification
 Cost Accounting  Elements of Cost
 Cost Accounting  Cost Sheet
 Cost Accounting  Cost Control
 Cost Accounting  Cost Reduction
 Cost Accounting  Budgeting
 Cost Accounting Techniques
 Cost Accounting  Marginal Costing
 Cost Accounting  Standard Costing
 Cost Accounting  Variance Analysis
 Cost Accounting  CVP Analysis
 Management Accounting
 Management A/c  Introduction
 Management A/c  vs. Cost A/c
 Management A/c  vs. Financial A/c
 Management A/c  Cash Flow
 Management A/c  Ratio Analysis
 Management A/c  Useful Ratios
 Management A/c  Working Capital
 Accounting Useful Resources
 Accounting Basics  Quick Guide
 Accounting Basics  Useful Resources
Accounting Basics  Ratio Analysis
Ratio is an expression of relationship between two or more items in mathematical terms. Exhibition of meaningful and useful relation between different accounting data is called Accounting Ratio. Ratio may be expressed as a:b (a is to b), in terms of simple fraction, integer, or percentage.
If the current assets of a concern is Rs 4,00,000 and the current liabilities is Rs 2,00,000, then the ratio of current assets to current liabilities is given as 4,00,000 / 2,00,000 = 2. This is called simple ratio. Multiply a ratio by 100 to express it in terms of percentage.
We can express the ratio between 200 and 100 in any of the following ways:
 2 : 1
 2/1
 200%
 2 to 1
 2
Ratios are extremely useful in drawing the financial position of a concern.
Accounting Analysis
Comparative analysis and interpretation of accounting data is called Accounting Analysis. When accounting data is expressed in relation to some other data, it conveys some significant information to the users of data.
Ratio Analysis and its Applications
Ratio analysis is a medium to understand the financial weakness and soundness of an organization. Keeping in mind the objective of analysis, the analyst has to select appropriate data to calculate appropriate ratios. Interpretation depends upon the caliber of the analyst.
Ratio analysis is useful in many ways to different concerned parties according to their respective requirements. Ratio analysis can be used in the following ways:
 To know the financial strength and weakness of an organization.
 To measure operative efficiency of a concern.
 For the management to review past year’s activity.
 To assess level of efficiency.
 To predict the future plans of a business.
 To optimize capital structure.
 In inter and intra company comparisons.
 To measure liquidity, solvency, profitability and managerial efficiency of a concern.
 In proper utilization of assets of a company.
 In budget preparation.
 In assessing solvency of a firm, bankruptcy position of a firm, and chances of corporate sickness.
Advantages of Ratio Analysis
It is powerful tool to measure short and longterm solvency of a company.
It is a tool to measure profitability and managerial efficiency of a company.
It is an important tool to measure operating activities of a business.
It helps in analyzing the capital structure of a company.
Large quantitative data may be summarized using ratio analysis.
It relates past accounting performances with the current.
It is useful in coordinating the different functional machineries of a company.
It helps the management in future decisionmaking.
It helps in maintaining a reasonable balance between sales and purchase and estimating working capital requirements.
Limitations of Ratio Analysis
Although Ratio Analysis is a very useful accounting tools to analyze and interpret different accounting equations, it comes with its own set of limitations:
If the data received from financial accounting is incorrect, then the information derived from ratio analysis could not be reliable.
Unauthenticated data may lead to misinterpretation of ratio analysis.
Future prediction may not be always dependable, as ratio analysis is based on the past performance.
To get a conclusive idea about the business, a series of ratios is to be calculated. A single ratio cannot serve the purpose.
It is not necessary that a ratio can give the real present situation of a business, as the result is based on historical data.
Trend analysis is done with the help of various calculated ratios that can be distorted due to the changes in the price level.
Ratio analysis is effective only where same accounting principles and policies are adopted by other concerns too, otherwise intercompany comparison will not exhibit a real picture at all.
Through ratio analysis, special events cannot be identified. For example, maturity of debentures cannot be identified with ratio analysis.
For effective ratio analysis, practical experience and knowledge about particular industry is essential. Otherwise, it may prove worthless.
Ratio analysis is a useful tool only in the hands of an expert.
Types of Ratio
Ratios can be classified on the basis of financial statements or on the basis of functional aspects.
Classification on the Basis of Financial Statement
Balance Sheet Ratios
Ratios calculated from taking various data from the balance sheet are called balance sheet ratio. For example, current ratio, liquid ratio, capital gearing ratio, debt equity ratio, and proprietary ratio, etc.
Revenue Statement Ratio
Ratios calculated on the basis of data appearing in the trading account or the profit and loss account are called revenue statement ratios. For example, operating ratio, net profit ratio, gross profit ratio, stock turnover ratio.
Mixed or Composite Ratio
When the data from both balance sheet and revenue statements are used, it is called mixed or composite ratio. For example, working capital turnover ratio, inventory turnover ratio, accounts payable turnover ratio, fixed assets turnover ratio, return of net worth ratio, return on investment ratio.
Classification of Ratios on the Basis of Financial Statements  

Balance Sheet Ratios  Profit and Loss A/c Ratios  Composite or Mixed Ratios 


































Classification on the Basis of Financial Aspects
Ratios can be further classified based on their functional aspects as discussed below.
Liquidity Ratios
Liquidity ratios are used to find out the shortterm paying capacity of a firm, to comment short term solvency of the firm, or to meet its current liabilities. Similarly, turnover ratios are calculated to know the efficiency of liquid resources of the firm, Accounts Receivable (Debtors) Turnover Ratio and Accounts Payable (Creditors).
LongTerm Solvency and Leverage Ratios
Debt equity ratio and interest coverage ratio are calculated to know the efficiency of a firm to pay longterm debts and to meet interest costs. Leverage ratios are calculated to know the proportion of debt and equity in the financing of a firm.
Activity Ratios
Activity ratios are also called turnover ratios. Activity ratios measure the efficiency with which the resources of a firm are employed.
Profitability Ratios
The results of business operations can be calculated through profitability ratios. These ratios can also be used to know the overall performance and effectiveness of a firm. Two types of profitability ratios are calculated in relation to sales and investments.
FUNCTIONAL CLASSIFICATION OF RATIOS  

Liquidity Ratios  LongTerm Solvency and Leverage Ratios  Activity Ratios Asset Management Ratios  Profit Abilities Ratios 
(A) 


(A) In relation to sales 




















(B)  






(B) In relation to Investments  














Chart of Useful Ratios
OBJECTIVES  RATIOS TO BE COMPUTED 

Short–term Financial Position or Test of Liquidity:  
(a) Current Ratios 
Current Ratio =
Current Assets
Current Liabilities

(b) Quick or Acid Test or Liquid Ratio 
Liquid Ratio =
Liquid Assets
Current Liabilities

(c) Absolute Liquid Ratio 
Absolute Liquid Ratio =
Absolute Liquid Assets
Current Liabilities

(d) Interval Measure 
Interval Measure =
Liquid Assets
Avg.Daily Operating Expenses

Current Assets Movement (Asset Management Ratios):  
(a) Inventory /Stock Turnover Ratio 
=
Cost of Goods Sold
Avg.Inventory at Cost

(b) Debtors or receivables Turnover Ratio/Velocity 
=
Net Credit Annual Sale
Avg.Trade Debtors

(c) Average Collection Period 
=
Total Trade Debtors
Sale per Day

(d) Creditors / Payable Turnover Ratio / Velocity 
=
Net Credit Annual Purchase
Avg.Trade Creditors

(e) Average Payment Period 
=
Total Trade Creditos / Payable
Avg.Daily Purchase

(f) Working Capital Turnover Ratio 
=
Sales or Cost of Sales
Net Working Capital

Analysis of Longterm Financial Position or Test of Solvency:  
(a) Debt Equity Ratio 
=
Outsiders Funds
Shareholders′ Funds
or
=
Outsiders′ Equities
Internal Equities

(b) Funded Debt to Total Capitalization Ratio 
=
Funded Debts
Total Capitalization
× 100

(c) Ratio of Long term Debt to Shareholders, Funds (Debt Equity) 
=
Long term Debts
Shareholders′ Funds

(d) Proprietary or Equity Ratio 
=
Shareholders Funds
Total Assets

(e) Solvency Ratio 
=
Total Liabilities to Outsiders
Total Assets

(f) Fixed Assets Net Worth Ratio 
=
Fixed Assets after Depreciation
Shareholders′ Funds

(g) Fixed Assets Ratio or Fixed Assets to Long Term Funds 
=
Fixed Assets after Depreciation
Total long term Fund

(h) Ratio of Current Assets to Proprietary funds 
=
Current Assets
Shareholders′ Funds

(i) DebtService or Interest Coverage 
=
Net Profit (before Int. & Taxes)
Fixed Interest Charges

(j) Total Coverage or Fixed Charge Coverage 
=
EBIT
Total Fixed Charges

(k) Preference Dividend Coverage Ratio 
=
Net Profit (before Int.& Tax)
Preference Dividend

(l) Cash to debtService Ratio or Debt Cash Flow Coverage 
=
CF
1 +
SFD
1  Tax Rate
CF = Annual cash flow before Int. & Tax SFD = Sinking fund appropriation on debt 
Analysis of Profitability:  
(i) General Profitability:  
(a) Gross Profit Ratio 
=
Gross Profit
Net Sale
× 100

(b) Operating Ratio 
=
Operating Cost
Net Sale
× 100

(c) Expenses Ratio 
=
Particular Expense
Net Sale
× 100

(d) Net Profit Ratio 
=
Net Profit after Tax
Net Sale
× 100

(e) Operating Profit Ratio 
=
Operating Profit
Net Sale
× 100

Overall Profitability:  
(a) Return on Shareholders’ Investment (RoI) 
=
Net Profiti after Tax & Interest
Shareholders′ Fund
× 100

(b) Return on Equity Capital 
=
Net Profit after Tax − Pref.Dividend
Paid up Equity Capital
× 100

(c) Earnings per Share (EPS) 
=
Net Profit after Tax − Pref.Dividend
Number of Equity Share
× 100

(d) Return on Gross Capital Employed 
=
Adjusted Net Profit
Gross Capital Employed
× 100

(e) Return on Net Capital Employed 
=
Adjusted Net Profit
Net Capital Employed
× 100

(f) Return on Assets 
=
Net Profit after Tax
Avg.Total Assets
× 100

(g) Capital Turnover Ratio 
=
Sale or Cost of Sale
Capital Employed
× 100

(h) Fixed Assets Turnover Ratio 
=
Sale or Cost of Goods Sold
Fixed Assets
× 100

(i) Working Capital Turnover Ratio 
=
Sale or Cost of Goods Sold
Net Working Capital
× 100

Market Test or Valuation Ratio:  
(a) Dividend Yield Ratio 
=
Dividend per Share
Market Value per Share

(b) Dividend Payout Ratio 
=
Dividend per Equity Share
Earnings per Share

(c) Price/Earnings (P/E) Ratio 
=
Market Price per Equity Share
Earnings per Share

(d) Earning Yield Ratio 
=
Earnings per Share
Market price per share

(e) Market Value Book Value Ratio 
=
Market value per share
Book value per share

(f) Market Price to Cash Flow Ratio 
=
Market price per share
Cash flow per share

Market Test or Valuation Ratio:  
(a) Capital Gearing Ratio 
=
Equity Share Capital + Reserve & Surplus
Pref.Capital + Long term Debt bearing Fixed Interest

(b) Total Investment to Long Term Liabilities 
=
Shareholders Fund + Long term Liabilities
Long term Liabilities

(c) Debt Equity Ratio 
=
Outsiders Funds
Shareholders Funds

(d) Ratio to Fixed Assets to Funded Debt 
=
Fixed Assets
Funded Debts

(e) Ratio of Current Liabilities to Proprietors fund 
=
Current Liabilities
Shareholders′ Funds

(f) Ratio of Reserve to Equity Capital 
=
Reserves
Equity Share Capital
× 100

(g) Financial Leverage 
=
EBIT
EBIT − Interest & Pref.Dividend

(h) Operating Leverage 
=
Contribution
EBIT

Working Capital
As per the definitions phrased by experts,
“Working capital is the amount of funds necessary to cover the cost of operating the enterprises.”Shubin
“Circulating capital means current assets of a company that are changed in the ordinary course of business from one form to another, as for example, from cash to inventories, inventories to receivables, receivables in to cash.”Genestenberg
Broadly, there are two types of capital required for a business:
 Fixed Capital
 Working Capital
Fixed capital requires investing in long term investments of business to create production facility through purchase of fixed assets such as building, plant, machinery, furniture etc. Investment in these assets means permanent blockage of capital or for a long term fixed term blockage of funds.
Capital is required for short term purposes to purchase raw material, payment of day to day needs of organization, routine business expenditure, payment of salaries, wages, taxes etc. These funds are called working capital. Working capital refers to capital to finance short term or current assets such as cash, securities, debtors and inventories.
Gross Working Capital and Net Working Capital
Gross working capital means the investment in current assets, whereas the Net working capital means the difference of current assets and current liabilities. Net working capital can be positive or negative.
NET WORKING CAPITAL  

(A) Current Assets  
Cash in hand  XXX  
Cash at Bank  XXX  
Sundry Debtors  XXX  
Bills receivables  XXX  
Inventories of Stock  XXX  


Short Term Investments  XXX  
Prepaid Expenses  XXX  
Accrued Incomes  XXX  
Total Current Assets  XXXXX  
(B) Less: Current Liabilities  
Sundry Creditors  XXX  
Short term Loans, advances and deposits  XXX  
Bank Overdraft  XXX  
Bills payable  XXX  
Provisions  XXX  
Expenses Payable  XXX  
Total Current Liabilities  XXXX  
Working Capital (A  B)  XX 
Working Capital Cycle
Generation and disbursement of cash is carried out in the manner depicted by the following diagram: