Types of Accounting Ratios - Testbook

Types of Accounting Ratios

RBI is an organization for which everyone has craving and passion to work. RBI Grade B posts provide a wide career option in terms of incentives to its officers. Types of Accounting Ratios is one of the important topics for preparing Bank Exams. Read this article i.e. on Types Accounting Ratios which is vital from RBI Grade B exam perspectives.

Types of Accounting Ratios - Meaning of Accounting Ratios

The role of a financial analyst wholly and solely depends on the financial statements of the company. They analyze the performance of the companies based on the comparison. It is difficult while comparing other parameters along with the size of the statements. Types of Accounting Ratios plays an important role in making financial analyst's job easier. Further you will read about the types of accounting ratios. What is a ratio? In simple words, ratio shows a mathematical relation in between two of the numbers.

Types of Accounting Ratios

1. Liquidity Ratios 2. Leverage Ratios 3. Turnover Ratios 4. Profitability Ratios 5. Valuation Ratios

You can learn the below given explanations that will help you in proper study of the types of Accounting Ratios. The first type of accounting ratio is Liquidity Ratio.

1. Liquidity Ratios In this, the time span is less i.e. for 1 year. This type of ratios basically reflects the relationship between current assets and current liabilities. We have three types of Liquidity ratios. They are as follows:

? Current ratio ? Acid-test ratio ? Cash ratio

a.Current Ratio -

? The ratio between Current assets and Current Liabilities is known as current ratio. ? Importance: It explains the ability of the firm to meet its current liabilities for the next 1 year. ? Current assets comprise of the following - Cash, Current investments, Debtors, Inventories

(stocks), Loans and advances, and pre-paid expenses. ? Current Ratio = Current Assets / Current Liabilities.

b. Acid-test Ratio/quick ratio -

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? The ratio between Quick Assets and Current Liabilities is acid - test ratio. ? Acid test ratio =Quick assets /Current liabilities. ? Acid-test Ratio / Quick Assets comprise of the following - Current assets without inventories.

c.Cash Ratio -

? Cash Ratio is the measure for most liquid assets to the current liabilities. ? The liquidity is measured in different forms and ranges by the terms mentioned above. ? Cash ratio = (Cash and bank balances + Current investments) / Current

liabilities

The second type of accounting ratio is Leverage Ratio. Along with the types Accounting ratios get to know more about the sub - types of the Accounting Ratios.

2. Leverage Ratios ? Leverage ratios make us to calculate the risk from the use of debt as capital. ? There are two types of ratios used for analyzing financial leverage. These are as follows:

a. Structural ratios

b. Coverage ratios

a. Structural Ratios

i. Debt-equity ratio -

? Debt-equity ratio shows the relative contributions of creditors and owners. It is the ratio of Debt to Assets.

? It comprises of short - term and long - term debts. ? Assets comprise of - Net-worth, preference capital and Deferred Tax Liability. ? Debt-Equity Ratio = Total Liabilities / Total Shareholders' Equity

ii. Debt Asset Ratio -

? It is the ratio of Debt to Assets which measures the extent to which borrowed funds support the firm's assets.

? The debt comprises of short and long term. ? Assets comprise of - all the assets of balance sheets. ? Debt-asset Ratio = Debt / Assets ? The relation between Debt Equity ratio(X) and Debt asset ratio(Y) is Y=X/(1+X)

The third type of the accounting ratio is Turnover Ratios.

3.Turnover Ratios

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? It is helpful in measuring how efficiently the assets are being used by a firm.

a. Inventory Turnover -

? This is also known by other name i.e. Stock turnover. ? This is helpful as it gives proper understanding that how fast the inventory is moving

throughout the firm and creating sales. ? If this ratio is high, then inventory management is considered better and efficient. ? Turnover Ratio=Cost of Goods Sold/Average Inventory

b. Debtors Turnover -

? This ratio reflects how many times the sundry debtors namely accounts receivable turn over during the year.

? If the debtors' turnover is higher, then the efficiency of the credit management is also considered higher.

? Debtors Turnover = Net Credit Sales/Average sundry Debtors

c. Average Collection Period -

? This ratio puts forth information on the number of days, worth of credit sales which is locked in sundry debtors.

? Average Collection Period = Average sundry debtors /Average daily credit sales ? The relation between b and c is, Average collection period = 365/ Debtors' turnover.

d. Fixed Assets Turnover -

? It is helpful in taking measures sales per rupee of investment in fixed assets. ? The higher ratio is an indicator of a high degree of efficiency in asset utilization. ? A low ratio shows inefficient use of assets in the firm. ? The denominator of the ratio is very low as the fixed assets turnover ratio tends to be high. ? Fixed Assets Turnover =Net sales /Average net fixed assets

e. Total Assets Turnover -

? It is synonymous to output-capital ratio in economics. ? This ratio explains that how well the assets are used in the firm. ? Total Assets Turnover = Net sales/ Average total assets

Profitability Ratio happens to be the fourth type of accounting ratio.

4. Profitability Ratios ? The final result of business operations is taken into consideration while dealing with

profitability.

Two types of profitability ratios:

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? Profit margins ratios ? Rate of return ratios.

a. Profit Margins Ratios -

? This deals with the relation between Profit and Sales. ? Profit is being measured in different levels of business operations so is the difference in ratios.

i. Gross Profit Margin Ratio -

? The difference between net sales and cost of goods sold is Gross Profit Margin Ratio. ? It is helpful in measuring the efficiency of production as well as pricing. ? Gross Profit Margin Ratio = Gross profit/ Net sales

ii.Operating Profit Margin Ratio -

? This is the margin after manufacturing expenses, selling, general, and administration expenses and depreciation charges.

? It shows Operating Efficiency. ? Operating Profit Margin Ratio= Operating profit /Net sales

iii. Net Profit Margin Ratio -

? The earnings left for shareholders as a percentage of net sales. ? The overall efficiency of production, pricing, administration, selling, financing, and tax

management is measured by it. ? understanding of the cost and profit is easier by the gross and net profit margin ratios. ? Net Profit Margin Ratio = Net profit/Net Sales

b. Rate of Return Ratios -

i. Return on Assets (ROA)

? The numerator namely Profit after tax calculates the return to shareholders. ? ROA happens to be an odd measure. ? If we talk about its denominator i.e. Average total assets is the contribution of all investors. ? ROA = Profit after tax/ Average total assets

ii. Earning Power -

? This is a measure of business performance which is not affected by interest charges and tax burden.

? The numerator represents a measure of pre-tax earnings belonging to all sources of finance and the denominator represents total financing.

? Earning power = Profit before interest and tax /Average total assets

iii. Return on Capital Employed -

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? It is known by other name i.e. return on invested capital (ROIC). ? The effect of taxation is counted vital but not the capital structure. ? The major advantage is that it can be compared directly with the post-tax weighted average

cost of capital of the firm. ? ROCE = Profit before interest and tax (1 -Tax rate) /Average total assets.

iv. Return on Equity

? ROA and ROE are the measures which are used in common. ? These happen to be the accounting rates of return. ? Practically, they refer to return on book assets and return on book equity. ? Equity earnings = profit after tax less preference dividends. ? Average equity comprises of all the contributions made by equity shareholders (paid-up

capital + reserves and surplus). ? This ratio is also known by the name i.e. the return on net worth. ? Return on Equity =Equity earnings/ Average equity

At last i.e. the fifth type of accounting ratio is Valuation Ratio.

5. Valuation Ratios ? These ratios give us the idea that how the equity stock is assessed in the capital market. ? These are considered important measure of performance.

a.Yield -

? Yield symbolizes the rate of return actually earned by equity shareholders. ? This is generally compared with the rate of return required by equity shareholders. ? Yield = (Dividend + Price change) /Initial price

b. Price-earnings Ratio -

? This is nothing but a summary measure. ? This mainly deals with the growth prospects, risk, shareholder orientation and the degree of

liquidity. ? The market price per share is the price on a certain day or may be the average price over a

period of time. ? Earnings per share = profit after tax less preference dividend / number of outstanding equity

shares. ? Price-earnings Ratio= Market price per share /Earnings per share

c. Market Value to Book Value Ratio -

? This shows the contribution of a firm to the wealth of society. ? If the value is more than 1 it shows that the creation of wealth is more than the invested

money. ? If the value is less than 1 then it reflects detraction of the firm from the wealth of the society.

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