Accounting Ratios

A ratio expresses one figure as a fraction or multiple of another, making relationships easy to judge. Liquidity ratios measure a firm's ability to meet its short-term obligations — whether it has enough liquid resources to pay current liabilities as they fall due.

Here Quick Assets = Current Assets − Inventories − Prepaid Expenses (because stock and prepaid items are the least liquid current assets). The quick ratio is therefore a stricter test than the current ratio.

Worked example. Current assets Rs 4,00,000 (including inventory Rs 1,00,000 and prepaid Rs 20,000) and current liabilities Rs 2,00,000.

• Current Ratio = 4,00,000 ÷ 2,00,000 = 2 : 1.
• Quick Assets = 4,00,000 − 1,00,000 − 20,000 = 2,80,000.
• Quick Ratio = 2,80,000 ÷ 2,00,000 = 1.4 : 1.

A current ratio around 2:1 and a quick ratio around 1:1 are usually considered satisfactory — high enough to pay short-term dues, but not so high that resources lie idle. A very high current ratio can actually signal over-investment in stock or debtors. So ratios are interpreted in context, never in isolation.

Solvency ratios measure a firm's ability to meet its long-term obligations — the safety of long-term lenders and the firm's capital structure.

Here Shareholders' Funds (Equity) = Share Capital + Reserves & Surplus (or Total Assets − Total external liabilities). Debt means long-term borrowings.

What they reveal:

• Debt-Equity — how much the firm relies on borrowed funds vs owners' funds. A common benchmark is 2:1; a high ratio means high financial risk.
• Proprietary ratio — the share of total assets financed by owners; a higher ratio means greater long-term stability.
• Interest coverage — how many times profit covers the interest bill; a higher figure means lenders' interest is safer.

Worked example. Long-term debt Rs 4,00,000, shareholders' funds Rs 8,00,000, total assets Rs 14,00,000. Debt-Equity = 4,00,000 ÷ 8,00,000 = 0.5 : 1 (low risk). Proprietary ratio = 8,00,000 ÷ 14,00,000 = 0.57 (57% owner-financed). If profit before interest and tax is Rs 3,00,000 and interest Rs 50,000, interest coverage = 3,00,000 ÷ 50,000 = 6 times — comfortably safe.

Activity (turnover) ratios measure how efficiently a firm uses its assets to generate sales; profitability ratios measure how well it converts sales (or capital) into profit.

A few notes: Average = (opening + closing) ÷ 2. Capital Employed = Shareholders' Funds + Long-term Debt (or Total Assets − Current Liabilities). The Operating Ratio and the Operating Profit Ratio are complements (they add to 100%).

Worked example. Cost of goods sold Rs 6,00,000 and average inventory Rs 1,00,000 → Inventory Turnover = 6 times (stock is sold and replaced six times a year — the higher, the more efficient). If revenue is Rs 10,00,000 and net profit Rs 1,20,000, Net Profit Ratio = (1,20,000 ÷ 10,00,000) × 100 = 12%. If PBIT is Rs 2,00,000 on capital employed Rs 10,00,000, ROI = 20%. Together with liquidity and solvency ratios, these activity and profitability ratios let an analyst judge a company from every angle — the practical pay-off of all the accounting you have learned.