Learn CBSE Accountancy Index Terms for Class 12, Part I, Chapter 5 Accounting Ratios
1. Accounting Ratios – Accounting ratios are also known as financial ratios. They are applied to calculate the profitability and performance of a business on the grounds of its financial statements. They provide a means of stating the association between one accounting data point to another and are the source of ratio analysis.
In other words, an accounting ratio implies a quantitative concurrence that is employed for the purpose of analysis and decision-making. It provides the basis for inter-firm as well as intra-firm comparisons. In order to make the ratios efficient, they are compared with ratios with the industry average ratios, criteria, or with the base period.
2. Composite Ratios – In case a ratio is calculated with 1 variable from the record of the balance sheet and another variable from the profit and loss account, it is known as a composite ratio. For example, the ratio of credit revenue of transactions to trade receivables (also known as trade receivables turnover ratio) is computed utilising 1 figure from the statement of profit and loss account (credit revenue from operations) and another figure (trade receivables) from the balance sheet.
3. Liquidity Ratios – An organisation must maintain some degree of liquidity in order to pay its shareholders their shares when they are outstanding. The assets of a business cannot be firmed up; a business should look after its short-term liquidity. Such ratios help in managing liquidity, so the business may rectify any complications. The two principal liquidity ratios are the quick ratio (or liquid ratio) and the current ratio.
4. Solvency Ratios – Solvency ratios determine the organisation’s capability to pay its long-term deficit. So they ascertain the association between the owner’s capital and the liability of the business. They determine the long-term financial health of a business, whether it has sufficient assets to repay all its shareholders, as well as all liability on the balance sheet. This is the reason they are known as leverage ratios. Some examples of solvency ratios are debt ratio, capital gearing ratio, and debt-equity ratio.
5. Activity or Turnover Ratio – Activity ratios assist in determining the efficiency and performance of an organisation. They assist in measuring the efficiency of the employment of the resources that a firm has. They portray the association between assets and sales of the enterprise. These types of ratios are also called performance ratios or turnover ratios. A few ratios like the stock turnover, debtors turnover, and stock to working capital ratio compute the production of a firm.
6. Profitability Ratio – Profitability ratios assess the profits earned by an organisation. They connect the assets to capital applied or revenue or profits of an organisation. These ratios reflect the business’s capability to obtain consistent returns with regard to the funds utilised. They even examine the correctness of the financing strategies and decision-making choices. For example, return on equity ratio, operating profit ratio, and gross profit ratio.
7. Current Ratio – The current ratio is also referred to as the working capital ratio. The current ratio is a formula that helps businesses to measure their capability to pay off their short-term liability debts within a year. Its objective is to show how a business can maximise its current assets to settle its short-term debts to creditors. The current ratio is calculated by dividing the total value of the current assets of a firm by the value of its current liabilities. The formula for calculating the current ratio is given below:
Current Ratio = Current Assets/Current Liabilities
Current assets are those assets on a firm’s balance sheet that can be converted into cash within a year. They include inventory, marketable securities, prepaid expenses, accounts receivable, and cash and cash equivalents.
Current liabilities are the short-term obligations that a business has to pay its debts to its creditors within a year. Common current liabilities found on the balance sheet include dividends payable, accounts payable, outstanding income taxes, accrued expenses, notes payable, and short-term debt.
8. Quick or Liquid Ratio – The quick ratio is also referred to as the acid test ratio. It is a financial ratio formula that aims to help organisations to measure their capacity to pay off their short-term liability debts within the next 90 days with the help of their cash and cash equivalents.
Quick ratio attempts to show how a firm can maximise its quick assets to settle short-term debts towards its creditors. The organisation can use this ratio to get an idea about its preparation to pay off its immediate debt obligations. The firm can also use this ratio to determine methods to increase its cash and near-cash assets. The ratio is arrived at by dividing the value of the quick assets of a firm by the value of its current liabilities. The formula to calculate the Quick Ratio is as mentioned below:
Quick Ratio = Quick Assets/Current Liabilities
Quick assets are the assets present in a company’s balance sheet that are convertible into cash at short notice. They include accounts receivable, marketable securities, and cash and cash equivalents.
Current liabilities are short-term obligations that a firm needs to pay off to the creditors within a year’s time. Some of the current liabilities that are present on the balance sheet include short-term debt, accounts payable, outstanding income taxes, dividends payable, accrued expenses, and short-term debt.
9. Debt-equity Ratio – Debt to equity ratio, also referred to as the debt-equity ratio, is a type of leverage ratio that is used to determine the financial leverage that a business uses. The debt to equity ratio takes into account the company’s liabilities and the shareholders’ equity.
The debt-equity ratio is regarded as an important ratio in accounting as it establishes a relationship between the total liabilities and shareholders’ equity of a company. In other words, the debt to equity ratio computes to an extent the company utilises debt as compared to equity for running the business.
A very important part of the debt-to-equity ratio is that it represents the ability of the shareholder’s equity to clear all the outstanding debt obligations in case the business goes bankrupt.
10. Proprietary Ratio – A proprietary ratio is a type of solvency ratio that is helpful for computing the proprietors to the total assets of the business amount or contribution of shareholders. It is also referred to as the equity ratio or shareholder equity ratio, or net worth ratio.
The main purpose of this ratio is to determine the proportion of the total assets of a business that is funded by the proprietors. The proprietary ratio can be used to evaluate the stability of the capital structure of a business or a firm and also show how the assets of a business are formed by issuing a number of equity shares rather than taking loans or debt from outside.
It clearly indicates how much the shareholders will receive in the event of liquidation of the company. The proprietary ratio is expressed in the form of a percentage and is calculated by dividing the shareholders’ equity by the total assets of the business.
11. Interest Coverage Ratio – The interest coverage ratio proceeds as a solvency check for the business firm, which utilises business analysts, investors, and financial advisors to determine the ability of a business or an organisation to pay off the accumulated interest on the debt they are holding.
The interest coverage ratio is also known as the debt service ratio or debt service coverage ratio. It is computed by dividing the Earnings Before Interest and Taxes (EBIT) by the interest expenses payable by the company during the same period.
In other words, the interest coverage ratio determines the number of times a company is able to make payments on its existing debt with the Earnings Before Interest and Taxes (EBIT). It is also known as the Times Interest Earned (TIE) Ratio.
12. Inventory Turnover Ratio – The inventory turnover ratio, also referred to as the stock turnover ratio, is used to compute the number of times a firm is able to replace and sell its stock of goods during a given time period.
In other words, it is a ratio that shows the number of times a company has replaced and sold the inventory or stock in a given time period.
13. Trade Receivables Turnover Ratio – The trade receivables turnover ratio is also referred to as the debtors turnover ratio or accounts receivable turnover ratio. It is used to ascertain the competence by which the business is managing the debt that is being extended to its customers, and evaluate how long it takes for the organisation to collect the outstanding debt in the accounting period.
A low receivable, on the other hand, depicts that the organisation lacks a clear collection mechanism, and no clear debt policy is defined along with customers, who are not financially viable and are defaulting on their payments.
A high receivables turnover ratio depicts that the collection mechanism of the firm is very effective, and the firm also has a high percentage of customers who are making their payments quickly in order to write off their debts.
14. Trade Payable Turnover Ratio – The trade payables turnover ratio is referred to as the creditors turnover ratio or the accounts payable turnover ratio. This ratio is used to measure the number of times the business is paying off its suppliers or creditors in an accounting period.
Accounts payables are short-term debts that a business owes to its creditors and suppliers. The accounts payable turnover ratio or trade payables turnover ratio portrays the ability of the firm with which the business makes payments to its creditors or suppliers.
A decrease in the value of the accounts payable turnover ratio shows that a firm is taking a longer time to make payments to its creditors than in the previous accounting years. A decline in the frequency of payments comes about as a sign of financial distress for the organisation.
A higher value of the accounts payable turnover ratio shows that the firm is making payments to its creditors on time, and the business is in a good stance with its suppliers and creditors.
15. Gross Profit Ratio – The profit margin formula is used to compute how much profit a business or product is. It is probably the most significant tool used by organisations to know the total profit percentage over a period of time. It is also known as net profit ratio, net margin, or net profit margin in business terms.
When net profit is divided by sales, the product one gets is the profit margin. Profit margin and gross profit margin terms are usually used by small firms for comparison in similar industries. It is denoted in percentages. The more the profit margin is, the more profitable the business will be.
To get the profit margin, the net income is divided by net sales. Thus, the formula for profit margin is:
Profit margin = (Net income/ Net sales) x 100
The gross profit margin formula is obtained by dividing the difference between revenue and cost of goods sold by the net sales.
Gross profit margin = (Gross profits / Net sales) x 100
16. Operating Ratio – Operating ratio is cited as the ratio that depicts the effectiveness of the management by setting up a relationship between the total operating expenses with the net sales.
The operating ratio is utilised to acquire the efficiency of the management, with which it is possible to generate a certain level of sales or revenue. It also helps in establishing how the firm’s management is instrumental in reducing costs.
The total operating expenses of a company are based on two main components, which are
a. Cost of Goods Sold: The cost of goods sold consists of factors like opening stock, direct expenses, manufacturing expenses, and closing stock.
b. Operating expenses: The operating expenses component includes administration expenses along with selling and distribution expenses.
17. Operating Profit Ratio – Operating Profit Ratio is cited as the ratio that is used to define a relationship between the operating profit and the net sales. Operating profit is also known as Earnings Before Interest and Taxes (EBIT), and net sales can also be defined as the revenue that is earned from operations.
The operating profit ratio is one type of profitability ratio, and is therefore expressed in the form of a percentage.
Net sales consist of cash and credit sales. Therefore, the operating profit ratio helps in comparing the operating profit earned by a business in relation to the revenue that will be generated by the business.
18. Net Profit Ratio – Net profit ratio, also referred to as the net profit margin ratio, is a profitability ratio that computes the firm’s profits to the total amount of money brought into the business. In other words, the net profit margin ratio portrays the relationship between the net profit after taxes and net sales taking place in a business.
It is a profitability ratio, and hence, expressed in the form of percentages. The net profit ratio is regarded as a good measure of the organisation’s overall performance, and it becomes more effective, when it is used in concurrence with the evaluation of the working capital of the firm.
It helps in determining the overall capability of the business, and the net profit ratio is not considered a reliable indicator of cash flows as it comprises many expenses such as accrued expenses, depreciation, amortisation and non-cash expenses.
19. Return on Capital Employed or Investment – ROCE or investment looks into how effectively any business can utilise the available capital.
​Capital employed is defined as the total amount of a business’s assets minus its current liabilities. It is synonymous with the available capital from the net profits. The higher the value that is derived using the ROCE formula, the more efficiently a business is utilising its capital. It is crucial to comprehend that if the ROCE exceeds the cost of capital, the business may end up facing financial issues. It can be very useful to compare and contrast the usage of capital by different firms that are engaged in the same business with regard to capital-intensive industries like auto companies, energy companies, and telecommunications firms.
The formula for calculating return on capital employed or investment is:
ROCE = EBIT/Capital Employed
where: EBIT = Earnings before interest and taxes and Capital Employed = Total assets minus current liabilities.
20. Return on Shareholder’s Fund – An accounting proportion of the rate of return that investors have derived on the capital in which they have invested reserves into the business. It is computed by separating profit after interest, and assessment by the shareholder’s capital employed.
21. Earnings Per Share – Earnings per share (EPS) is calculated as a firm’s profit divided by the outstanding shares of its common stock. The resulting figure serves as an indicator of a firm’s profitability. It is common for a company to report EPS that is adjusted for extraordinary items, and potential share dilution. The higher a firm’s EPS, the more profitable it is considered to be.
22. Book Value Per Share – The book value, also referred to as the net book value, is defined as the total estimated value that shareholders of an organisation would receive, if the management decides to sell or liquidate it at any given point in time. It aims to calculate the total assets of a business minus the intangible assets and liabilities.
The book value is an important accounting technique that helps investors, as well as analysts, to assess whether a particular business’s stock is underpriced or overpriced compared to its actual and fair market value.
It also helps the management of a firm to get an overall estimation of the total price for which their business can be sold in the market, which will help them to understand the future prospects of the firm. The net book value is a very handy tool that can be helpful in evaluating the profits and losses of a business over a given period of time.
The book value of a share is defined as a method to measure the net value of an asset, which the investors get for buying a share of the total stock of a company. Investors can calculate the book value per share by dividing a company’s book value by the number of outstanding shares.
23. Dividend Payout Ratio – The dividend payout ratio shows exactly how much dividend a particular organisation is paying to its shareholders from its actual earned profits. It is calculated by dividing the annual dividend received per share by the actual earnings of the share.
Dividend Payout Ratio = (Annual Dividend per Share / Earning per share) x 100
For example, If the annual dividend on a firm’s share is Rs. 400, and the earning per share is Rs. 700, then the dividend payout for a share would be 57%, which indicates the company is reinvesting a majority of its profits for their future operations.
The dividend payout ratio can also be negative, when the net income of a company becomes negative. It has been observed that the payout is lower for developing businesses, when compared to mature companies because they tend to reinvest the profits within the firm for better growth. The dividend payout ratio is also related to the retention ratio. A higher retention ratio automatically means a lower dividend payout ratio, but retention can also lead to higher growth and result in better dividends for the future.
24. Price/Earning Ratio – This is also referred to as P/E Ratio. It establishes a relationship between the stock (share) price of a business and the earnings per share. It is very useful for investors, as they will be more interested in knowing the profitability of the shares of the company, and how much profitable it will be in the future. The P/E ratio shows if the company’s stock is overvalued, or undervalued.
The P/E ratio is calculated as follows:
P/E Ratio = Market value per share / Earnings per share
25. Dividend Payouts – A dividend payout is a ratio or proportion that portrays how much profit a business is providing for its investors from its procured benefits. It tends to be determined, by taking the level or percentage of profit per share, to acquire or gain from that share. It goes from 0% to 100%. Though 0% means the firm doesn’t pay anything to its investors as a dividend or profit, and 100 % implies that the firm generally pays its dividends or benefits as a profit to its investors.
The dividend payout is usually, for the most part, between 0% to 100%; however, sometimes, it can likewise be negative, when the overall profit of the business becomes negative. Manufacturing businesses will generally have less profit payout than mature businesses, as they give less profit since they need to keep profits to re-contribute and develop their business.
Dividend payout is connected with the ‘Retention Ratio’, as profit payout is the profit given to financial backers, yet the retention ratio is the profit saved for re-contributing. A higher retention ratio implies a lower dividend payout; however, it guarantees business development, bringing about a higher profit or dividend payout later on.
So, while contributing or investing, one should focus on the two angles, on the grounds that a low-profit payout can pay them a higher payout proportion or ratio. All things considered, a higher profit payout can prompt an invalid or null dividend or profit payout later on.
26. Efficiency Ratios – The efficiency ratio is typically utilised to examine how well a business uses its assets and liabilities internally. An efficiency ratio can calculate the turnover of the repayment of liabilities, the quantity and usage of equity, and the general use of inventory, machinery and receivables. This ratio can also be used to track and analyse the performance of investment and commercial banks.
27. Average Collection Period – Accounts receivable is an accounting term that is used to describe money that other business firms owe to an organisation, when they purchase goods or services. Organisations normally make these sales to their customers on credit. Accounts receivables are listed on the firms’ balance sheets as current assets and measure their liquidity. As such, they indicate their ability to pay off their short-term debts without the need to rely on additional cash flows.
The average collection period is an accounting metric used to represent the average number of days between a credit sale date and the date when the purchaser remits payment. A firm’s average collection period is indicative of the effectiveness of its accounts receivables management practices. Businesses must be able to manage their average collection period to operate smoothly.
A lower average collection period is generally more favourable than a higher one. A low average collection period indicates that the firm collects payments faster. However, this may mean that the company’s credit terms are too strict. Customers who don’t find their creditors’ terms very friendly may choose to seek suppliers or service providers with more lenient payment terms.
We hope that the offered Accountancy Index Terms for Class 11 with respect to Part 2, Chapter 5: Accounting Ratios will help you.
Related Links:
- Class 12 Accountancy Index Terms Part 1 Chapter 1: Accounting for Share Capital
- Class 12 Accountancy Index Terms Part II Chapter 2: Issue and Redemption of Debentures
- Class 12 Accountancy Index Terms Part II Chapter 3: Financial Statements of a Company
- Class 12 Accountancy Index Terms Part II Chapter 4: Analysis of Financial Statements
- Class 12 Accountancy Index Terms Part II Chapter 5: Accounting Ratios
- Class 12 Accountancy Index Terms Part II Chapter 6: Cash Flow Statement
- Class 12 Accountancy Index Terms Part I Chapter 2: Accounting for Partnership: Basic Concepts
- Class 12 Accountancy Index Terms Part I Chapter 3: Reconstitution of a Partnership Firm – Admission of a Partner
- Class 12 Accountancy Index Terms Part I Chapter 4: Reconstitution of a Partnership Firm – Retirement/Death of a Partner
- Class 12 Accountancy Index Terms Part I Chapter 5: Dissolution of a Partnership Firm
