RATIOS

Q. Describe the following ratios:

a)  Gross Profit Ratio;

b)  Net Profit Ratio;

c)  Operating ratio;

d)  Working Capital Turnover ratio;

 

a)    Gross Profit Ratio:

This ratio expresses relationship between gross profit and net sale. Its formula is:

Gross Profit  x 100

Net sales     

Significance of Gross Profit Ratio:

The ratio indicates the degree to which the selling price of goods per unit may decline without resulting in losses from operations to the firm. It also helps in ascertaining whether the average percentage of mark up on the goods is maintained.

b)    Net Profit Ratio:

This ratio indicates net margin earned on a sale of Rs. 100. it is calculated as follows:

Net Operating Profit      x 100

Net Sales

Significance of Net Profit Ratio:

This ratio helps in determining the efficiency with which affairs of the business are being managed. An increase in the ratio over the previous period indicate improvement in the operational, efficiency of the business provided the gross profit ratio is constant. The ratio is thus an effective measure to check the profitability or business.

 

c)    Operating Ratio:

This ratio is a complementary of net profit ratio. In case the net profit ratio is 20% it means that the operating ratio is 80%. It is calculated as follows:

Operating Costs       x  100

Net Sales

Significance of Operating Ratio;

This ratio is the test of the operational efficiency with which the business is being carried. The operating ratio should be low enough to leave a portion of sales to give a fair return to the investors. A comparison of the operating ratio will indicate whether the cost component is high or low in the figure of sales. In case the comparison shows that there is increase in this ratio, the reason for such increase should be found out and management be advised to check the increase.

 

d)    Working Capital Turnover Ratio:

This ratio indicates whether or not working capital has been effectively utilized in making sales. The ratio is calculated as follows:

Net      Sales

Working Capital

i) Debtors Turnover Ratio (debtors Velocity):

Debtors constitute an important constituent of current assets and therefore the quality of debtors to a great extent determines a firm’s liquidity. Two ratios are used by financial analysis to judge the liquidity of a firm. They are (i) Debtors turnover ratio, and (ii) Debt collection period ratio.

The debtors turnover ratio is calculated as under:

             Credit         Sales            

Average Accounts Receivable

 

Significance of Working Capital Turnover ratio:

Sales of accounts receivable ratio indicates the efficiency of the staff entrusted with collection of book debts. The higher the ratio, the better it is, since it would indicate that debts are being collected more promptly. For measuring the efficiency, it is necessary to set up a standard figure; a ratio lower than the standard will indicate in efficiency.

 

ii)   Debt collection period ratio:

The ratio indicates the extent to which the debts have been collected in time. It gives the average debts collected in time. It gives the average debt collection period. The ratio is very helpful to the lenders because it explains to them whether their borrowers are collecting money within a reasonable time. an increase in the period will result in greater blockage of funds in debtors. The ratio may be calculated by any of the following methods:

 

a)        Months (or days) in a year  

          debtors turnover

 

b)    Average account receivable x Months or days in a year

                               Credit sales for the year

 

c)                        Accounts Receivable            

        Average monthly or daily credit sales