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Q.4. Classify the various Turnover/Activity/Performance Ratios.
Also explain the meaning, method of calculation and objective of
these ratios.
Answer:
Classification of Turnover/Activity/Performance
Ratios: -
- Capital Turnover Ratio
- Fixed Assets Turnover Ratio (CBSE 1998, 2000, Outside Delhi
2001)
- Working Capital Turnover Ratio (CBSE Outside Delhi 2001)
- Stock Turnover Ratio (CBSE 1989, 2000, Outside Delhi 2001)
- Debtors Turnover Ratio (CBSE Outside Delhi 2001, Delhi 2002)
- Debt Collection Period
Meaning, Objective and Method of Calculation: -
- Capital Turnover Ratio: Capital turnover ratio establishes
a relationship between net sales and capital employed. The ratio
indicates the times by which the capital employed is used to generate
sales. It is calculated as follows: -
Capital Turnover Ratio = Net Sales/Capital
Employed
Where Net Sales = Sales – Sales Return
Capital Employed = Share Capital (Equity + Preference) + Reserves
and Surplus + Long-term Loans – Fictitious Assets.
Objective and Significance: The objective of capital
turnover ratio is to calculate how efficiently the capital invested
in the business is being used and how many times the capital is
turned into sales. Higher the ratio, better the efficiency of
utilisation of capital and it would lead to higher profitability.
- Fixed Assets Turnover Ratio: Fixed assets turnover ratio
establishes a relationship between net sales and net fixed assets.
This ratio indicates how well the fixed assets are being utilised.
Fixed Assets Turnover Ratio = Net Sales/Net
Fixed Assets
In case Net Sales are not given in the question cost of goods
sold may also be used in place of net sales. Net fixed assets
are considered cost less depreciation.
Objective and Significance: This ratio expresses the number
to times the fixed assets are being turned over in a stated period.
It measures the efficiency with which fixed assets are employed.
A high ratio means a high rate of efficiency of utilisation of
fixed asset and low ratio means improper use of the assets.
- Working Capital Turnover Ratio: Working capital turnover
ratio establishes a relationship between net sales and working
capital. This ratio measures the efficiency of utilisation of
working capital.
Working Capital Turnover Ratio = Net Sales or Cost of Goods
Sold/Net Working Capital
Where Net Working Capital = Current Assets – Current Liabilities
Objective and Significance: This ratio indicates the
number of times the utilisation of working capital in the process
of doing business. The higher is the ratio, the lower is the investment
in working capital and the greater are the profits. However, a
very high turnover indicates a sign of over-trading and puts the
firm in financial difficulties. A low working capital turnover
ratio indicates that the working capital has not been used efficiently.
- Stock Turnover Ratio: Stock turnover ratio is a ratio
between cost of goods sold and average stock. This ratio is also
known as stock velocity or inventory turnover ratio.
Stock Turnover Ratio = Cost of Goods Sold/Average Stock
Where Average Stock = [Opening Stock + Closing Stock]/2
Cost of Goods Sold = Opening Stock + Net Purchases + Direct Expenses
– Closing Stock
Objective and Significance: Stock is a most important
component of working capital. This ratio provides guidelines to
the management while framing stock policy. It measures how fast
the stock is moving through the firm and generating sales. It
helps to maintain a proper amount of stock to fulfill the requirements
of the concern. A proper inventory turnover makes the business
to earn a reasonable margin of profit.
- Debtors’ Turnover Ratio: Debtors turnover ratio indicates
the relation between net credit sales and average accounts receivables
of the year. This ratio is also known as Debtors’ Velocity.
Debtors Turnover Ratio = Net Credit Sales/Average Accounts
Receivables
Where Average Accounts Receivables = [Opening Debtors and B/R
+ Closing Debtors and B/R]/2
Credit Sales = Total Sales – Cash Sales
Objective and Significance: This ratio indicates the
efficiency of the concern to collect the amount due from debtors.
It determines the efficiency with which the trade debtors are
managed. Higher the ratio, better it is as it proves that the
debts are being collected very quickly.
- Debt Collection Period: Debt collection period is the
period over which the debtors are collected on an average basis.
It indicates the rapidity or slowness with which the money is
collected from debtors.
Debt Collection Period = 12 Months or 365 Days/Debtors Turnover
Ratio
Or
Debt Collection Period = Average Trade Debtors/Average Net
Credit Sales per day
Or
365 days or 12 months x Average Debtors/Credit Sales
It may be noted that some authors prefer to use 360 days instead
of 365 days for the sake of convenience.
Objective and Significance: This ratio indicates how
quickly and efficiently the debts are collected. The shorter the
period the better it is and longer the period more the chances
of bad debts. Although no standard period is prescribed anywhere,
it depends on the nature of the industry.
Q.5. Classify the various Liquidity Ratios. Also explain the
meaning, method of calculation and objective of these ratios.
Answer:
Classification of Liquidity Ratios:
- Current Ratio (CBSE 1989, 2000, Outside Delhi 2001)
- Liquid Ratio (CBSE Outside Delhi 2001, Delhi 2002)
Meaning, Objective and Method of Calculation:
- Current Ratio: Current ratio is calculated in order
to work out firm’s ability to pay off its short-term liabilities.
This ratio is also called working capital ratio. This ratio explains
the relationship between current assets and current liabilities
of a business. Where current assets are those assets which are
either in the form of cash or easily convertible into cash within
a year. Similarly, liabilities, which are to be paid within an
accounting year, are called current liabilities.
Current Ratio = Current Assets/Current Liabilities
Current Assets include Cash in hand, Cash at Bank, Sundry
Debtors, Bills Receivable, Stock of Goods, Short-term Investments,
Prepaid Expenses, Accrued Incomes etc.
Current Liabilities include Sundry Creditors, Bills Payable,
Bank Overdraft, Outstanding Expenses etc.
Objective and Significance: Current ratio shows the short-term
financial position of the business. This ratio measures the ability
of the business to pay its current liabilities. The ideal current
ratio is suppose to be 2:1 i.e. current assets must be twice the
current liabilities. In case, this ratio is less than 2:1, the
short-term financial position is not supposed to be very sound
and in case, it is more than 2:1, it indicates idleness of working
capital.
- Liquid Ratio: Liquid ratio shows short-term solvency
of a business in a true manner. It is also called acid-test ratio
and quick ratio. It is calculated in order to know how quickly
current liabilities can be paid with the help of quick assets.
Quick assets mean those assets, which are quickly convertible
into cash.
Liquid Ratio = Liquid Assets/Current Liabilities
Where liquid assets include Cash in hand, Cash at Bank, Sundry
Debtors, Bills Receivable, Short-term Investments etc. In other
words, all current assets are liquid assets except stock and prepaid
expenses.
Current liabilities include Sundry Creditors, Bills Payable,
Bank Overdraft, Outstanding Expenses etc.
Objective and Significance: Liquid ratio is calculated
to work out the liquidity of a business. This ratio measures the
ability of the business to pay its current liabilities in a real
way. The ideal liquid ratio is suppose to be 1:1 i.e. liquid assets
must be equal to the current liabilities. In case, this ratio
is less than 1:1, it shows a very weak short-term financial position
and in case, it is more than 1:1, it shows a better short-term
financial position.
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