Financial Statement Analysis

Need for Analyzing Financial Statement

• Earning capacity or Profitability
• Comparative position in relation with other firms
• Efficiency of management
• Financial Strength
• Solvency of the firm
Parties interested in Analysis of Financial Statement
• Short term Creditor
• Long term Creditor
• Share holders
• Management
• Trade Union
• Taxation Authority
• Researchers
• Employees

Financial Ratio Analysis

The term accounting ratios is used to describe significant relationships which exist between
figures shown in a balance sheet, in a profit and loss account, in a budgetary control system or in
any other part of the accounting organization.
Significance of Ratio Analysis
• Simplification of accounting data
• Helpful in comparative Study
• Focus in trends
• Setting Standards
• Study of financial Soundness
Based on the purpose for which a ratio is computed, is the most commonly used classification
which is as follows:
1. Liquidity Ratios: To meet its commitments, business needs liquid funds. The ability of
the business to pay the amount due to stakeholders as and when it is due is known as
 liquidity, and the ratios calculated to measure it are known as ‘Liquidity Ratios’. These
are essentially short-term in nature.
2. Solvency Ratios: Solvency of business is determined by its ability to meet its contractual
obligations towards stakeholders, particularly towards external stakeholders, and the
ratios calculated to measure solvency position are known as ‘Solvency Ratios’. These are
essentially long-term in nature.
3. Activity (or Turnover) Ratios: This refers to the ratios that are calculated for
measuring the efficiency of operations of business based on effective utilization of
resources. Hence, these are also known as ‘Efficiency Ratios’.
4. Profitability Ratios: It refers to the analysis of profits in relation to revenue from
operations or funds (or assets) employed in the business and the ratios calculated to meet
this objective are known as ‘Profitability Ratios’.

Liquidity Ratios
1. Current ratio
Current ratio is also known as working capital ratio. It is the ratio of total current assets to total
current liabilities. Current assets are those which are usually converted into cash or consumed
with in short period (say one year). Current liabilities are required to be paid in short period (say
one year).
Current ratio is calculated by using the following formula:
𝒄𝒖𝒓𝒓𝒆𝒏𝒕 𝒂𝒔𝒔𝒆𝒕𝒔
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑹𝒂𝒕𝒊𝒐 =
𝒄𝒖𝒓𝒓𝒆𝒏𝒕 𝒍𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔
Significance: It provides a measure of degree to which current assets cover current liabilities.
The excess of current assets over current liabilities provides a measure of safety margin available
against uncertainty in realization of current assets and flow of funds. Normally, it is safe to have
this ratio within the range of 2:1.

2. Quick ratio

Quick ratio is also known as liquid ratio or acid test ratio. Current ratio provides a rough idea of
the liquidity of a firm so subsequently a second testing device was developed named as acid test
ratio or quick ratio. It establishes relationship between liquid assets and current liabilities. In
many businesses a significant proportion of current assets may comprise of inventory. Inventory,
by nature, cannot be converted into ready cash abruptly. The term liquid assets does not include
inventory.
Following formula is used to calculate quick ratio:
𝒍𝒊𝒒𝒖𝒊𝒅 (𝒒𝒖𝒊𝒄𝒌) 𝒂𝒔𝒔𝒆𝒕𝒔
𝑸𝒖𝒊𝒄𝒌 𝑹𝒂𝒕𝒊𝒐 =
𝒄𝒖𝒓𝒓𝒆𝒏𝒕 𝒍𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔
The liquid (quick) assets are defined as those assets which are quickly convertible into cash.
While calculating quick assets we exclude the inventories at the end and other current assets such
as prepaid expenses, advance tax, etc., from the current assets.
Significance: The ratio provides a measure of the capacity of the business to meet its short-term
obligations without any flaw. Normally, it is advocated to be safe to have a ratio of 1:1 as
unnecessarily low ratio will be very risky and a high ratio suggests unnecessarily deployment of
resources in otherwise less profitable short-term investments.

3. Absolute liquid ratio

Absolute liquid ratio extends the logic further and eliminates accounts receivable (sundry debtors
and bills receivables) also. Though receivables are more liquid as comparable to inventory but
still there may be doubts considering their time and amount of realization. Therefore, absolute
liquidity ratio relates cash, bank and marketable securities to the current liabilities. Since
absolute liquidity ratio lays down very strict and exacting standard of liquidity, therefore,
acceptable norm of this ratio is 50 percent. It means absolute liquid assets worth one half of the
value of current liabilities are sufficient for satisfactory liquid position of a business. However,
this ratio is not as popular as the previous two ratios discussed.
Absolute liquid ratio is calculated by using the following formula:
𝒂𝒃𝒔𝒐𝒍𝒖𝒕𝒆 𝒍𝒊𝒒𝒖𝒊𝒅 𝒂𝒔𝒔𝒆𝒕𝒔
𝑨𝒃𝒔𝒐𝒍𝒖𝒕𝒆 𝒍𝒊𝒒𝒖𝒊𝒅 𝑹𝒂𝒕𝒊𝒐 =
𝒄𝒖𝒓𝒓𝒆𝒏𝒕 𝒍𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔
Where absolute liquid assets = Cash balance + Bank balance + marketable securities.
Normally, it is safe to have this ratio within the range of 1:2.
Activity (or Turnover) Ratios
1. Inventory turnover ratio
Inventory turnover ratio or Stock turnover ratio indicates the velocity with which stock of
finished goods is sold i.e. replaced. Generally it is expressed as number of times the average
stock has been turned over or rotates of during the year.
𝑪𝒐𝒔𝒕 𝒐𝒇 𝑹𝒆𝒗𝒆𝒏𝒖𝒆 𝒇𝒓𝒐𝒎 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒐𝒏𝒔
𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 𝒕𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝑹𝒂𝒕𝒊𝒐 =
𝒂𝒗𝒆𝒓𝒂𝒈𝒆 𝒊𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚
(Opening stock + Closing stock)
average inventory =
2
cost of revenue from operations = (𝑛𝑒𝑡 𝑠𝑎𝑙𝑒𝑠 − 𝑔𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡)
Significance: It studies the frequency of conversion of inventory of finished goods into revenue
from operations. It is also a measure of liquidity. It determines how many times inventory is
purchased or replaced during a year. Low turnover of inventory may be due to bad buying,
obsolete inventory, etc., and is a danger signal. High turnover is good but it must be carefully
interpreted as it may be due to buying in small lots or selling quickly at low margin to realize
cash. Thus, it throws light on utilization of inventory of goods.

2. Debtor’s turnover ratio

Ratio of net credit sales to average trade debtors is called debtors turnover ratio. It is also known
as trade receivables turnover ratio. This ratio is expressed in times.
𝐍𝐞𝐭 𝐂𝐫𝐞𝐝𝐢𝐭 𝐑𝐞𝐯𝐞𝐧𝐮𝐞 𝐟𝐫𝐨𝐦 𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐨𝐧
𝐓𝐫𝐚𝐝𝐞 𝐑𝐞𝐜𝐞𝐢𝐯𝐚𝐛𝐥𝐞 𝐓𝐮𝐫𝐧𝐨𝐯𝐞𝐫 𝐫𝐚𝐭𝐢𝐨 (𝐝𝐞𝐛𝐭𝐨𝐫𝐬 𝐭𝐮𝐫𝐧𝐨𝐯𝐞𝐫 𝐫𝐚𝐭𝐢𝐨) =
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐓𝐫𝐚𝐝𝐞 𝐑𝐞𝐜𝐞𝐢𝐯𝐚𝐛𝐥𝐞

(Opening Debtors and Bills Receivable + Closing Debtors and Bills Receivable)
average trade receivable =
2

It needs to be noted that debtors should be taken before making any provision for doubtful debts.
Significance: The liquidity position of the firm depends upon the speed with which trade
receivables are realized. This ratio indicates the number of times the receivables are turned over
and converted into cash in an accounting period. Higher turnover means speedy collection from
trade receivable. This ratio also helps in working out the average collection period.
𝑵𝒐 𝒐𝒇 𝒅𝒂𝒚𝒔 𝒐𝒓 𝒎𝒐𝒏𝒕𝒉𝒔
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐜𝐨𝐥𝐥𝐞𝐜𝐭𝐢𝐨𝐧 𝐩𝐞𝐫𝐢𝐨𝐝 =
𝒕𝒓𝒂𝒅𝒆 𝒓𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆𝒔 𝒕𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝒓𝒂𝒕𝒊𝒐
 3. Creditor’s turnover ratio
It is a ratio of net credit purchases to average trade creditors. Creditor’s turnover ratio is also
known as trade payables turnover ratio.
𝐍𝐞𝐭 𝐂𝐫𝐞𝐝𝐢𝐭 𝐏𝐮𝐫𝐜𝐡𝐚𝐬𝐞𝐬
𝐓𝐫𝐚𝐝𝐞 𝐩𝐚𝐲𝐚𝐛𝐥𝐞 𝐓𝐮𝐫𝐧𝐨𝐯𝐞𝐫 𝐫𝐚𝐭𝐢𝐨 (𝐜𝐫𝐞𝐝𝐢𝐭𝐨𝐫𝐬 𝐭𝐮𝐫𝐧𝐨𝐯𝐞𝐫 𝐫𝐚𝐭𝐢𝐨) =
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐓𝐫𝐚𝐝𝐞 𝐏𝐚𝐲𝐚𝐛𝐥𝐞

(Opening Creditors and Bills Payable + Closing Creditors and Bills Payable)
average trade payable =
𝟐
Significance: It reveals average payment period. Lower ratio means credit allowed by the
supplier is for a long period or it may reflect delayed payment to suppliers which is not a very
good policy as it may affect the reputation of the business. The average period of payment can be
calculated as:
𝑵𝒐 𝒐𝒇 𝒅𝒂𝒚𝒔 𝒐𝒓 𝒎𝒐𝒏𝒕𝒉𝒔
𝐂𝐫𝐞𝐝𝐢𝐭𝐨𝐫𝐬 𝐩𝐚𝐲𝐦𝐞𝐧𝐭 𝐩𝐞𝐫𝐢𝐨𝐝 =
𝒕𝒓𝒂𝒅𝒆 𝒑𝒂𝒚𝒂𝒃𝒍𝒆 𝒕𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝒓𝒂𝒕𝒊𝒐

4. Assets turnover ratio

a) Working capital turnover ratio:
Working capital turnover ratio establishes relationship between cost of sales and net working
capital. As working capital has direct and close relationship with cost of goods sold, therefore,
the ratio provides useful idea of how efficiently or actively working capital is being used.
𝒏𝒆𝒕 𝒓𝒆𝒗𝒆𝒏𝒖𝒆 𝒇𝒓𝒐𝒎 𝒐𝒑𝒆𝒓𝒂𝒕𝒊𝒐𝒏
𝐖𝐨𝐫𝐤𝐢𝐧𝐠 𝐜𝐚𝐩𝐢𝐭𝐚𝐥 𝐭𝐮𝐫𝐧𝐨𝐯𝐞𝐫 𝐫𝐚𝐭𝐢𝐨 =
𝒘𝒐𝒓𝒌𝒊𝒏𝒈 𝒄𝒂𝒑𝒊𝒕𝒂𝒍
b) Fixed Assets Turnover Ratio:
𝒏𝒆𝒕 𝒓𝒆𝒗𝒆𝒏𝒖𝒆 𝒇𝒓𝒐𝒎 𝒐𝒑𝒆𝒓𝒂𝒕𝒊𝒐𝒏
𝐅𝐢𝐱𝐞𝐝 𝐀𝐬𝐬𝐞𝐭𝐬 𝐭𝐮𝐫𝐧𝐨𝐯𝐞𝐫 𝐫𝐚𝐭𝐢𝐨 =
𝑭𝒊𝒙𝒆𝒅 𝑨𝒔𝒔𝒆𝒕𝒔

Net revenue from operation = (Opening stock + Net purchases + Direct expense – closing stock)
Net working capital = (Current assets - Current liabilities)
Significance: High turnover of capital employed, working capital and fixed assets is a good sign
and implies efficient utilization of resources.
Profitability Ratios
1. Gross profit ratio
Gross profit ratio is the ratio of gross profit to net sales i.e. sales less sales returns. The ratio thus
reflects the margin of profit that a concern is able to earn on its trading and manufacturing
activity.
Following formula is used to calculated gross profit ratio (GP Ratio):
𝒈𝒓𝒐𝒔𝒔 𝒑𝒓𝒐𝒇𝒊𝒕 × 𝟏𝟎𝟎
𝐆𝐫𝐨𝐬𝐬 𝐏𝐫𝐨𝐟𝐢𝐭 𝐫𝐚𝐭𝐢𝐨 =
𝑵𝒆𝒕 𝒓𝒆𝒗𝒆𝒏𝒖𝒆 𝒐𝒇 𝒐𝒑𝒆𝒓𝒂𝒕𝒊𝒐𝒏𝒔
Gross profit = (Net sales - Cost of goods sold)
Cost of goods sold = (Opening stock + Net purchases + Direct expenses - Closing stock)
Net revenue of operations = (Sales - Returns inwards)
Significance: It indicates gross margin on products sold. It also indicates the margin available to
cover operating expenses, non-operating expenses, etc. Change in gross profit ratio may be due
to change in selling price or cost of revenue from operations or a combination of both. A low
ratio may indicate unfavorable purchase and sales policy. Higher gross profit ratio is always a
good sign.

2. Net profit ratio

Net profit ratio expresses the relationship between net profit after taxes and sales. The ratio
indicates what portion of the net sales is left for the owners after all expenses have been met.
Following formula is used to calculate net profit ratio:
𝒏𝒆𝒕 𝒑𝒓𝒐𝒇𝒊𝒕 × 𝟏𝟎𝟎
𝐍𝐞𝐭 𝐏𝐫𝐨𝐟𝐢𝐭 𝐫𝐚𝐭𝐢𝐨 =
𝑵𝒆𝒕 𝒓𝒆𝒗𝒆𝒏𝒖𝒆 𝒐𝒇 𝒐𝒑𝒆𝒓𝒂𝒕𝒊𝒐𝒏𝒔
Significance: It is a measure of net profit margin in relation to revenue from operations. Besides
revealing profitability, it is the main variable in computation of Return on Investment. It reflects
the overall efficiency of the business, assumes great significance from the point of view of
investors.

3. Operating Ratio
The operating ratio is determined by comparing the cost of the goods sold and other operating
expenses with net sales.
Following formula is used to calculate operating ratio:
 (𝒄𝒐𝒔𝒕 𝒐𝒇 𝒓𝒆𝒗𝒆𝒏𝒖𝒆 𝒇𝒓𝒐𝒎 𝒐𝒑𝒆𝒓𝒂𝒕𝒊𝒐𝒏𝒔 + 𝒐𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝒆𝒙𝒑𝒆𝒏𝒔𝒆𝒔) × 𝟏𝟎𝟎
𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐫𝐚𝐭𝐢𝐨 =
𝑵𝒆𝒕 𝒓𝒆𝒗𝒆𝒏𝒖𝒆 𝒐𝒇 𝒐𝒑𝒆𝒓𝒂𝒕𝒊𝒐𝒏𝒔
Cost of goods sold = (O/P stock + Net purchases + Manufacturing expenses – C/L stock)
Operating expenses include office expenses, administrative expenses, selling expenses,
distribution expenses, depreciation and employee benefit expenses etc.
𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐩𝐫𝐨𝐟𝐢𝐭 𝐫𝐚𝐭𝐢𝐨 = (𝟏𝟎𝟎 − 𝐨𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐫𝐚𝐭𝐢𝐨)
Significance: Operating ratio is computed to express cost of operations excluding financial
charges in relation to revenue from operations. A corollary of it is ‘Operating Profit Ratio’. It
helps to analyze the performance of business and throws light on the operational efficiency of the
business. It is very useful for inter-firm as well as intra-firm comparisons. Lower operating ratio
is a very healthy sign.

4. Return on Investment (ROI) / Return on Capital Employed (ROCE)

It explains the overall utilization of funds by a business enterprise. Capital employed means the
long-term funds employed in the business and includes shareholders’ funds, reserves and surplus,
debentures and long-term loans
𝑷𝒓𝒐𝒇𝒊𝒕 𝒃𝒆𝒇𝒐𝒓𝒆 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒂𝒏𝒅 𝑻𝒂𝒙 × 𝟏𝟎𝟎
𝑹𝒆𝒕𝒖𝒓𝒏 𝒐𝒏 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 (𝒐𝒓 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝑬𝒎𝒑𝒍𝒐𝒚𝒆𝒅) =
𝒄𝒂𝒑𝒊𝒕𝒂𝒍 𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒅
Significance: It measures return on capital employed in the business. It reveals the efficiency of
the business in utilization of funds entrusted to it by shareholders, debenture-holders and long-
term loans. For inter-firm comparison, return on capital employed funds is considered a good
measure of profitability.

5. Return on Shareholders’ Funds / Return on Net-worth

This ratio is very important from shareholders’ point of view in assessing whether their
investment in the firm generates a reasonable return or not. It should be higher than the return on
investment otherwise it would imply that company’s funds have not been employed profitably. A
better measure of profitability from shareholders point of view is obtained by determining return
on total shareholders’ funds; it is also termed as Return on Net worth (RONW) and is calculated
as:
𝑷𝒓𝒐𝒇𝒊𝒕 𝒂𝒇𝒕𝒆𝒓 𝑻𝒂𝒙 × 𝟏𝟎𝟎
𝑹𝒆𝒕𝒖𝒓𝒏 𝒐𝒏 𝑺𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓 𝒔 𝑭𝒖𝒏𝒅𝒔 =
𝑺𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓 𝒔 𝑭𝒖𝒏𝒅𝒔
 6. Earnings per Share (EPS)
Earnings refer to profit available for equity shareholders which are worked out as Profit after Tax
less Dividend on Preference Shares. This ratio is very important from equity shareholders point
of view and also for the share price in the stock market. This also helps comparison with other to
ascertain its reasonableness and capacity to pay dividend. The ratio is computed as:
𝑷𝒓𝒐𝒇𝒊𝒕 𝒂𝒗𝒂𝒊𝒍𝒂𝒃𝒍𝒆 𝒇𝒐𝒓 𝒆𝒒𝒖𝒊𝒕𝒚 𝒔𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓
𝑬𝑷𝑺 =
𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝑬𝒒𝒖𝒊𝒕𝒚 𝑺𝒉𝒂𝒓𝒆𝒔

7. Price / Earnings Ratio

The ratio is computed as:
𝑴𝒂𝒓𝒌𝒆𝒕 𝒑𝒓𝒊𝒄𝒆 𝒐𝒇 𝒂 𝒔𝒉𝒂𝒓𝒆
𝑷/𝑬 =
𝒆𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆
For example, if the EPS of X Ltd. is Rs. 10 and market price is Rs. 100, the price earnings ratio
will be 10 (100/10). It reflects investor’s expectation about the growth in the firm’s earnings and
reasonableness of the market price of its shares. P/E Ratio varies from industry to industry and
company to company in the same industry depending upon investor’s perception of their future.

Solvency Ratios
1. Debt-Equity Ratio
Debt-Equity Ratio measures the relationship between long-term debt and equity. If debt
component of the total long-term funds employed is small, outsiders feel more secure. From
security point of view, capital structure with less debt and more equity is considered favorable as
it reduces the chances of bankruptcy. Normally, it is considered to be safe if debt equity ratio is
2:1. However, it may vary from industry to industry. It is computed as follows:
𝑳𝒐𝒏𝒈 𝒕𝒆𝒓𝒎 𝒅𝒆𝒃𝒕𝒔
𝑫𝒆𝒃𝒕 − 𝑬𝒒𝒖𝒊𝒕𝒚 𝒓𝒂𝒕𝒊𝒐 =
𝑺𝒉𝒂𝒓𝒆 𝒉𝒐𝒍𝒅𝒆𝒓 𝒔 𝒇𝒖𝒏𝒅𝒔
Where:
Shareholders’ Funds (Equity) = (Share capital + Reserves and Surplus + Money received against
share warrants)
Share Capital = (Equity share capital + Preference share capital)
Or
Shareholders’ Funds (Equity) = (Non-current assets + Working capital – Non-current liabilities)
Working Capital = (Current Assets – Current Liabilities)
Significance: This ratio measures the degree of indebtedness of an enterprise and gives an idea to
the long-term lender regarding extent of security of the debt. As indicated earlier, a low debt
equity ratio reflects more security. A high ratio, on the other hand, is considered risky as it may
put the firm into difficulty in meeting its obligations to outsiders.

2. Proprietary Ratio
Proprietary ratio expresses relationship of proprietor’s (shareholders) funds to net assets and is
calculated as follows:
𝑺𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓𝒔 𝒇𝒖𝒏𝒅𝒔
𝑷𝒓𝒐𝒑𝒓𝒊𝒆𝒕𝒂𝒓𝒚 𝒓𝒂𝒕𝒊𝒐 =
𝑵𝒆𝒕 𝒂𝒔𝒔𝒆𝒕𝒔
Significance: Higher proportion of shareholders funds in financing the assets is a positive feature
as it provides security to creditors. This ratio can also be computed in relation to total assets
instead of net assets (capital employed).

3. Debt Service Ratio or Interest Coverage Ratio

The ratio measures debts servicing capacity of a business so far as interest on long-term loans is
concerned. This ratio shows how many times the interest charges are covered by the earnings.
Debt service ratio is also known as interest coverage ratio.
The ratio is calculated with following formula:
𝐄𝐚𝐫𝐧𝐢𝐧𝐠𝐬 𝐛𝐞𝐟𝐨𝐫𝐞 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐚𝐧𝐝 𝐭𝐚𝐱𝐞𝐬 (𝐄𝐁𝐈𝐓)
𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑪𝒐𝒗𝒆𝒓𝒂𝒈𝒆 𝒓𝒂𝒕𝒊𝒐 =
𝐅𝐢𝐱𝐞𝐝 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐜𝐡𝐚𝐫𝐠𝐞𝐬
Significance: It reveals the number of times interest on long-term debts is covered by the profits
available for interest. A higher ratio ensures safety of interest on debts.

4. Debt to Capital Employed Ratio

The Debt to capital employed ratio refers to the ratio of long-term debt to the total of external
and internal funds (capital employed or net assets). It is computed as follows:
𝑳𝒐𝒏𝒈 𝒕𝒆𝒓𝒎 𝑫𝒆𝒃𝒕𝒔
𝑫𝒆𝒃𝒕 𝒕𝒐 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒅 𝒓𝒂𝒕𝒊𝒐 =
𝒄𝒂𝒑𝒊𝒕𝒂𝒍 𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒅 (𝑵𝒆𝒕 𝒂𝒔𝒔𝒆𝒕𝒔)
𝑻𝒐𝒕𝒂𝒍 𝑫𝒆𝒃𝒕𝒔
𝑫𝒆𝒃𝒕 𝒕𝒐 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒅 𝒓𝒂𝒕𝒊𝒐 =
𝑻𝒐𝒕𝒂𝒍 𝒂𝒔𝒔𝒆𝒕𝒔
Capital employed is equal to the long-term debt + shareholders’ funds. Alternatively, it may be
taken as net assets which are equal to the total assets – current liabilities.
Significance: Like debt-equity ratio, it shows proportion of long-term debts in capital employed.
Low ratio provides security to lenders and high ratio helps management in trading on equity.

5. Total Assets to Debt Ratio

This ratio measures the extent of the coverage of long-term debts by assets. It is calculated as:
𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔
𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔 𝒕𝒐 𝑫𝒆𝒃𝒕 𝒓𝒂𝒕𝒊𝒐 =
𝑳𝒐𝒏𝒈 𝒕𝒆𝒓𝒎 𝑫𝒆𝒃𝒕𝒔
Long term debts = (debentures + long term loans)
The higher ratio indicates that assets have been mainly financed by owner’s funds and the long-
term loans are adequately covered by assets. It is better to take the net assets (capital employed)
instead of total assets for computing this ratio also. It is observed that in that case, the ratio is the
reciprocal of the debt to capital employed ratio.
Significance: This ratio primarily indicates the rate of external funds in financing the assets and
the extent of coverage of their debts are covered by assets.

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