Understanding Financial Ratios Required Under Schedule III of the Companies Act: A Comprehensive Guide

Introduction

The Ministry of Corporate Affairs (MCA) in India introduced amendments to Schedule III of the Companies Act, 2013, effective from April 1, 2021, to enhance transparency and accountability in financial reporting. One of the key mandates under these amendments is the disclosure of 11 specific financial ratios in the financial statements of companies. These ratios provide critical insights into a company’s financial health, operational efficiency, and compliance with regulatory standards.

This blog post on Financial Ratios Schedule III Companies Act, 2013, explores these financial ratios, their formulas, and their significance, along with the pros and cons of such disclosures.

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What is Schedule III of the Companies Act, 2013?

Schedule III outlines the format and disclosure requirements for preparing financial statements under the Companies Act, 2013. The amendments introduced in 2021 mandate companies to disclose additional regulatory information, including key financial ratios, to improve transparency for stakeholders such as investors, creditors, and regulators. Companies must also explain any variation exceeding 25% in these ratios compared to the previous year.

For a deeper understanding of financial statement preparation, stay tuned to TaxRoutine’s Blog Posts.

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Financial Ratios Schedule III Companies Act, 2013

Here’s a detailed breakdown of the 11 financial ratios mandated under Schedule III, along with their financial ratio formula and explanations:

1. Current Ratio
   • Formula: Current Assets ÷ Current Liabilities
   • Explanation: This ratio measures a company’s ability to meet its short-term obligations using its short-term assets (e.g., cash, inventory, receivables). A ratio above 1 indicates good liquidity.
   • Example: If current assets are ₹50 lakh and current liabilities are ₹25 lakh, the current ratio is 2, suggesting strong liquidity.
2. Debt-Equity Ratio
   • Formula: Total Debt ÷ Shareholders’ Equity
   • Explanation: This ratio assesses the proportion of debt financing relative to equity. A higher ratio indicates greater reliance on borrowed funds, which could signal financial risk.
   • Example: Total debt of ₹20 lakh and equity of ₹40 lakh result in a debt-equity ratio of 0.5.
3. Debt Service Coverage Ratio (DSCR)
   • Formula: Net Operating Income ÷ Total Debt Service (Principal + Interest)
   • Explanation: DSCR evaluates a company’s ability to service its debt with operating income. A ratio above 1.5–2 is generally considered healthy.
   • Example: If net operating income is ₹30 lakh and total debt service is ₹15 lakh, the DSCR is 2.
4. Return on Equity (ROE)
   • Formula: (Net Profit After Tax – Preference Dividend) ÷ Average Shareholders’ Equity × 100
   • Explanation: ROE measures the profitability generated from shareholders’ equity. A higher ROE reflects efficient use of equity capital.
   • Example: Net profit of ₹10 lakh and average equity of ₹50 lakh yield an ROE of 20%.
5. Inventory Turnover Ratio
   • Formula: Cost of Goods Sold (COGS) ÷ Average Inventory
   • Explanation: This ratio indicates how efficiently a company manages its inventory by showing how many times inventory is sold and replaced in a year.
   • Example: COGS of ₹60 lakh and average inventory of ₹10 lakh result in a turnover of 6 times.
6. Trade Receivables Turnover Ratio
   • Formula: Net Credit Sales ÷ Average Trade Receivables
   • Explanation: It measures how quickly a company collects payments from its debtors. A higher ratio suggests efficient credit management.
   • Example: Net credit sales of ₹80 lakh and average receivables of ₹20 lakh give a ratio of 4.
7. Trade Payables Turnover Ratio
   • Formula: Net Credit Purchases ÷ Average Trade Payables
   • Explanation: This ratio shows how frequently a company pays its suppliers. A lower ratio may indicate delayed payments.
   • Example: Net purchases of ₹50 lakh and average payables of ₹10 lakh result in a ratio of 5.
8. Net Capital Turnover Ratio
   • Formula: Net Sales ÷ Working Capital (Current Assets – Current Liabilities)
   • Explanation: This ratio evaluates how effectively a company utilizes its working capital to generate sales.
   • Example: Net sales of ₹100 lakh and working capital of ₹25 lakh yield a ratio of 4.
9. Net Profit Ratio
   • Formula: Net Profit ÷ Net Sales × 100
   • Explanation: It indicates the percentage of revenue that translates into profit, reflecting overall profitability.
   • Example: Net profit of ₹15 lakh and net sales of ₹100 lakh result in a net profit ratio of 15%.
10. Return on Capital Employed (ROCE)
    • Formula: Earnings Before Interest and Taxes (EBIT) ÷ Capital Employed (Total Assets – Current Liabilities) × 100
    • Explanation: ROCE measures the efficiency of capital utilization in generating profits. A higher ratio signifies better performance.
    • Example: EBIT of ₹20 lakh and capital employed of ₹80 lakh give an ROCE of 25%.
11. Return on Investment (ROI)
    • Formula: (Net Profit from Investment ÷ Cost of Investment) × 100
    • Explanation: ROI assesses the profitability of specific investments, helping stakeholders evaluate returns on capital projects or assets.
    • Example: Net profit from an investment of ₹5 lakh and a cost of ₹25 lakh result in an ROI of 20%.

For more insights into interpreting these ratios, visit Corporate Finance Institute’s Guide to Financial Ratios.

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Pros and Cons

Pros of Disclosing Financial Ratios Under Schedule III

1. Enhanced Transparency: Stakeholders gain a clearer picture of a company’s financial position, fostering trust.
2. Better Decision-Making: Investors and creditors can make informed decisions based on standardized metrics.
3. Regulatory Compliance: Aligns with MCA’s push for accountability, reducing the risk of financial misrepresentation.
4. Comparative Analysis: Facilitates benchmarking against industry peers or historical performance.
5. Fraud Detection: Significant variations in ratios (over 25%) must be explained, deterring manipulation.

Explore more benefits of financial compliance on TaxRoutine’s Blog.

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Cons of Disclosing Financial Ratios Under Schedule III

1. Increased Compliance Burden: Small companies may struggle with the resources needed to compute and disclose these ratios.
2. Competitive Disadvantage: Public disclosure of financial health could expose vulnerabilities to competitors.
3. Complexity for Stakeholders: Non-financial users may find it challenging to interpret technical ratios.
4. Cost Implications: Additional auditing and reporting requirements may raise operational costs.
5. Ambiguity in Explanation: Explaining a >25% variance can be subjective, leading to potential misinterpretation.

For tips on managing compliance costs, refer to TaxRoutine’s Cost-Saving Strategies.

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Conclusion

The disclosure of financial ratios under Schedule III of the Companies Act, 2013, marks a significant step toward greater transparency in India’s corporate ecosystem. By providing formulas and explanations for ratios like Current Ratio, ROE, and ROCE, companies empower stakeholders to assess liquidity, profitability, and efficiency. While the pros include improved trust and decision-making, the cons highlight challenges like compliance costs and complexity. Striking a balance between regulatory requirements and operational feasibility is key.

Stay updated on financial regulations with TaxRoutine and ensure your business thrives in a compliant environment!

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