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Accountancy: Class 12 (Part 2) — Chapter 5: Accounting Ratios

5.1 Meaning of Accounting Ratios

Financial statements provide financial data which require analysis, comparison, and interpretation for decision-making by both external and internal users. This process is termed as financial statement analysis.

An accounting ratio is a mathematical relationship between two or more accounting numbers derived from financial statements. It can be expressed as a fraction, proportion, percentage, or number of times.

For example, if Gross Profit is Rs. 10,000 and Revenue from Operations is Rs. 1,00,000, the Gross Profit Ratio is:

$$\text{Gross Profit Ratio} = \frac{10,000}{1,00,000} \times 100 = 10\%$$
5.2 Objectives of Ratio Analysis

Ratio analysis is an indispensable part of interpreting financial statements. Its primary objectives are:

5.3 & 5.4 Advantages and Limitations of Ratio Analysis

Advantages of Ratio Analysis
  • Efficacy of Decisions: Helps understand the impact of operating, investing, and financing decisions.
  • Simplification: Simplifies complex accounting figures and establishes clear relationships.
  • Comparative Analysis: Enables trend analysis over multiple years and inter-firm comparisons.
  • SWOT Analysis: Assists management in identifying strengths, weaknesses, opportunities, and threats.

Limitations of Ratio Analysis
  • Limitations of Accounting Data: Ratios inherit any errors or biases present in the underlying financial statements.
  • Ignores Price-level Changes: Inflationary changes can render historical comparisons misleading.
  • Ignores Qualitative Factors: Focuses purely on monetary aspects, ignoring non-monetary factors like management quality.
  • Variations in Accounting Practices: Differences in inventory valuation or depreciation methods hinder cross-sectional comparisons.
5.5 Types of Ratios

Ratios are broadly classified into two categories: Traditional Classification (based on financial statements) and Functional Classification (based on purpose). The functional classification is most commonly used:

  1. Liquidity Ratios: Measure short-term solvency.
  2. Solvency Ratios: Measure long-term ability to meet obligations.
  3. Activity (or Turnover) Ratios: Measure efficiency of resource utilization.
  4. Profitability Ratios: Measure earning capacity.
5.6 Liquidity Ratios

Liquidity ratios assess the firm's ability to meet its current obligations.

5.6.1 Current Ratio

The proportion of current assets to current liabilities.

$$\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}$$

An ideal current ratio is generally considered to be 2:1.

5.6.2 Quick (or Liquid) Ratio

Measures the ability to meet short-term obligations using highly liquid assets (excluding inventory and prepaid expenses).

$$\text{Quick Ratio} = \frac{\text{Quick Assets}}{\text{Current Liabilities}}$$

Where:

$$\text{Quick Assets} = \text{Current Assets} - (\text{Inventories} + \text{Prepaid Expenses})$$

An ideal quick ratio is 1:1.

5.7 Solvency Ratios

Solvency ratios determine the long-term viability and debt-servicing capacity of a business.

5.7.1 Debt-Equity Ratio

 $$\text{Debt-Equity Ratio} = \frac{\text{Long-term Debts}}{\text{Shareholders' Funds}}$$

A safe norm is generally considered to be 2:1.

5.7.2 Debt to Capital Employed Ratio

 $$\text{Debt to Capital Employed Ratio} = \frac{\text{Long-term Debt}}{\text{Capital Employed}}$$

5.7.3 Proprietary Ratio

 $$\text{Proprietary Ratio} = \frac{\text{Shareholders' Funds}}{\text{Capital Employed (or Total Assets)}}$$

5.7.4 Total Assets to Debt Ratio

 $$\text{Total Assets to Debt Ratio} = \frac{\text{Total Assets}}{\text{Long-term Debts}}$$

5.7.5 Interest Coverage Ratio

 $$\text{Interest Coverage Ratio} = \frac{\text{Net Profit before Interest and Tax}}{\text{Interest on Long-term Debts}}$$
5.8 Activity (or Turnover) Ratios

These ratios measure how efficiently a firm uses its assets to generate sales.

5.8.1 Inventory Turnover Ratio

 $$\text{Inventory Turnover Ratio} = \frac{\text{Cost of Revenue from Operations}}{\text{Average Inventory}}$$

Where:

$$\text{Average Inventory} = \frac{\text{Opening Inventory} + \text{Closing Inventory}}{2}$$

5.8.2 Trade Receivables Turnover Ratio

 $$\text{Trade Receivables Turnover Ratio} = \frac{\text{Net Credit Revenue from Operations}}{\text{Average Trade Receivables}}$$

Average Collection Period is calculated as:

$$\text{Average Collection Period} = \frac{365}{\text{Trade Receivables Turnover Ratio}}$$

5.8.3 Trade Payables Turnover Ratio

 $$\text{Trade Payables Turnover Ratio} = \frac{\text{Net Credit Purchases}}{\text{Average Trade Payables}}$$

5.8.4 Working Capital Turnover Ratio

 $$\text{Working Capital Turnover Ratio} = \frac{\text{Net Revenue from Operations}}{\text{Working Capital}}$$
5.9 Profitability Ratios

Profitability ratios analyze the earning capacity of the business in relation to sales or capital employed.

Key Profitability Formulas
  • Gross Profit Ratio: $$\text{Gross Profit Ratio} = \frac{\text{Gross Profit}}{\text{Net Revenue of Operations}} \times 100$$
  • Operating Ratio: $$\text{Operating Ratio} = \frac{\text{Cost of Revenue from Operations} + \text{Operating Expenses}}{\text{Net Revenue from Operations}} \times 100$$
  • Net Profit Ratio: $$\text{Net Profit Ratio} = \frac{\text{Net Profit}}{\text{Revenue from Operations}} \times 100$$
  • Return on Investment (ROI): $$\text{ROI} = \frac{\text{Profit before Interest and Tax}}{\text{Capital Employed}} \times 100$$
  • Earnings Per Share (EPS): $$\text{EPS} = \frac{\text{Profit available for Equity Shareholders}}{\text{Number of Equity Shares}}$$