Class 12 Accountancy Notes Chapter 5 (Accounting Ratios) – Accountancy-II Book

Alright class, let's dive into Chapter 5: Accounting Ratios. This is a crucial chapter, not just for your board exams, but also for various government exams where financial statement analysis is tested. Ratios help us make sense of the numbers presented in the Balance Sheet and Statement of Profit and Loss.

What are Accounting Ratios?

An accounting ratio is essentially a mathematical expression that shows the relationship between two accounting figures (or groups of figures) drawn from the financial statements. It simplifies complex accounting data and makes it understandable. Think of it as using a magnifying glass to examine specific aspects of a company's financial health and performance.

Objectives of Ratio Analysis

Why do we calculate these ratios? The primary objectives are:

1. To Simplify Accounting Information: Ratios present large, complex data in a simple, understandable format.
2. To Assess Financial Health: They help determine a company's ability to meet its short-term (liquidity) and long-term (solvency) obligations.
3. To Evaluate Operational Efficiency: Ratios measure how effectively a company utilizes its resources (assets) to generate sales.
4. To Analyze Profitability: They help assess the company's earning capacity and overall performance.
5. To Facilitate Comparison: Ratios allow for:
   • Intra-firm comparison: Comparing a company's performance over different time periods.
   • Inter-firm comparison: Comparing a company's performance with that of its competitors or industry averages.
6. To Aid in Forecasting and Planning: Past trends revealed by ratio analysis can help in future projections.
7. To Assist in Decision Making: Management, investors, creditors, and government agencies use ratios to make informed decisions.

Advantages of Ratio Analysis

• Helps understand financial statements better.
• Simplifies complex data.
• Useful in assessing operating efficiency, liquidity, solvency, and profitability.
• Facilitates intra-firm and inter-firm comparisons.
• Helps in locating weak areas of the business.
• Aids in forecasting and planning.

Limitations of Ratio Analysis

Despite their usefulness, ratios have limitations:

1. Based on Historical Data: Ratios analyze past performance, which may not accurately predict the future.
2. Ignores Price Level Changes: Inflation can distort comparisons over time.
3. Ignores Qualitative Factors: Ratios are purely quantitative and ignore factors like management quality, employee morale, brand reputation, etc.
4. Lack of Standard Definitions: Different firms may use slightly different formulas or definitions for components (e.g., what constitutes 'Operating Expense'), making comparisons difficult.
5. Window Dressing: Companies might manipulate figures (legally or illegally) around the year-end to present a better financial picture, thus distorting ratios.
6. Misleading if Used in Isolation: A single ratio doesn't tell the whole story. A holistic view requires analyzing multiple ratios together and considering the context.
7. Varying Accounting Policies: Differences in policies (e.g., depreciation method, inventory valuation) can affect ratios and hinder comparison.

Classification of Ratios

Ratios are broadly classified based on the purpose they serve:

(I) Liquidity Ratios (Short-term Solvency)

These ratios measure the firm's ability to meet its short-term obligations (current liabilities) as they become due.

1. Current Ratio:

   • Formula: Current Assets / Current Liabilities
   • Components:
     • Current Assets: Include Cash, Bank Balance, Marketable Securities, Short-term Investments, Trade Receivables (Debtors & Bills Receivable), Inventories (Stock), Prepaid Expenses, Accrued Income.
     • Current Liabilities: Include Trade Payables (Creditors & Bills Payable), Short-term Borrowings, Outstanding Expenses, Unearned Income, Short-term Provisions (like Provision for Tax).
   • Significance: Measures the overall short-term solvency. A higher ratio indicates a better ability to pay current debts.
   • Ideal Ratio: Generally considered to be 2:1, but varies by industry. Too high might indicate inefficient use of assets (idle cash, high inventory).

2. Quick Ratio (or Liquid Ratio or Acid-Test Ratio):

   • Formula: Quick Assets / Current Liabilities
   • Components:
     • Quick Assets (or Liquid Assets): Current Assets - Inventories - Prepaid Expenses. (These are assets quickly convertible into cash).
   • Significance: A more stringent test of liquidity than the current ratio, as it excludes inventory (which might not be easily sellable) and prepaid expenses (which won't generate cash).
   • Ideal Ratio: Generally considered to be 1:1.

(II) Solvency Ratios (Long-term Solvency)

These ratios measure the firm's ability to meet its long-term obligations (interest and principal repayment on long-term debt). They assess the long-term financial viability.

1. Debt-Equity Ratio:

   • Formula: Debt / Equity
   • Components:
     • Debt: Long-Term Borrowings + Long-Term Provisions.
     • Equity (or Shareholders' Funds or Net Worth): Share Capital (Equity + Preference) + Reserves & Surplus.
   • Significance: Shows the proportion of debt financing relative to equity financing. A high ratio indicates higher financial risk (more reliance on borrowed funds). A low ratio suggests greater long-term financial safety.
   • Ideal Ratio: Generally considered safe up to 2:1, but depends heavily on the industry and company strategy.

2. Total Assets to Debt Ratio:

   • Formula: Total Assets / Debt (Long-term Debt)
   • Components:
     • Total Assets: All assets (Non-Current + Current).
     • Debt: Long-Term Borrowings + Long-Term Provisions.
   • Significance: Measures the extent to which total assets are financed by long-term debt. A higher ratio indicates greater safety for lenders, as assets cover the debt multiple times over.

3. Proprietary Ratio:

   • Formula: Equity (Shareholders' Funds) / Total Assets
   • Components:
     • Equity: Share Capital + Reserves & Surplus.
     • Total Assets: All assets.
   • Significance: Shows the proportion of total assets financed by the owners' funds. A higher ratio indicates a stronger long-term solvency position and less reliance on external debt.

4. Interest Coverage Ratio (or Times Interest Earned):

   • Formula: Net Profit Before Interest and Tax (EBIT) / Interest on Long-term Debt
   • Components:
     • EBIT: Earnings Before Interest and Tax.
     • Interest: Interest expense on long-term borrowings.
   • Significance: Measures the company's ability to meet its interest obligations out of its profits. A higher ratio indicates a greater ability to pay interest charges, providing more safety to lenders. Expressed in 'times'.

(III) Activity Ratios (or Turnover Ratios or Efficiency Ratios)

These ratios measure how effectively a company utilizes its resources or assets to generate revenue. Higher turnover ratios generally indicate better efficiency.

1. Inventory Turnover Ratio:

   • Formula: Cost of Goods Sold (COGS) / Average Inventory
     • COGS: Opening Inventory + Net Purchases + Direct Expenses - Closing Inventory OR Revenue from Operations - Gross Profit.
     • Average Inventory: (Opening Inventory + Closing Inventory) / 2.
   • Significance: Measures how quickly inventory is sold or used. A high ratio indicates efficient inventory management (fast-moving stock). A very low ratio might suggest overstocking or obsolete inventory. Expressed in 'times'.

2. Trade Receivables Turnover Ratio:

   • Formula: Net Credit Revenue from Operations (Net Credit Sales) / Average Trade Receivables
     • Average Trade Receivables: (Opening Debtors + Opening B/R + Closing Debtors + Closing B/R) / 2. (If only closing figures are available, use those).
   • Significance: Measures how quickly cash is collected from credit customers. A high ratio indicates efficient credit management and quick collection. Expressed in 'times'.
   • (Related: Average Collection Period = 365 days / Trade Receivables Turnover Ratio)

3. Trade Payables Turnover Ratio:

   • Formula: Net Credit Purchases / Average Trade Payables
     • Average Trade Payables: (Opening Creditors + Opening B/P + Closing Creditors + Closing B/P) / 2. (If only closing figures are available, use those).
   • Significance: Measures how quickly the company pays its suppliers. A very high ratio might mean the company isn't utilizing the available credit period fully, while a very low ratio might indicate delayed payments. Expressed in 'times'.
   • (Related: Average Payment Period = 365 days / Trade Payables Turnover Ratio)

4. Working Capital Turnover Ratio:

   • Formula: Revenue from Operations / Working Capital
     • Working Capital: Current Assets - Current Liabilities.
   • Significance: Measures how efficiently working capital is being used to generate sales. A high ratio indicates efficient utilization of working capital. Expressed in 'times'.

(IV) Profitability Ratios

These ratios measure the overall performance and earning capacity of the business. They are crucial for owners, investors, and management.

1. Gross Profit Ratio:

   • Formula: (Gross Profit / Revenue from Operations) * 100
     • Gross Profit: Revenue from Operations - Cost of Goods Sold (COGS).
   • Significance: Shows the margin earned on sales after deducting the direct cost of goods sold. A higher ratio indicates better efficiency in production and purchasing, or higher selling prices. Expressed as a percentage.

2. Operating Ratio:

   • Formula: ((Cost of Goods Sold + Operating Expenses) / Revenue from Operations) * 100
     • Operating Expenses: Include office & administrative expenses, selling & distribution expenses, employee benefit expenses, depreciation, etc. (Exclude non-operating items like interest, loss on sale of assets, income tax).
   • Significance: Measures the proportion of sales consumed by the cost of operations (COGS + Operating Expenses). A lower ratio is generally better, indicating higher operational efficiency. Expressed as a percentage.

3. Operating Profit Ratio:

   • Formula: (Operating Profit / Revenue from Operations) * 100
     • Operating Profit: Revenue from Operations - Operating Cost (COGS + Operating Expenses) OR Gross Profit - Operating Expenses OR Net Profit Before Tax + Non-Operating Expenses - Non-Operating Incomes.
   • Significance: Shows the profit earned from the core business operations relative to sales. A higher ratio indicates better operational profitability. Expressed as a percentage.
   • Note: Operating Ratio + Operating Profit Ratio = 100%

4. Net Profit Ratio:

   • Formula: (Net Profit After Tax (PAT) / Revenue from Operations) * 100
   • Significance: Measures the overall profitability after considering all expenses and taxes. It reflects the overall efficiency of the business. A higher ratio is desirable. Expressed as a percentage.

5. Return on Investment (ROI) or Return on Capital Employed (ROCE):

   • Formula: (Net Profit Before Interest, Tax, and Dividend (EBIT) / Capital Employed) * 100
   • Components:
     • EBIT: Earnings Before Interest and Tax.
     • Capital Employed: Can be calculated using two approaches:
       • Liabilities Side Approach: Shareholders' Funds (Equity) + Non-Current Liabilities (Debt).
       • Assets Side Approach: Non-Current Assets + Working Capital (Current Assets - Current Liabilities). (Excluding fictitious assets and non-trade investments).
   • Significance: This is a key ratio measuring the overall profitability of the business in relation to the total funds invested (by owners and lenders). It assesses how efficiently the capital employed is generating profits. A higher ratio indicates better performance. Expressed as a percentage.

Key Points for Exam Preparation

• Memorize the formulas accurately.
• Understand the components of each formula (e.g., what is included in Current Assets, Debt, Operating Expenses, Capital Employed).
• Focus on the significance and interpretation of each ratio – what does a high or low value indicate?
• Know the ideal benchmarks (like 2:1 for Current Ratio), but remember they are just guidelines.
• Be able to classify ratios based on their function (Liquidity, Solvency, Activity, Profitability).
• Practice numerical problems involving calculation and interpretation.
• Understand the relationships between ratios (e.g., Operating Ratio and Operating Profit Ratio).
• Be aware of the limitations of ratio analysis.

Multiple Choice Questions (MCQs)

Here are 10 MCQs to test your understanding:

1. Which of the following ratios measures the short-term debt-paying ability of a company?
   a) Debt-Equity Ratio
   b) Quick Ratio
   c) Inventory Turnover Ratio
   d) Return on Investment

2. A Current Ratio of 2.5:1 indicates:
   a) The company has ₹2.5 of current liabilities for every ₹1 of current assets.
   b) The company has ₹2.5 of current assets for every ₹1 of current liabilities.
   c) The company's quick assets are 2.5 times its current liabilities.
   d) The company's long-term solvency is very strong.

3. Which asset is excluded when calculating the Quick Ratio (Acid-Test Ratio)?
   a) Cash
   b) Trade Receivables
   c) Marketable Securities
   d) Inventory

4. A high Debt-Equity Ratio generally signifies:
   a) Higher long-term financial risk for the company.
   b) Greater safety for lenders.
   c) A large proportion of assets financed by owners' funds.
   d) High operational efficiency.

5. Inventory Turnover Ratio is calculated using:
   a) Revenue from Operations / Average Inventory
   b) Net Credit Sales / Average Inventory
   c) Cost of Goods Sold / Average Inventory
   d) Gross Profit / Average Inventory

6. Which ratio measures the overall profitability considering all expenses and taxes relative to sales?
   a) Gross Profit Ratio
   b) Operating Profit Ratio
   c) Net Profit Ratio
   d) Return on Investment

7. Interest Coverage Ratio is calculated as:
   a) Net Profit After Tax / Interest on Long-term Debt
   b) Net Profit Before Tax / Interest on Long-term Debt
   c) Net Profit Before Interest and Tax / Interest on Long-term Debt
   d) Total Assets / Interest on Long-term Debt

8. Which of the following is considered an 'Activity Ratio'?
   a) Proprietary Ratio
   b) Current Ratio
   c) Trade Receivables Turnover Ratio
   d) Operating Profit Ratio

9. Capital Employed can be calculated as:
   a) Total Assets - Current Liabilities
   b) Shareholders' Funds + Current Liabilities
   c) Non-Current Assets + Current Assets
   d) Shareholders' Funds + Long-Term Debt

10. Which of the following is a limitation of Ratio Analysis?
    a) It simplifies complex data.
    b) It ignores qualitative factors.
    c) It helps in comparing performance.
    d) It assesses profitability.

Answers to MCQs:

1. b) Quick Ratio
2. b) The company has ₹2.5 of current assets for every ₹1 of current liabilities.
3. d) Inventory
4. a) Higher long-term financial risk for the company.
5. c) Cost of Goods Sold / Average Inventory
6. c) Net Profit Ratio
7. c) Net Profit Before Interest and Tax / Interest on Long-term Debt
8. c) Trade Receivables Turnover Ratio
9. d) Shareholders' Funds + Long-Term Debt (Liabilities Side Approach) or Non-Current Assets + Working Capital (Assets Side Approach, which simplifies to Total Assets - Current Liabilities only if Non-Current Assets + Current Assets - Current Liabilities is considered, matching option a. However, d is the more standard definition from the liability side). Let's stick with (d) as the most direct liability-side definition.
10. b) It ignores qualitative factors.

Study these notes thoroughly, understand the logic behind each ratio, and practice calculations. This chapter is all about applying formulas correctly and interpreting the results meaningfully. Good luck with your preparation!