Important Notes for Class 12 Accountancy Accounting Ratios
Accounting Ratios
Meaning :-
The quantitative relation between two amounts showing the number of times one value contains or is contained within the other.
A ratio may be expressed in the following ways:
(1) 'Proportion' or Pure Ratio or Simple Ratio:
It is the division of one number with the other and expressing in the lowest form of divisibility. The numbers are related with a ':'
sign. For example, a simple ratio of Current Assets (say, ₹3,00,000 and Current Liabilities (say, ₹1,50,000) will be 3,00,000:1,50,000 i.e. in the lowest/simplest form 2:1 (Two is to one)
(2) Rate or So many times:
In this we find out that 'how many times' one number is, in comparison to another number.
For example, if we compare 10 and 5, so we may say: 10/5=2 i.e. 10 is 2 times 5.
(3) Percentage:
Example: Gross Profit= ₹2,00,000 and Sales=₹10,00,000 then, GP ratio=₹2,00,000/₹10,00,000 X 100= 20%
(4) Fraction:
Example: Gross Profit= ₹2,00,000 and Sales=₹12,00,000 then,
we may say Gross Profit is one-sixth of Sales.
Now, if we talk about firms, then there are two types of ratio analysis involved viz. Cross-sectional analysis (when the data/ratios of one firm is compared with other firms) and Timeseries or trend analysis (when the data/ratios of the same firm is compared over various time periods like ratios of 2017, 2018 and 2019 are compared).
Classification of Ratios:
1. Liquidity Ratios
2. Solvency Ratios
3. Activity or Turnover Ratios
4. Profitability or Income Ratios
Liquidity Ratios:
Liquidity refers to the ability of a firm to meet its current liabilities. They are also known as 'Short-term Solvency ratios'.
It includes 2 ratios:
A. Current Ratio or Working capital ratio
B. Quick Ratio or Liquid Ratio or Acid Test Ratio
Solvency Ratios:
These ratios reveal the long term solvency of the firm.
They include the following ratios:
A. Debt Equity ratio
B. Total Assets to Debt Ratio
C. Proprietary Ratio
D. Interest Coverage Ratio
Activity Ratios:
They are also known as 'Turnover Ratios' because they are calculated on the basis of 'Cost of Revenue from operations' or 'Revenue from operations'.
They include the following ratios:
A. Inventory Turnover Ratio or Stock Turnover Ratio
B. Debtors or Receivables Turnover Ratio
C. Creditors or Payables Turnover Ratio
D. Working Capital Turnover Ratio
Profitability Ratios or Income Ratios:
These ratios measure the Proportion of profitability with respect to various profit centres i.e. items that affect the profitability of the firm.
They include the following ratios:
A. Gross Profit ratio
B. Operating ratio
C. Operating Profit ratio
D. Net Profit ratio
E. Return on Investment or R.O.I
Formulae:
I. Current ratio = Current Assets/ Current Liabilities
The ideal ratio is 2:1. If it is more, it is considered as better. If the ratio is less than 2:1, then it indicates that there is a shortage of Working capital.
II. Quick Ratio= Liquid Assets/Current Liabilities
Liquid Assets=
Current Assets- Inventories- Prepaid Expenses and Advance Tax.
Or
= Current Investments + Trade Receivables + Cash and Cash Equivalents + Short term Loans and Advances
The ideal ratio is 1:1. If it is more, it is considered as better. If the ratio is less than 1:1, then it indicates that the short term financial position of the company is not good.
Note: Provision for Doubtful Debts is reduced from Trade Receivables while calculating Current and Quick ratio.
Long term Debts include long term borrowings and long term provisions maturing after one year. For example, Debentures, Bank Loan,etc.
Shareholder's Fund = Share Capital + Reserves and Surplus OR
= Non-Current assets + Current Assets - Current liabilities - Non Current Liabilities
{Also, Current Assets - Current liabilities = Working Capital}
Share Capital = Equity + preference shares
The ideal Debt-Equity ratio is 2:1. If it is more than that, then the financial position of the firm is risky. Hence, the lower the ratio, the better it is for the long term lenders.
It ascertains the soundness of the long term policies of the firm.
This ratio indicates how much of total assets have been financed by long-term debts. A higher ratio indicates that assets have been mainly financed by owners funds and less of long-term debts.
Shareholder's Fund is also known as Proprietor's Fund
Total Assets= Non Current Assets + Current Assets
This ratio shows the proportion of total assets funded by owners or shareholders.
Higher the ratio, the better it is. It is usually expressed in percentage.
It is expressed in 'TIMES'. It is also known as Debt Service Ratio.
The higher the ratio, the better it is. a high ratio provides a sense of security to the lender with respect to interest payments.
Net profit after tax means Net Profit after Interest and tax because tax is deducted only after deduction of Interest.
Hence, profit after tax means that the interest is already subtracted.
Cost of revenue from operations is also known as Cost of Goods Sold.
It is calculated in 'TIMES'. The Inventory Turnover Ratio provides insight on how long cash is tied up in the cycle of being used to purchase raw materials or a finished product for sale through to
selling the product. The higher the ratio, the better it is.
Cost of revenue from operations=
Revenue from operations- Gross Profit
OR
Revenue from Operations + Gross Loss
OR
Opening Inventory + Purchases + Carriage + Wages + Other Direct Expenses - Closing Inventory
It is calculated in 'TIMES'. It measures how many times a business can turn its accounts receivable into cash during a period. In other words, the accounts receivable turnover ratio measures how many times a business can collect its average accounts receivable during the year. The higher the ratio, the better it is. If the amount of credit Revenue from operations isn't given in the question and it can't be found out using the values in the question, then the ratio may be calculated on the basis of
Total Revenue from operations.
Average Trade
It is calculated in 'TIMES'. If the amount if credit purchases isn't given in the question and it can't be found out using the values in the question, then the ratio may be calculated on the basis of Total Purchases. It shows a company’s ability to pay off its accounts payable by comparing net credit purchases to the average accounts payable during a period. In other words, the accounts payable turnover ratio is how many times a company can pay off its average accounts payable balance during the course of a year.
It is calculated in 'Times'. Working capital is current assets minus current liabilities. A high turnover ratio indicates that management is being extremely efficient in using a firm's shortterm assets and liabilities to support sales. Conversely, a low ratio indicates that a business is investing in too many accounts receivable and inventory assets to support its sales, which could eventually lead to an excessive amount of bad debts and obsolete inventory write-offs.
A higher ratio is considered better. The ratio can be used to test the business condition by comparing it with past years’ ratio and with the ratio of other companies in the industry. A consistent improvement in gross profit ratio over the past years is the indication of continuous improvement .
Gross Profit = Revenue from Operations - Cost of Revenue from Operations
Cost of Revenue from Operations = Opening Inventory + Net Purchases + Carriage + Wages + Other Direct Expenses - Closing Inventory
Note: Spare parts and Loose Tools are not included in Inventory
Operating Expenses = Employee Benefit expenses +
Depreciation and Amortization expenses+ Other expenses ( like Office and Administration expenses + Selling and distribution expenses+ Discount + Bad-debts+ Interest on short-term loans)
{In short, Operating expenses are those expenses which are incurred in the day to day operations of the company}
Operating Income = Trading commission received, Cash Discount Received
The operating ratio is used to measure the operational efficiency of the management. It shows whether or not the cost component in the sales figure is within the normal range. A low operating ratio means a high net profit ratio (i.e., more operating profit) and vice versa.
Operating Profit = Gross profit - operating expenses + Operating Incomes
OR
Operating Profit = Net profit (before tax) + Non Operating
expenses (like Loss on sale of fixed assets, loss from fire, income tax, finance charges relating to interest on long term debts, interest on debentures,etc.) - Non Operating Incomes (like Profit on sale of fixed assets, Interest and dividend received on investments, etc.)
A company with higher operating margin ratio is financially sound. It can easily pay its fixed costs and interest on the debt.
A company with good operating ratio can successfully survive during an economic crisis. Only a company with higher operating margin ratio can successfully compete with the competitors by lowering the price of products to such level that competitors will not be able to survive.
Note: Operating Ratio + Operating Profit Ratio = 100%
Net Profit = Gross Profit - Indirect Expenses and losses + Other Incomes - Tax
Indirect Expenses and losses = Office expenses + Selling expenses+ Interest on Long term Borrowings + Accidental Losses + Other indirect expenses
As such, it is one of the best measures of the overall results of a firm. The measure is commonly reported to judge performance over time. It is also used to compare the results of a business with its competitors.
It is also known as 'Rate of Return' or 'Yield on Capital' or 'Return on Capital Employed'.
Return on investment (ROI) measures the gain or loss generated on an investment relative to the amount of money invested. ROI is usually expressed as a percentage and is typically used for personal financial decisions, to compare a company's profitability or to compare the efficiency of different investments.
Non Current Assets = Tangible Assets + Intangible Assets + Non Current Investments + Long term Loans and Advances
ACCOUNTING RATIOS
1. Calculate the liquidity ratios and comment on the short term financial position of the company from the following information: Rs. Closing Inventory 2,00,000
Trade Receivables
Less: Provision for Doubtful Debts 1,00,000
Cash 30,000
Marketable Securities 20,000
Income Tax Paid in Advance 10,000
Share Issue Expenses 15,000
Liability for current taxation 20,000
Liability for Future Taxation 30,000
Trade Payables 34,000
Outstanding Salaries 5,000
Bank Overdraft 25,000
Dividends Payable 36,000
2. Assuming that the current ratio is 2:1, state giving reasons, which of the following transactions would (i) improve, (ii) reduce, or (iii) not alter, the current ratio:
(a) Cash collected from trade receivables
(b) B/R received from trade receivables
(c) B/R endorsed to trade payables
(d) B/R dishonoured
(e) Sale of inventories at par for cash
(f) Sale of inventories at profit for cash
(g) Sale of inventories at profit on credit
(h) Sale of a fixed asset on a credit of 2 months.
(i) Sale of a fixed asset on long term deferred payment basis
(j) Issue of new shares against purchase of fixed asset
3. A firm had current assets of Rs.2,00,000. Ot then paid a current liability of Rs.40,000. After this payment the current ratio was 2:1. Determine:
(a) The size of current liabilities and working capital after the payment
(b) Also determine the size of these two items before the payment was made.
4. The current assets pf Monarch Company are Rs. 29,745 and the current ratio is 1.5. The inventories stood at Rs.8,827. Calculate the liquid ratio and comment on the liquidity position of the company.
5. From the given information, calculate the inventory turnover ratio:
Revenue from operations Rs.2,00,000; GP : 25% on cost; Opening inventory was 1/3rd of the value of Closing Inventory. Closing Inventory was 30% of Revenue from Operations.
6. Calculate the amount of Opening and Closing Trade receivables from the following:
Trade Receivables Turnover Ratio : 6 Times
Cost Of Revenue from Operations : Rs.6,00,000
Gross Profit Ratio : 20% on cost
Cash Revenue from Operations being 25% of Total Revenue from Operations
Opening Trade Receivables were 1/4th of Closing Trade Receivables.
7. From the following figures pertaining to two companies A Ltd. and B Ltd., belonging to
Plastic Industry. Calculate the Gross Profit Ratio of the two companies. Which company is doing
better?
Particulars A Ltd. B Ltd.
Net Profit after Interest 75,000 1,10,000
Indirect Expenses 10,000 15,000
Interest paid on Debentures 15,000 25,000
Revenue from Operations(Gross) 3,30,000 3,80,000
Revenue from Operations Return 10,000 20,000
8. Following information is available for the year ending 31st March, 2008. Calculate Gross
Profit Ratio:
Rs.
Cash Revenue from Operations 2,00,000
Purchases: Cash 1,50,000
Credit 4,50,000
Carriage Inwards 6,000
Salaries 75,000
Decrease in Inventory 80,000
Return Outwards 20,000
Wages
Ratio of Cash Revenue from Operations and Credit
revenue from Operations 50,000
9. Opening Inventory Rs.60,000; Closing Inventory Rs.1,00,000; Inventory Turnover Ratio 8
Times; Selling Price 25% above cost. Calculate Gross Profit Ratio.
10. Calculate (i) Operating Profit Ratio; (ii) Net Profit Ratio, from the following:
Particulars Rs.
Revenue from Operations 4,10,000
Revenue from Operations Return 10,000
Gross Profi t 1,50,000
Office Expenses 15,000
Selling Expenses 26,000
Interest On Debentures 10,000
Loss by fire 24,000
Income from Investments 5,000
11. Gross Profit Ratio of a Company was 20%. Its credit revenue from operations were Rs18,00,000 and its cash revenue from operations were 10% of the total revenue from operations. If the indirect expenses of the company were Rs.50,000, calculate its net profit ratio.
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