NCERT Class 12 Accountancy Accounting Ratios

Accounting Ratios

Financial statements aim at providing financial information about a business enterprise to meet the information needs of the decision-makers. Financial statements prepared by a business enterprise in the corporate sector are published and are available to the decision-makers. These statements provide financial data which require analysis, comparison and interpretation for taking decision by the external as well as internal users of accounting information. The act is termed asfinancial statement analysis. It is regarded as an integral and important part of accounting. As  indicated in the previous chapter, the most commonly used techniques of financial statement,  analysis are comparative statements, common size statements, trend analysis, accounting ratios and cash flow analysis. The first three have been discussed in detail in the previous chapter. This chapter covers the technique of accounting ratios for analysing the information contained in financial statements for assessing the solvency, efficiency and profitability of the firms.

5.1 Meaning of Accounting Ratios

As stated earlier, accounting ratios are an important tool of financial statement analysis. A ratio is a mathematical number calculated as a reference to relationship of two or more numbers and can b  expressed as a fraction, proportion, percentage, and a number of times. When the number is calculated by referring to two accounting numbers derived from the financial statements, it is termed as accounting ratio. For example if the gross profit of the business is Rs. 10,000 and the sales are Rs. 1,00,000, it can be said that the gross profit is 10% (10,000/1,00,000) of the sales. This ratio is termed as gross profit ratio. Similarly, inventory turnover ratio may be 6 which implies that inventory turns into sales six times in a year. It needs to be observed that accounting ratios exhibit relationship, if any between accounting numbers extracted from financial statements, they are essentially derived numbers and their efficacy depends a great deal upon the basic numbers from which they are calculated. Hence, if the financial statements contain some errors, the derived numbers in terms of ratio analysis would also present an erroneous scenerio. Further, a ratio must be calculated using numbers which are meaningfully correlated. A ratio calculated by using two unrelated numbers would hardly serve any purpose. For example, the furniture of the business is Rs. 1,00,000 and Purchases are Rs. 3,00,000. The ratio of purchases to furniture is 3 (3,00,000/1,00,000) but it hardly has any relevance. The reason is that there is no relationship between these two aspects.

5.2 Objectives of Ratio Analysis

Ratio analysis is indispensable part of interpretation of results revealed by the financial statements. It provides users with crucial financial information and points out the areas which require investigation. Ratio analysis is a technique. Which involves regrouping of data by application of arithmetical relationships, though its interpretation is a complex matter. It requires a fine understanding  of the way and the rules used for preparing financial statements. Once done effectively, it provides a wealth of information which helps the analyst:

1. To know the areas of the business which need more attention;

2. To know about the potential areas which can be improved with the effort in the desired direction;

3. To provide a deeper analysis of the profitability, liquidity, solvency and efficiency levels in the business;

4. To provide information for making cross sectional analysis by comparing the performance with the best industry standards;

5. To provide information derived from financial statements useful for making projections and estimates for the future.

Question for Practice

A. Short Answer Questions

1. What do you mean by Ratio Analysis?

2. What are various types of ratios?

3. What relationships will be established to study:

a. Inventory Turnover

b. Debtor Turnover

c. Payables Turnover

d. Working Capital Turnover.

4. Why would the inventory turnover ratio be more important when analysing

a grocery store than an insurance company?

5. The liquidity of a business firm is measured by its ability to satisfy its long-term obligations as they become due ? Comment.

6. The average age of inventory is viewed as the average length of time inventory is held by the firm or as the average number of day’s sales in inventory. Explain.

B. Long Answer Questions

1. Who are the users of financial ratio analysis? Explain the significance of ratio analysis to them?

2. What are liquidity ratios? Discuss the importance of current and liquid ratio.

3. How would you study the Solvency position of the firm?

4. What are important profitability ratios? How are they worked out?

5. Financial ratio analysis are conduced by four groups of analysts: managers, equity investors, long-term creditors, and short-term creditors. What is the primary emphasis of each of these groups in evaluating ratios?

6. The current ratio provides a better measure of overall liquidity only when  a firm’s inventory cannot easily be converted into cash. If inventory is liquid, the quick ratio is a preferred measure of overall liquidity. Explain.

Please refer to attached file for NCERT Class 12 Accountancy Accounting Ratios