ISHANT COMMERCE CLASSES 2019

Accounting Ratios – CBSE Notes for Class 12 Accountancy

Introduction

1. Ratio It is an arithmetical expression of relationship between two related or interdependent items.

2. Accounting Ratios It is a mathematical expression that shows the relationship between various items or groups of
items shown in financial statements. When ratios are calculated on the basis of accounting information, they are called
accounting ratios.

3. Ratio Analysis It is a technique which involves re-grouping of data by application of arithmetical relationship.

Objectives of Ratio Analysis

(i) To know the areas of an enterprise which need more attention.

(ii) To know about the potential areas which can be improved on.
(iii) Helpful in comparative analysis of the performance.
(iv) Helpful in budgeting and forecasting.
(v) To provide analysis of the liquidity, solvency, activity and profitability of an enterprise.
(vi) To provide information useful for making estimates and preparing the plans for future.
Advantages of Ratio Analysis

(i) It is useful in analysis of financial statements.

(ii) Helps in simplifying accounting figures.
(iii) Useful in judging the operating efficiency of business.
(iv) Helps in identification of problem areas.
(v) Helpful in comparative analysis.
Limitations of Ratio Analysis

(i) Accounting ratios ignore qualitative factors.

(ii) Absence of universally accepted terminology.
(iii) Ratios are affected by window-dressing.
(iv) Effects of inherent limitations of accounting.
(v) Misleading results in the absence of absolute data.
(vi) Price level changes ignored.
(vii) Affected by personal bias and ability of the analyst.

Classification of Accounting Ratios

In view of the requirements of various users, the accounting ratios may be classified as under

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Ratio

Profitability
Liquidity Ratio Solvency Ratio Activity Ratio
Ratio

Trade
Debt Equity Total Assets to Proprietory Inventory Trade Payable Operating Profit
Current Ratio Receievable G.P Ratio Operation Ratio
Ratio Debt ratio Turnover ratio Turnover Ratio ratio
Turnover Ratio

Interest Working Capital

Quick Ratio N.P Ratio
Coverage Ratio Turnover Ratio

ROI

1. LIQUIDITY RATIO
Meaning: Liquidity Ratios Liquidity ratios measure the firm’s ability to fulfill its short-term financial obligations.

(i) Current ratio/Working capital ratio: This ratio establishes relationship between current assets and current
liabilities and is used to assess the short-term financial position of the business concern. Current ratio of 2:1 is
considered to be ideal.

Current Ratio: Current Assets

Current Liabilities

Note: Exclude Loose Tools and Spare Parts from Current Assets

(ii) Liquid ratio/Quick ratio/Acid test ratio: This ratio establishes relationship between liquid assets and current
liabilities and is used to measure the firm’s ability to pay the claims of creditors immediately. This ratio is a better
indicator of liquidity and 1 : 1 is considered to be ideal.

Quick Ratio: Quick Assets

Current Liabilities

Quick Assets: Current Assets – Inventories – Prepaid Expenses – Advance Tax

Current Assets: Quick Assets + Inventories + Prepaid Expenses + Advance Tax

Inventories: Current Assets – Quick Assets

Working Capital: Current Assets – Current Liabilities

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2. SOLVENCY RATIO
Meaning: Solvency Ratios Solvency ratios judge the long-term financial position of an enterprise i.e. whether
business is able to pay its long-term liabilities or not.

1. Debt to Equity ratio: It establishes the relationship between long-term debt (external equities) and the equity
(internal equities) i.e. shareholders’ funds. It is computed to ascertain soundness of the long-term financial
position of the firm.

Generally, the ratio of 2 : 1 is considered as an ideal.

Debt to Equity Ratio: Debts i.e. Long Term Borrowing

Equity Shareholders Funds

Debt (Long-term Debts): long-term borrowings and long-term provisions.

Long Term Borrowing: All Debentures, Loans, Public Deposits

Equity or Shareholders’ Funds: Share Capital + Reserve and Surplus

Share Capital: Equity Share Capital and Preference Share Capital

Or

Equity: Non-current Asset (Tangible assets + Intangible assets + Non-current trade investments + Long-term loans
and advances) + Working Capital – Non-current Liabilities (Long-term borrowings + Long-term provisions)

Working Capital = Current Assets – Current Liabilities

2. Proprietary ratio: It establishes the relationship between proprietors’ funds and total assets.

Proprietary Ratio: Equity

Total Assets

Total Assets: Total assets include

» Non-current Assets [Fixed assets (Tangible and intangible assets) + Non-current Investments + Long-term Loans
and Advances

» Current Assets [Current investments + Inventories (including spare parts and loose tools) + Trade Receivables +
Cash and Cash Equivalents + Short-term Loans and Advances + Other Current Assets]

Note: It is expressed as Pure Ratio say 1:1

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3. Total assets to debt ratio: It establishes a relationship between total assets and total long-term debts.

Total assets to debt ratio: Total Assets

Debts

4. Interest Coverage Ratio: It establishes the relationship between Net profit before interest and Tax and
Interest on Long term debts.

Interest Coverage Ratio: Profit before interest and Tax

Interest on Long term Debts

Profit before Interest and Tax xxxx

Less: Interest on Long term Debts xxxx

Profit before Tax xxxx

Less: Tax xxxx

Profit after Tax xxxx

3. ACTIVITY RATIO
Turnover or Performance or Activity Ratios These ratios measure how efficiently a company is using its assets to
generate sales.

(i) Stock turnover ratio or Inventory turnover ratio The ratio indicates the number of times the stock is turned in
sales during the accounting period, i.e. it measures how fast the stock is moving through the firm and generating sales.

Inventory Turnover Ratio: Cost of Revenue from Operation

Average Inventory

Cost of Revenue from Operation : Opening Inventory + Net purchases + Direct Expenses – Closing Inventory
Or
Revenue from Operation – Gross Profit
Or
Revenue from Operation + Gross Loss

In case of Manufacturing Firm : Cost of Goods Sold = Cost of Materials Consumed + Purchases of Stock-in-trade
+ Change in Inventories of Finished Goods, Work-in-progress and Stock in-trade +
Direct Expenses

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Average Inventory: Opening Inventory + Closing Inventory

(ii) Trade Receivables or Debtors turnover ratio It indicates economy and efficiency in the collection of amount due
from debtors.

Trade Receivable Turnover Ratio: Net Credit Revenue from Operation

Average Trade Receivable

Net Credit Revenue from Operation:- Total Revenue from Operation – Cash Revenue from Operation

Average Trade Receivable: Opening Trade Receivable + Closing Trade Receivable

Opening B/R + Closing B/R + Opening Debtors + Closing Debtors

Debtors Collection Period: 365 = No. of days

Trade Receivable Turnover Ratio

(iii) Trade payables or Creditors turnover ratio It indicates the speed with which the amount is being paid to
creditors. The higher the ratio, the better it is.

Trade Payable Turnover Ratio: Net Credit Purchase

Average Trade Payables

Net Credit Purchases:- Total Purchases– Cash Purchases

Average Trade Payables: Opening Trade Payables + Closing Trade Payables

Opening B/P + Closing B/P + Opening Creditors + Closing Creditors

In the absence of opening creditors and bills payable, closing creditors and bills payable can be used in the above
formula. Also, if credit purchases are not given, then all purchases are deemed to be on credit.

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(iv) Working capital turnover ratio This ratio shows the number of times the working capital has been rotated in
generating sales.

Working Capital Turnover ratio: Net Revenue from Operation

Working Capital

Working Capital: Current Assets – Current Liabilities

4. PROFITABILITY RATIO
Profitability Ratios These ratios measure the profitability of a business assessing the and helps in overall efficiency
of the business.

(i) Gross profit ratio: Gross profit ratio shows the relationship between the net sales gross profit to net sales (revenue
from operations)

Gross Profit Ratio: Gross Profit

Net Revenue from Operation

Gross Profit: Net Revenue from Operation – Cost of Revenue from Operation (COGS)
Cost of Goods Sold (COGS): Opening Stock + Purchases - Purchase Return + Direct Expenses –Closing Stock

In case, statement of profit and loss is given, cost of revenue from operations i.e. cost of goods sold is computed by
adding cost of materials consumed, purchases of stock-in-trade, changes in inventories of finished goods, work-in-
progress and stock-in-trade and direct expenses.

(ii) Operating ratio: Operating ratio establishes the relationship between operating cost and revenue from operations
i.e. net sales.

Operating Ratio: Cost of revenue from Operation + Operation Expenses – Operating Income

Net revenue from Operation

Operating Expenses: (a) Office and Administrative Expenses

(b) Selling and Distribution Expenses
(c) Employee Benefit Expenses
(d) Depreciation and Amortization
(e) Interest on Short Term Loan

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(f) Bad Debts
(g) Discount

Operating Income: (a) Discount Receive

(b) Commission Receive

Alternatively operating cost may be calculated as follows:

Operating Cost = Cost of Materials Consumed + Purchases of Stock-in-trade + Change in Inventories of Finished
Goods, Work-in-progress and Stock-in-trade + Employees Benefits Expenses + Other Expenses (Other than non-
operating expenses)

(iv) Operating profit ratio: Operating profit ratio establishes the relationship between the operating profit and i.e.
(revenue from operations) net sales. Operating profit ratio is an indicator of operational efficiency of the business.

Operating Profit Ratio Operating Profit

Net Revenue from Operation

Operating Profit: G.P + Operating Income – Operating Expenses

Or
Net Profit + Non-Operating Expenses – Non Operating Income

Note: operating Ratio + operating Profit Ratio = 100%

(iv) Net Profit Ratio: Net profit ratio establishes the relationship between the Net profit and i.e. (revenue from
operations) net sales

Net Profit Ratio Net Profit After Tax

Net Revenue from Operations i.e Net Sales

Net Profit: G.P + Indirect Income – Indirect Expenses

Or
Operating profit + Non-Operating Income – Non Operating Expenses

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(v) Return on investment/Capital employed It establishes the relationship between net profit before interest, tax and
preference dividend and capital employed (equity + debts).

ROI: Net Profit before Interest, Tax and Preference Share Dividend

Capital Employed

Capital employed can be calculated from liabilities side approach and assets side approach as follows:

When Liabilities Approach is Followed It is computed by adding

(a) Shareholders’ funds (i.e. share capital, reserves and surplus).

(b) Non-current liabilities (i.e. long-term borrowings and long-term provisions).

When Assets Approach is Followed It is computed by adding

(i) Non-current assets, i.e.

(a) Fixed assets (tangible fixed assets, intangible fixed assets).

(b) Non-current trade investments.

(c) Long-term loans and advances.

(ii) Working capital, i.e. current assets – current liabilities.

NOTE Since, non-operating assets are excluded while determining capital employed, income from non-operating
assets should also be excluded from profit

Profit before Interest and Tax xxxx

Less: Interest on Long term Debts xxxx

Profit before Tax xxxx

Less: Tax xxxx

Profit after Tax xxxx

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Accountancy Notes: Financial Statements

Trading and Profit & Loss A/c
Particulars Rs. Particulars Rs.

Direct Exp.

To G.P c/d

By G.P b/d

Operating Exp Operating Inc.

Indirect To Operating Profit c/d Indirect

Expenditure By Operating Income
Profit b/d

Non-Operat. Exp Non-Oper. Inc

To Net Profit

Cost of Goods Sold (COGS): Opening Stock + Purchases - Purchase Return + Direct
Expenses –Closing Stock
Or
COGS: Sales – G.P

Operating Profit: G.P + Operating Income – Operating Expenses

Or
Net Profit + Non-Operating Exp – Non Operating Income

Net Profit: G.P + Indirect Income – Indirect Expenses

Or

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Operating profit + Non-Operating Income – Non Operating Expenses

Operating Expenses: (a) Office and Administrative Expenses

(b) Selling and Distribution Expenses
(c) Employee Benefit Expenses
(d) Depreciation and Amortization
(e) Interest on Short Term Loan
(f) Bad Debts
(g) Discount

Operating Income: (a) Discount Receive

(b) Commission Receive

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