Accountancy Class 12

Financial Statements
Chapter - 3
Accounting
Ratios
 Meaning of Ratio
 Relationship between two figures, expressed in arithmetical terms is called a 'ratio'.
 In the words of R.N. Anthony : "A Ratio is simply one number expressed in terms of
another. It is found by dividing one number into the other."

Ratio may be expressed in the following four ways :

1) 'Proportion' or Pure Ratio or Simple Ratio : It is expressed by
the simple division of one number by another.

2) 'Rate' or So many times : In this type, it is calculated how

many times a figure is, in comparison to another figure.

3) Percentage : In this type, the relation between two figures is

expressed in hundredth.

4) Fraction : Say, Net profit is one-fifth of capital.

While calculating a ratio, it should be understood that it is desirable to divide the "more favorable
figure" by the "less favorable figure".
 Cross-sectional and Time-series Analysis
It involves the comparison of a
Cross firm's ratios with that of some
Sectional selected firms in the same
Analysis industry or industry average at
the same point of time.

Another way of comparison is to

compare a firm's present ratios with its
Time Series past ratios. When ratios of the same
Analysis firm over a period of time are
compared, it is known as the time series
(or trend) analysis.
Objectives of Ratio Analysis
1) To locate the weak spots of business which need
more attention.
2) To provide deeper analysis of the liquidity,
solvency, activity and profitability of the
business.
3) To provide information for making cross-
sectional analysis, i.e., for making comparison
with that of some selected firms in the same
industry.
4) To provide information for making time-series
analysis, i.e., for making comparison of a firm's
present ratios with its past ratios.
5) To provide information useful for making
estimates and preparing the plans for the future.
 Advantages or Uses of Accounting Ratios

Helpful in Analysis of Financial Statements :

It helps the bankers, trade payables, investors, shareholders etc. in acquiring enough
knowledge about the profitability and financial health of the business.

Simplification of Accounting Data :

Accounting ratio simplifies and summarizes a long array of accounting data and makes them understandable.

Helpful in Comparative Study :

With the help of ratio analysis comparison of profitability and financial soundness can be made between one firm and
another in the same industry.

Helpful in Locating the weak Spots of the Business :

Current year's ratios are compared with those of the previous years and if some weak spots are thus located, remedial
measures are taken to correct them.

Helpful in Forecasting :
Accounting ratios are very helpful in forecasting and preparing the plans for the future.

Estimate about the trend of the business :

If accounting ratios are prepared for a number of years, they will reveal the trend of costs, revenue from operations, profits
and other important facts.
 Limitations of Accounting Ratios
False Accounting
Accounting ratios are calculated on the basis of data given in
Data gives False
Ratios : profit and loss statement and balance sheet.

Ratio Analysis becomes Price level over the years goes on changing, therefore, the ratios of various years
Less Effective due to
Price Level Changes : cannot be compared.

Limited use of a The analyst should not merely rely on a single ratio. He should study several
single ratio : connected ratios before reaching a conclusion.

Some companies in order to cover up their bad financial position resort to window
Window Dressing :
dressing, i.e., showing a better position than the one which really exists.

Lack of Proper Circumstances differ from firm to firm hence no single standard ratio can be fixed
Standards : for all the firms against which the actual ratio may be compared.

Ignores Qualitative Ratio analysis is a quantitative measurement of the performance of the business.
Factors : It ignores qualitative factors which are also essential for interpretation.
 Classification of Ratios

Liquidity Profitability
Ratios or
Ratios Income Ratios

Solvency Activity or
Turnover
Ratios Ratios
Liquidity Ratios :
 "Liquidity" refers to the ability of the firm
to meet its current liabilities.
 The liquidity ratios are also called
'Short-term Solvency Ratios'.
 These ratios are used to assess the short-term financial position of
the concern. They indicate the firm's ability to meet its current
obligations out of current obligations out of current resources.
 Liquidity ratios include two ratios :
a) Current Ratio or Working Capital Ratio
b) Quick Ratio or Acid Test Ratio or Liquid Ratio
Solvency Ratios :
 These ratios are calculated to assess the ability of the firm to
meet its long term liabilities as and when they become due.
 Solvency ratios disclose the firm's ability to meet the interest
costs regularly and long-term indebtedness at maturity.
 Some important solvency ratios are :
i. Debt Equity Ratio
ii. Total Assets to Debt Ratio
iii. Proprietary Ratio
iv. Interest Coverage Ratio
Activity Ratios :
 These ratios are calculated on the basis of 'cost of revenue from operations' or
'revenue from operations', therefore these ratios are also called as ‘Turnover
Ratios’.
 These ratios indicate how efficiently the working capital and inventory is
being used to obtain revenue from operations.
 Higher turnover ratios indicate the better use of capital or resources and in
turn lead to higher profitability.
 Some important turnover ratios are :
i. Inventory Turnover Ratio or Stock Turnover Ratio
ii. Debtors or Receivables Turnover Ratio
iii. Creditors or Payables Turnover Ratio
iv. Working Capital Turnover Ratio
Profitability Ratios OR Income Ratios :
 The efficiency and the success of a business can be
measured with the help of profitability ratios.
 The main object of all the business concerns is to
earn profit. Profit is the measurement of the
efficiency of the business.
 Some important profitability ratios are :
i. Gross Profit Ratio
ii. Operating Ratio
iii. Operating Profit Ratio
iv. Net Profit Ratio
v. Return on Investment or (R.O.I)
 A. Liquidity Ratios (Short – Term Solvency Ratios)
i. Current Ratio or Working Capital Ratio :
This ratio explains the relationship between current assets and current liabilities
of a business.
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐀𝐬𝐬𝐞𝐭𝐬
Current Ratio =
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬

Current Assets : Current Assets are the assets which are likely to be
converted into Cash or Cash Equivalents within 12 months from the
date of Balance Sheet or within the period of Operating Cycle.
Current Assets include the following Assets :
a) Current Investments
b) Inventories (excluding Loose Tools, Stores and Spares)
c) Trade Receivables (Bills Receivables and Sundry Debtors Less Provision for Doubtful Debts)
d) Cash and Cash Equivalents (Cash in Hand, Cast at Bank, Cheque/Drafts In Hand etc.)
e) Other Current Assets (restricted to prepaid expenses, accrued incomes and advance tax).
Items excluded from current assets :
a) Loose Tools, Stores and Spares
b) Provision for Doubtful Debts
Current Liabilities : Current liabilities are the liabilities payable
within 12 months from the date of Balance Sheet or within the
period of Operating cycle.
Current liabilities include the following liabilities :
a) Short Term Borrowings (including Bank Overdraft)
b) Trade Payables (Bills Payables and Sundry Creditors)
c) Other Current Liabilities (current maturities of long term
debts, interest accrued on borrowings, income received in
advance, outstanding expenses, unclaimed dividends, calls
in advance etc.)
d) Short Term Provisions (Provision for Tax)
ii. Quick ratio or Acid test ratio or Liquid ratio :
Quick ratio indicates whether the firm is in a position to pay its current
liabilities within a month or if they have to be paid immediately.
𝐋𝐢𝐪𝐮𝐢𝐝 𝐀𝐬𝐬𝐞𝐭𝐬
Quick Ratio or Acid Test Ratio =
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬

 'Liquid assets' means those assets which will be converted into cash and
cash equivalents very shortly.
 All current assets except inventory and prepaid expenses are included in liquid assets.
 Inventory and prepaid expenses are excluded from liquid assets.
Thus liquid assets include the following :
a) Current Investments
b) Trade Receivables (Bills Receivables and Sundry Debtors Less Provision for Doubtful Debts)
c) Cash and Cash Equivalents
d) Short Term Loans and Advances
Liquid Assets = Current Assets – Inventories – Prepaid Expenses and Advance Tax
Objective and Significance : An ideal quick ratio is said to be 1 : 1.
Distinction between Current Ratio and Quick Ratio
Basis of
Distinction Current Ratio Quick Ratio
It establishes a relationship
It establishes a relationship between Current
Relationship between liquid assets and
Assets and Current Liabilities.
current liabilities.
Formula for Current Assets Liquid Assets
Current Ratio = Quick ratio =
Computation Currrent Liabilities Currrent Liabilities
It measures the ability of the firm to meet its
It measures the ability of the
current liabilities within 12 months from the
Objective firm to meet its current liabilities
date of Balance Sheet or within the period of
immediately or within a month.
operating cycle.
Current ratio of 2 : 1 is considered as an ideal Quick ratio of 1 : 1 is considered
Ideal Ratio
ratio. as an ideal ratio.
It is not a true measurement of short-term
It removes this shortcoming of
True financial position of the firm as it may
current ratio by excluding the
Measurement include a large amount of inventories which
amount of inventories.
may not be quickly convertible into cash.
 B.Solvency Ratios
i. Debt equity Ratio :
This ratio expresses the relationship between Long Term Debts and Shareholder's Funds.
𝐃𝐞𝐛𝐭 𝐋𝐨𝐧𝐠 𝐓𝐞𝐫𝐦 𝐃𝐞𝐛𝐭𝐬
Debt Equity Ratio = or
𝐄𝐪𝐮𝐢𝐭𝐲 𝐒𝐡𝐚𝐫𝐞𝐡𝐨𝐥𝐝𝐞𝐫 ′ 𝐬 𝐅𝐮𝐧𝐝𝐬 𝐨𝐫 𝐍𝐞𝐭 𝐖𝐨𝐫𝐭𝐡

Long Term Debts These include 'long term borrowings' and 'Long term provisions' which mature after one year.

Shareholder’s
Funds
include Share Capital and Reserve & Surplus.

Share Capital include Equity Share Capital and Preference Share Capital

Reserves & include Capital Reserve, Securities Premium, General Reserve & Balance In Statement of
Surplus Profit & Loss.

Objective and Significance : This ratio is calculated to assess the ability of the firm to meet its long term
liabilities. Generally, debt equity ratio of 2 : 1 is considered safe.
ii. Total Assets to Debt Ratio :
This ratio is a variation of the Debt Equity Ratio and gives the same indication as the Debt Equity Ratio.
𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔 𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔
Total Assets to Debt Ratio = or
𝑫𝒆𝒃𝒕 𝑳𝒐𝒏𝒈 𝑻𝒆𝒓𝒎 𝑫𝒆𝒃𝒕𝒔
This ratio is usually expressed as a pure ratio, i.e., 1 : 1 or 2 : 1.

Non Current Assets (Tangible Assets + Intangible Assets + Non Current Investments + Long Term
Total Assets = Loans & Advances) + Current Assets

Debt = Long Term Borrowings + Long Term Provisions

iii. Proprietary Ratio :

This ratio indicates the proportion of total assets funded by owners or shareholders.
𝑬𝒒𝒖𝒊𝒕𝒚 𝑷𝒓𝒐𝒑𝒓𝒊𝒆𝒕𝒐𝒓′ 𝒔 𝑭𝒖𝒏𝒅𝒔 𝒐𝒓 𝑺𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓′ 𝒔 𝑭𝒖𝒏𝒅𝒔
Proprietary Ratio = or
𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔 𝑵𝒐𝒏 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑨𝒔𝒔𝒆𝒕𝒔+𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑨𝒔𝒔𝒆𝒕𝒔

iv. Interest Coverage Ratio :

This ratio is also termed as 'Debt Service Ratio'. This ratio is calculated by dividing the 'profit before charging interest
and income-tax' by 'Fixed Interest Charges'.
𝑷𝒓𝒐𝒇𝒊𝒕 𝒃𝒆𝒇𝒐𝒓𝒆 𝑪𝒉𝒂𝒓𝒈𝒊𝒏𝒈 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒂𝒏𝒅 𝑰𝒏𝒄𝒐𝒎𝒆 𝑻𝒂𝒙
Interest Coverage Ratio = = ……… times
𝑭𝒊𝒙𝒆𝒅 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑪𝒉𝒂𝒓𝒈𝒆𝒔
Objective & Significance : An interest coverage ratio of 6 to 7 times is considered appropriate.
 C. Activity Ratios or Turnover Ratios
i. Inventory Turnover Ratio :
This ratio indicates the relationship between the cost of revenue from operations
(i.e., Cost of Goods Sold) during the year and average inventory kept during that year.
𝑪𝒐𝒔𝒕 𝒐𝒇 𝑹𝒆𝒗𝒆𝒏𝒖𝒆 𝒇𝒓𝒐𝒎 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒐𝒏𝒔 (𝑪𝒐𝒔𝒕 𝒐𝒇 𝑮𝒐𝒐𝒅𝒔 𝑺𝒐𝒍𝒅)
Inventory Turnover Ratio = 𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚
= ……. times.

1) Cost of revenue from operations (Cost of goods sold) can be calculated by two
ways :
a. Cost of Revenue from Operations = Opening Inventory + Purchases + Carriage + Wages
+ Other Direct Charges – Closing Inventory
OR
b. Cost of Revenue from Operations (Cost of Goods Sold) = Revenue from Operations – Gross Profit.
OR
Revenue from Operations + Gross Loss
2) Average inventory can be calculated as follows :
Opening Inventory + Closing Inventory
Average Inventory = 2
ii. Trade Receivables Turnover Ratio :
This ratio indicates the relationship between credit Revenue from Operations and average trade
receivables during the year :
𝐂𝐫𝐞𝐝𝐢𝐭 𝐑𝐞𝐯𝐞𝐧𝐮𝐞 𝐟𝐫𝐨𝐦 𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐨𝐧𝐬 (𝐂𝐫𝐞𝐝𝐢𝐭 𝐒𝐚𝐥𝐞𝐬)
Trade Receivables Turnover Ratio = = ……. times.
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐓𝐫𝐚𝐝𝐞 𝐑𝐞𝐜𝐞𝐢𝐯𝐚𝐛𝐥𝐞𝐬

Average Trade Receivables :

𝑶𝒑𝒆𝒏𝒊𝒏𝒈 𝑻𝒓𝒂𝒅𝒆 𝑹𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆𝒔+𝑪𝑳𝒐𝒔𝒊𝒏𝒈 𝑻𝒓𝒂𝒅𝒆 𝑹𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆𝒔
Average Trade Receivables = 𝟐
Note : Trade Receivables = Debtors + Bills Receivables

Average Collection Period :

Trade receivables turnover ratio can also be converted into number of days within
which the cash is collected from trade receivables. It is calculated as under :
𝟑𝟔𝟓
Average Collection Period = = Number of Days
𝑻𝒓𝒂𝒅𝒆 𝑹𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆𝒔 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝑹𝒂𝒕𝒊𝒐
OR
𝟏𝟐
= = Number of Months
𝑻𝒓𝒂𝒅𝒆 𝑹𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆𝒔 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝑹𝒂𝒕𝒊𝒐
iii. Trade Payables Turnover Ratio :
This ratio indicates the relationship between Credit Purchase and average trade payables during the year :
𝑵𝒆𝒕 𝑪𝒓𝒆𝒅𝒊𝒕 𝑷𝒖𝒓𝒄𝒉𝒂𝒔𝒆𝒔
Trade Payables Turnover Ratio = = ……. times.
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑻𝒓𝒂𝒅𝒆 𝑷𝒂𝒚𝒂𝒃𝒍𝒆𝒔
Trade Payables include Creditors and Bills Payables.

Average Trade Payables :

𝑶𝒑𝒆𝒏𝒊𝒏𝒈 𝑻𝒓𝒂𝒅𝒆 𝑷𝒂𝒚𝒂𝒃𝒍𝒆𝒔 +𝑪𝑳𝒐𝒔𝒊𝒏𝒈 𝑻𝒓𝒂𝒅𝒆 𝑷𝒂𝒚𝒂𝒃𝒍𝒆𝒔
Average Trade Payables = 𝟐
Note : Trade Payables = Creditors + Bills Payables

Average Payment Period :

Trade payable turnover ratio can also be converted into number of days within
which the cash is paid to trade payables. It is calculated as under :
𝟑𝟔𝟓
Average Payment Period = = Number of Days
𝑻𝒓𝒂𝒅𝒆 𝑷𝒂𝒚𝒂𝒃𝒍𝒆𝒔 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝑹𝒂𝒕𝒊𝒐

OR
𝟏𝟐
= = Number of Months
𝑻𝒓𝒂𝒅𝒆 𝑷𝒂𝒚𝒂𝒃𝒍𝒆𝒔 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝑹𝒂𝒕𝒊𝒐
 D. Profitability Ratios or Income Ratios
i. Gross Profit Ratio :
This ratio establishes a relationship between gross profit and Revenue from
Operations i.e. , Net sales. This ratio is computed and presented in percentage.
The formula for computing this ratio is :

Gross Profit Ratio =

Gross profit
× 100
Revenue from operations i.e. , Net sales
Gross Profit =
Revenue from Operations – Cost of Revenue from Operations
Cost of Revenue from Operations = Opening Inventory + Net Purchases
+ Direct Expenses (Carriage, Wages etc.)
- Closing Inventory
OR Revenue from Operations – Gross Profit
 ii. Operating Ratio :
This ratio measures the proportion of an enterprise's cost of Revenue from Operations
and operating expenses in comparison to its Revenue from Operations :
Operating Ratio =
Cost of Revenue from Operations + Operating Expenses
× 100
Revenue from Operations
Where, Cost of Revenue from Operations =
Opening Inventory + Net Purchases + Direct Expenses (Carriage, Wages etc.) - Closing Inventory
OR
Revenue from Operations – Gross Profit
Operating Expenses = Employee Benefit Expenses + Depreciation And Amortization Expenses + Other Expenses (i.e.
Office and Administration Expenses + Selling And Distribution Expenses + Discount + Bad
Debts + Interest On Short-Term Loans)

Other Operating Income = Trading Commission Received, Cash Discount Received

Attention : a. Depreciation and Amortization Expenses are included in Operating Expenses.
b. Spare Parts and Loose Tools are excluded from Inventory.
iii. Operating Profit Ratio :
This ratio shows the relationship between
operating profit and net Revenue from Operations.
Operating Profit
Operating Profit Ratio = × 100
Revenue from Operations
Operating Profit = Gross Profit – Operating Expenses + Operating Incomes
Operating Expenses = Employee Benefit Exp., Depreciation, Office and Administrative Expenses,
Selling and Distribution Expenses, Discount, Bad-debts, Interest on short
term loans etc.
Operating Income = Commission Received + Discount Received
If net profit is given in the question, operating profit may be calculated as follows :
Operating profit = Net Profit (before Tax) + Non Operating Expenses/Losses
- Non Operating Incomes
iv. Net Profit Ratio :
This ratio shows the relationship between Net Profit
and net Revenue from Operations.
Net Profit after Tax
Net Profit Ratio = × 100
Revenue from Operations
Net Profit = Gross profit – Indirect Expenses & Losses
+ Operating Incomes - Tax
Indirect Expenses & Losses = Office Expenses + Selling Expenses +
Interest on Long term borrowings +
Accidental Losses
v. Return on Investment or R.O.I. :
This ratio is usually in percentage and is also known as ‘Rate of
Return' or ‘Return on Capital Employed' or ‘Yield on Capital'.
Net Profit before Interest, Tax and Dividends
Return on Investment = Capital Employed
× 100

Capital Employed can be computed by any of the following two methods :

First Method (Liabilities Side Approach) :
Capital Employed = Shareholder's Funds + Non Current Liabilities i.e.
(Long Term Borrowings + Long Term Provisions)
Second Method (Assets Side Approach) :
Capital Employed = Non Current Assets + Working Capital
Non Current Assets = Tangible Assets + Intangible Assets
+ Non Current Investments + Long Term Loans and Advances
Working Capital = Current Assets – Current Liabilities