Class 12 Accountancy Notes
Unit – 9: Ratio Analysis
Important Notes for March 2025 Exam [AHSEC Class 12 Accountancy Notes]
Q.N.1.
what do you mean by ratio analysis? What are the objectives and advantages of
such analysis? Also point out the limitations of ratio analysis. 2012, 2012, 2018,
2020, 2022, 2023, 2024
Answer: A Ratio is an arithmetical expression
of relationship between two related or interdependent items. If such ratios are
calculated on the basis of accounting information, then they are called
accounting ratios. Simply, accounting ratio is an expression of relationship
between two accounting terms or variables or two set of accounting heads or
group of items stated in financial statement. It is one of the techniques of
financial analysis which is used to evaluate the operating efficiency and
financial position of a business concern.
According to J. Betty,” The term
accounting ratio is used to describe significant relationships which exist
between figures shown in a balance sheet and in a profit and loss account.”
Objectives
of Ratio analysis 2018
1. To
know the weak 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 decision making.
5. To
provide information for inter-firm and intra-firm comparison.
Advantages
and Uses of Ratio Analysis
1. Helpful
in analysis of financial situation: It helps the management to know about the financial
strength and weakness of the business concern. Bankers, Investors, Creditors
etc. analyse financial statements with the help of ratios.
2. Useful
in judging the operating efficiency of business: Accounting ratios are useful
in evaluating the operating results financial health of an enterprise. This is
done by evaluating liquidity, solvency, profitability etc.
3. Helpful
in inter-firm and intra-firm comparison: Ratio analysis helps in comparing the
performance of business with that of other firms and of industry in general.
This comparison is called inter-firm comparison. Ratio analysis also helps in
comparing results of different units belonging to the same firm. This
comparison is called intra-firm comparison.
4. Simplifies
the accounting information: It simplifies and summarises the accounting figures
to make them understandable to the users. It gives a brief idea about the whole
story of changes in the financial condition of a business.
5. Useful
for forecasting: Ratios are helpful in business planning and forecasting. What
should be the course of action in the future can be decided with the help of
trend percentage.
Limitations
of Ratio Analysis
1.
False
Result: Ratios are calculated from the financial
statements, so the reliability of ratio is dependent upon the correctness of
the financial statements. If financial statements are misleading, then the
accounting ratios also gives a false picture.
2.
Ignores
Price Level Changes: Change is price level affects the
comparability of ratios. A change in the price level makes the ratio analysis
of different accounting years invalid because accounting records ignores change
in value of money.
3.
Qualitative
aspect Ignored: Since the financial statements are based on
quantitative aspects only, the quality aspect such as quality of management,
quality of labour force etc., are ignored while calculating accounting ratios.
Under such circumstances, the conclusions derived from ratio analysis would be
misleading.
4.
Lack
of standard ratio: The financial and economic scenario is
dynamic; therefore, it is very difficult to evolve a standard ratio acceptable
for all time. There is almost no single standard ratio which is acceptable in
every scenario.
5.
Not
free from Bias: Financial statements are largely affected by
the personal judgment of the accountant in selecting accounting policies,
therefore accounting ratios are also not free from this limitation. If the
personal judgement of the analyst is biased, then the conclusion drawn will be
misleading.
Q.N.2.
What are the types of Ratios according to traditional classification? 2016, 2017
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ALSO READ (AHSEC ASSAM BOARD CLASS 12):
1. AHSEC CLASS 12 ACCOUNTANCY CHAPTERWISE NOTES
2. AHSEC CLASS 12 ACCOUNTANCY IMPORTANT QUESTION (THEORY)
3. AHSEC CLASS 12 ACCOUNTANCY IMPORTANT QUESTION BANK (PRACTICAL)
4. AHSEC CLASS 12 ACCOUNTANCY PAST EXAM PAPERS (FROM 2012 TILL DATE)
5. AHSEC CLASS 12 ACCOUNTANCY SOLVED QUESTION PAPERS (FROM 2012 TILL DATE)
6. AHSEC CLASS 12 ACCOUNTANCY CHAPTERWISE MCQS
********************************************
Ans: CLASSIFICATION OF RATIOS
The ratios are used for different
purposes, for different users and for different analysis. The ratios can be
classified as under:
a)
Traditional classification
b)
Functional classification
c)
Classification from user ‘s point of
view
1)
Traditional classification: As per this classification, the ratios
readily suggest through their names, their respective resources. From this
point of view, the ratios are classified as follows.
a) Balance
Sheet Ratio: This ratio is also known as financial ratios.
The ratios which express relationships between two items or group of items
mentioned in the balance sheet at the end of the year. Example: Current ratio, Liquid ratio, Stock to Working Capital
ratio, Capital Gearing ratio, Proprietary ratio, etc.
b) Revenue
Statement Ratio: This ratio is also known as income statement
ratio which expresses the relationship between two items or two groups of items
which are found in the income statement of the year. Example: Gross Profit ratio, operating ratio, Expenses Ratio, Net
Profit ratio, Stock Turnover ratio, Operating Profit ratio.
c) Combined
Ratio: These ratios show the relationship between two items or two groups
of items, of which one is from balance sheet and another from income statement
(Trading A/c and Profit & Loss A/c and Balance Sheet). Example: Return on Capital Employed, return
on Proprietors' Fund ratio, return on Equity Capital ratio, Earning per Share
ratio, Debtors' Turnover ratio, Creditors Turnover ratio.
2) Functional Classification of
Ratios: The
accounting ratios can also be classified according their functions as follows:
a) Liquidity
Ratios: These ratios show relationship between current assets and current
liabilities of the business enterprise. Example:
Current Ratio, Liquid Ratio.
b) Leverage
Ratios: These ratios show relationship between proprietor's fund and debts
used in financing the assets of the business organization. Example: Capital gearing ratio,
debt-equity ratio, and proprietary ratio. This ratio measures the relationship
between proprietor’s fund and borrowed funds.
c)
Efficiency/Activity Ratio: This ratio is also known as turnover
ratio or productivity ratio or efficiency and performance ratio. These ratios
show relationship between the sales and the assets. These are designed to
indicate the effectiveness of the firm in using funds, degree of efficiency,
and its standard of performance of the organization. Example: Stock Turnover Ratio, Debtors' Turnover Ratio, Turnover
Assets Ratio, Stock working capital Ratio, working capital Turnover Ratio, Fixed
Assets Turnover Ratio. 2017
d) Profitability Ratio (2019): These ratios show relationship between
profits and sales and profit & investments. It reflects overall efficiency
of the organizations, its ability to earn reasonable return on capital employed
and effectiveness of investment policies. Example: i) Profits and Sales: Operating Ratio, Gross Profit
Ratio, Operating Net Profit Ratio, Expenses Ratio etc. ii) Profits and Investments:
Return on Investments, Return on Equity Capital etc.
e) Coverage
Ratios: These ratios show relationship between profit in hand and claims
of outsiders to be paid out of profits. Example:
Dividend Payout Ratio, Debt Service Ratio and Debt Service Coverage
Ratio.
3) Classification from the view point
of user: Ratio from the users' point of view is
classified as follows:
a)
Shareholders' point of view: These ratios serve the purposes of
shareholders. Shareholders, generally expect the reasonable return on their
capital. They are interested in the safety of shareholder’s investments and
interest on it. Example: Return
on proprietor's funds, return on capital, Earning per share.
b) Long term
creditors: Normally leverage ratios provide useful
information to the long term creditors which include debenture holders, vendors
of fixed assets, etc. The creditors interested to know the ability of repayment
of principal sum and periodical interest payments as and when they become due. Example: Debt equity ratio, return on
capital employed, proprietary ratio.
c) Short
term creditors: The short-term creditors of the company are
basically interested to know the ability of repayment of short-term liabilities
as and when they become due. Therefore, the creditors has important place on
the liquidity aspects of the company's assets. Example: a) Liquidity Ratios - Current Ratio, Liquid Ratio. b)
Debtors Turnover Ratio. c) Stock working capital Ratio.
d)
Management: Management is interested to use borrowed funds
to improve the earnings. Example: Return
on capital employed, Turnover Ratio, Operating Ratio, Expenses Ratio.
Q.N.3.
Explain the meaning and method of calculation of some specific ratios. 2022
Ans: a)
Current Ratio: Current ratio is calculated in order to work
out firm’s ability to pay off its short-term liabilities. This ratio is also
called working capital ratio. This ratio explains the relationship between
current assets and current liabilities of a business. It is calculated by
applying the following formula:
Current Ratio = Current Assets/Current
Liabilities
Current Assets includes Cash in hand,
Cash at Bank, Sundry Debtors, Bills Receivable, Stock of Goods, Short-term
Investments, Prepaid Expenses, Accrued Incomes etc.
Current Liabilities includes Sundry
Creditors, Bills Payable, Bank Overdraft, Outstanding Expenses etc.
Objective and Significance: Current
ratio shows the short-term financial position of the business. This ratio
measures the ability of the business to pay its current liabilities. The ideal
current ratio is supposed to be 2:1. In case, if this ratio is less than 2:1,
the short-term financial position is not supposed to be very sound and in case,
if it is more than 2:1, it indicates idleness of working capital.
b)
Liquid Ratio: Liquid ratio shows short-term solvency of a
business. It is also called acid-test ratio and quick ratio. It is calculated
in order to know whether or not current liabilities can be paid with the help
of quick assets quickly. Quick assets mean those assets, which are quickly
convertible into cash.
Liquid Ratio = Liquid Assets/Current
Liabilities
Liquid assets includes Cash in hand,
Cash at Bank, Sundry Debtors, Bills Receivable, Short-term investments etc. In
other words, all current assets are liquid assets except stock and prepaid
expenses.
Current liabilities include Sundry
Creditors, Bills Payable, Bank Overdraft, Outstanding Expenses etc.
Objective and Significance: Liquid
ratio is calculated to work out the liquidity of a business. This ratio
measures the ability of the business to pay its current liabilities in a real
way. The ideal liquid ratio is supposed to be 1:1. In case, this ratio is less
than 1:1, it shows a very weak short-term financial position and in case, it is
more than 1:1, it shows a better short-term financial position.
c)
Gross Profit Ratio: Gross Profit Ratio shows the
relationship between Gross Profit of the concern and its Net Sales. Gross
Profit Ratio can be calculated in the following manner: 2019
Gross Profit Ratio = Gross Profit/Net
Sales x 100
Where Gross Profit = Net Sales – Cost
of Goods Sold
Cost of Goods Sold = Opening Stock +
Net Purchases + Direct Expenses – Closing Stock
And Net Sales = Total Sales – Sales
Return
Objective and Significance: Gross
Profit Ratio provides guidelines to the concern whether it is earning
sufficient profit to cover administration and marketing expenses and is able to
cover its fixed expenses. This ratio can also be used in stock-inventory
control. Maintenance of steady gross profit ratio is important. Any fall in
this ratio would put the management in difficulty in the realisation of fixed
overheads of the business.
d)
Net Profit Ratio: Net Profit Ratio shows the relationship
between Net Profit of the concern and Its Net Sales. Net Profit Ratio can be
calculated in the following manner:
Net Profit Ratio = Net Profit/Net
Sales x 100
Where, Net Profit = Gross Profit –
Selling and Distribution Expenses – Office and Administration Expenses –
Financial Expenses – Non Operating Expenses + Non-Operating Incomes.
And Net Sales = Total Sales – Sales
Return
Objective and Significance: In order
to work out overall efficiency of the concern Net Profit ratio is calculated.
This ratio is helpful to determine the operational ability of the concern.
While comparing the ratio to previous years’ ratios, the increment shows the
efficiency of the concern.
e)
Operating Profit Ratio: Operating Profit Ratio shows the
relationship between Operating Profit and Net Sales. Operating Profit Ratio can
be calculated in the following manner: 2019
Operating Profit Ratio = (Operating
Profit/Net Sales) x 100
Where Operating Profit = Gross Profit
– Operating Expenses
Or Operating Profit = Net Profit + Non-Operating
Expenses – Non Operating Incomes
And Net Sales = Total Sales – Sales
Return
Objective and Significance: Operating
Profit Ratio indicates the earning capacity of the concern on the basis of its
business operations and not from earning from the other sources. It shows
whether the business is able to stand in the market or not.
f)
Operating Ratio: Operating Ratio matches the operating cost to
the net sales of the business. Operating Cost Means Cost of goods sold plus
Operating Expenses.
Operating Ratio = Operating Cost/Net
Sales x 100
Where Operating Cost = Cost of goods
sold + Operating Expenses
(Operating Expenses = Selling and
Distribution Expenses, Office and Administration Expenses, Repair and
Maintenance.)
Cost of Goods Sold = Opening Stock +
Net Purchases + Direct Expenses – Closing Stock
Or Cost of Goods Sold = Net sales –
Gross Profit
Objective and Significance: Operating
Ratio is calculated in order to calculate the operating efficiency of the
concern. As this ratio indicates about the percentage of operating cost to the
net sales, so it is better for a concern to have this ratio in less percentage.
The less percentage of cost means higher margin to earn profit.
g)
Return on Investment or Return on Capital Employed: This
ratio shows the relationship between the profit earned before interest and tax
and the capital employed to earn such profit.
Return on Capital Employed = Net
Profit before Interest, Tax and Dividend/Capital Employed x 100
Where Capital Employed = Share Capital
(Equity + Preference) + Reserves and Surplus + Long-term Loans – Fictitious
Assets
Or
Capital Employed = Fixed Assets +
Current Assets – Current Liabilities
Objective and Significance: Return on
capital employed measures the profit, which a firm earns on investing a unit of
capital. The profit being the net result of all operations, the return on
capital expresses all efficiencies and inefficiencies of a business. This ratio
has a great importance to the shareholders and investors and also to
management. To shareholders it indicates how much their capital is earning and
to the management as to how efficiently it has been working. This ratio
influences the market price of the shares. The higher the ratio, the better it
is.
h)
Return on Equity: Return on equity is also known as return on
shareholders’ investment. The ratio establishes relationship between profit
available to equity shareholders with equity shareholders’ funds.
Return on Equity = Net Profit after
Interest, Tax and Preference Dividend/Equity Shareholders’ Funds x 100
Where Equity Shareholders’ Funds =
Equity Share Capital + Reserves and Surplus – Fictitious Assets
Objective and Significance: Return on
Equity judges the profitability from the point of view of equity shareholders.
This ratio has great interest to equity shareholders. The return on equity
measures the profitability of equity funds invested in the firm. The investors
favour the company with higher ROE.
i)
Earnings Per Share: Earnings per share is calculated by
dividing the net profit (after interest, tax and preference dividend) by the
number of equity shares.
Earnings Per Share = Net Profit after
Interest, Tax and Preference Dividend/No. Of Equity Shares
Objective and Significance: Earning
per share helps in determining the market price of the equity share of the
company. It also helps to know whether the company is able to use its equity
share capital effectively with compare to other companies. It also tells about
the capacity of the company to pay dividends to its equity shareholders.
j)
Price-earnings Ratio: Price earnings ratio establishes the
relationship between market prices and earning per share. It is computed
as: Price-earnings ratio = Market price
/ Earning per share
The purpose of this ratio is to make
comparison with the other companies in the same business. It helps in
forecasting the market value of the shares.
k)
Debt-Equity Ratio: Debt equity ratio shows the relationship
between long-term debts and shareholders funds’. It is also known as
‘External-Internal’ equity ratio.
Debt Equity Ratio = Debt/Equity
Where Debt (long term loans) include
Debentures, Mortgage Loan, Bank Loan, Public Deposits, Loan from financial
institution etc.
Equity (Shareholders’ Funds) = Share
Capital (Equity + Preference) + Reserves and Surplus – Fictitious Assets
Objective and Significance: This ratio
is a measure of owner’s stock in the business. Proprietors are always keen to
have more funds from borrowings because:
(i) Their stake in the business is
reduced and subsequently their risk too
(ii) Interest on loans or borrowings
is a deductible expenditure while computing taxable profits. Dividend on shares
is not so allowed by Income Tax Authorities.
The normally acceptable debt-equity
ratio is 2:1.
l)
Proprietary Ratio: Proprietary Ratio establishes the
relationship between proprietors’ funds and total tangible assets. This ratio
is also termed as ‘Net Worth to Total Assets’ or ‘Equity-Assets Ratio’.
Proprietary Ratio = Proprietors’
Funds/Total Assets
Where Proprietors’ Funds =
Shareholders’ Funds = Share Capital (Equity + Preference) + Reserves and
Surplus – Fictitious Assets
Total Assets include only Fixed Assets
and Current Assets. Any intangible assets without any market value and
fictitious assets are not included.
Objective and Significance: This ratio
indicates the general financial position of the business concern. This ratio
has a particular importance for the creditors who can ascertain the proportion
of shareholder’s funds in the total assets of the business. Higher the ratio,
greater the satisfaction for creditors of all types.
m)
Capital Turnover Ratio: Capital turnover ratio establishes a
relationship between net sales and capital employed. The ratio indicates the
times by which the capital employed is used to generate sales. It is calculated
as follows:
Capital Turnover Ratio = Net
Sales/Capital Employed
Where Net Sales = Sales – Sales Return
Capital Employed = Share Capital
(Equity + Preference) + Reserves and Surplus + Long-term Loans – Fictitious
Assets.
Objective and Significance: The
objective of capital turnover ratio is to calculate how efficiently the capital
invested in the business is being used and how many times the capital is turned
into sales. Higher the ratio, better the efficiency of utilisation of capital
and it would lead to higher profitability.
n)
Fixed Assets Turnover Ratio: Fixed assets turnover ratio
establishes a relationship between net sales and net fixed assets. This ratio indicates
how well the fixed assets are being utilised.
Fixed Assets Turnover Ratio = Net
Sales/Net Fixed Assets
In case Net Sales are not given in the
question cost of goods sold may also be used in place of net sales. Net fixed
assets are considered cost less depreciation.
Objective and Significance: This ratio
expresses the number to times the fixed assets are being turned over in a
stated period. It measures the efficiency with which fixed assets are employed.
A high ratio means a high rate of efficiency of utilisation of fixed asset and
low ratio means improper use of the assets.
o)
Working Capital Turnover Ratio: Working capital turnover ratio
establishes a relationship between net sales and working capital. This ratio
measures the efficiency of utilisation of working capital.
Working Capital Turnover Ratio = Net
Sales or Cost of Goods Sold/Net Working Capital
Where Net Working Capital = Current
Assets – Current Liabilities
Objective and Significance: This ratio
indicates the number of times the utilisation of working capital in the process
of doing business. The higher is the ratio, the lower is the investment in
working capital and the greater are the profits. However, a very high turnover
indicates a sign of over-trading and puts the firm in financial difficulties. A
low working capital turnover ratio indicates that the working capital has not
been used efficiently.
p)
Stock Turnover Ratio: Stock turnover ratio is a ratio
between cost of goods sold and average stock. This ratio is also known as stock
velocity or inventory turnover ratio.
Stock Turnover Ratio = Cost of Goods
Sold/Average Stock
Where Average Stock = [Opening Stock +
Closing Stock]/2
Cost of Goods Sold = Opening Stock +
Net Purchases + Direct Expenses – Closing Stock
Objective and Significance: Stock is a
most important component of working capital. This ratio provides guidelines to
the management while framing stock policy. It measures how fast the stock is
moving through the firm and generating sales. It helps to maintain a proper
amount of stock to fulfill the requirements of the concern. A proper inventory
turnover makes the business to earn a reasonable margin of profit.
q)
Debtors’ Turnover Ratio: Debtors turnover ratio indicates the
relation between net credit sales and average accounts receivables of the year.
This ratio is also known as Debtors’ Velocity.
Debtors Turnover Ratio = Net Credit
Sales/Average Accounts Receivables
Where Average Accounts Receivables =
[Opening Debtors and B/R + Closing Debtors and B/R]/2
Credit Sales = Total Sales – Cash
Sales-Return Inward
Objective and Significance: This ratio
indicates the efficiency of the concern to collect the amount due from debtors.
It determines the efficiency with which the trade debtors are managed. Higher
the ratio, better it is as it proves that the debts are being collected very
quickly.
r)
Debt Collection Period: Debt collection period is the period
over which the debtors are collected on an average basis. It indicates the
rapidity or slowness with which the money is collected from debtors.
ALSO READ: ACCOUNTANCY CHAPTERWISE COMPLETE NOTES
1. BASICS OF PARTNERSHIP (INCLUDING GOODWILL)
2. RECONSTITUTION OF PARTNERSHIP (ADMISSION, RETIREMENT AND DEATH)
3. DISSOLUTION OF PARTNERSHIP FIRM
4. ACCOUNTING FOR SHARE CAPITAL
5. ISSUE AND REDEMPTION OF DEBENTURES
6. FINANCIAL STATEMENTS OF A COMPANTY
7. FINANCIAL STATEMENTS ANALYSIS
8. RATIO ANALYSIS
9. CASH FLOW STATEMENTS
Debt Collection Period = 12 Months or
365 Days/Debtors Turnover Ratio
Or
Debt
Collection Period = Average Trade Debtors/Average Net Credit Sales per day
Or
365
days or 12 months’ x Average Debtors/Credit Sales (360 days can also be used
instead of 365 days)
Objective and Significance: This ratio
indicates how quickly and efficiently the debts are collected. The shorter the
period the better it is and longer the period more the chances of bad debts.
Although no standard period is prescribed anywhere, it depends on the nature of
the industry.
s)
Creditor’ Turnover Ratio: Creditors turnover ratio indicates
the relation between net credit purchase and average accounts payable of the
year. This ratio is also known as Creditors’ Velocity.
Creditors’ Turnover Ratio = Net Credit
Purchase/Average Accounts Payables
Where Average Accounts Payables =
[Opening Creditors and B/P + Closing Creditors and B/P]/2
Credit Purchase = Total Purchase– Cash
Purchase-Return Outward
Objective and Significance: This ratio
indicates the payment period of the concern. Lower the ratio, better is the
liquidity position of the firm and higher the ratios, the lesser is the liquid
position of the firm.
t)
Average Payment Period: Average Payment period is the period within
which creditors are paid off. It indicates the liquidity of the firm in paying
creditors. It is calculated as:
Average Payment Period = 12 Months or
365 Days/Creditors Turnover Ratio
Or
365
days or 12 months’ x Average Accounts Payables/Credit Purchase (360 days can
also be used instead of 365 days)