Accounting Ratios | CBSE Class 12 Accountancy Notes

This note covers the meaning, objectives, advantages and limitations of accounting ratios, their classification, liquidity and solvency, inventory and other turnover ratios, profit margins, returns on investment, shareholder measures and calculations involving missing figures.

What do accounting ratios reveal about a business?

Definition: An accounting ratio expresses a mathematical relationship between accounting numbers derived from financial statements. It can be presented as a fraction, proportion, percentage or number of times.

Ratio analysis helps interpret financial information by relating figures that are meaningfully connected. Financial statements contain data about performance and position, but calculating relationships makes that data more useful for assessing liquidity, solvency, efficiency and profitability.

Why must the figures be related?

A calculation can be arithmetically correct without being useful. Purchases of ₹3,00,000 divided by furniture of ₹1,00,000 give 3, but this relationship does not meaningfully explain the business's efficiency or solvency. The selection of related figures matters as much as division.

By contrast, gross profit of ₹10,000 on revenue from operations of ₹1,00,000 gives a gross profit ratio of 10%. This directly connects profit with the revenue that produced it and shows the gross margin on operations.

A ratio expressed as times has a different meaning from a percentage. An inventory turnover of six times indicates that inventory turns into revenue from operations six times during the year. Its purpose is to explain the speed of activity.

Why is interpretation necessary?

Ratios are derived figures, so their usefulness depends on the underlying accounts. Errors in financial statements carry into ratio calculations. Understanding the accounting rules, policies and classifications behind the figures is therefore necessary before drawing conclusions from the calculated result.

What are the advantages and limitations of ratio analysis?

What objectives and advantages does it serve?

The objectives are to identify areas needing attention, recognise areas capable of improvement, examine profitability and financial strength more deeply, enable comparison with industry standards, and provide information useful for future estimates. Calculation is relatively straightforward; interpretation requires an understanding of financial statements.

• Decision review: Ratios help assess whether operating, investing and financing decisions have improved business performance.
• Simplification: They make complex figures easier to understand and reveal relationships relevant to creditworthiness, earning capacity and managerial efficiency.
• Trend analysis: Comparing several accounting periods helps identify movements that may assist projections.
• Problem identification: Weak areas require attention, while stronger areas can be developed further.
• SWOT analysis: Changes in ratios help management examine strengths, weaknesses, opportunities and threats.
• Comparison: Results can be compared with earlier periods, other enterprises or standards set for the firm or industry.

Intra-firm comparison examines the same business over time. Inter-firm comparison compares different businesses. Comparison with a standard asks whether performance meets the chosen benchmark. These approaches answer different questions and should be distinguished when interpreting results.

What limitations require caution?

Accounting figures reflect recorded facts, conventions and personal judgements. A reported profit is affected by accounting policies, so apparent numerical precision does not remove the need to examine how the figure was prepared. Ratios inherit these limitations.

Ratios indicate problems; they do not themselves supply solutions. They are a means of investigation rather than a final conclusion. A ratio based on unrelated figures is also unhelpful, even when its arithmetic is correct.

How are accounting ratios classified?

Traditional classification groups ratios according to the financial statements supplying their figures. A statement of profit and loss ratio uses two figures from that statement, such as gross profit and revenue from operations. A balance sheet ratio uses two balance sheet figures, such as current assets and current liabilities.

A composite ratio combines a figure from the statement of profit and loss with one from the balance sheet. Trade receivables turnover connects credit revenue from operations with trade receivables and is therefore a composite ratio.

What does functional classification measure?

Functional classification is more commonly used because it follows the purpose of the analysis. Liquidity is essentially concerned with short-term payment ability, while solvency considers the longer term. Turnover measures resource use, and profitability examines the earnings generated through business activity.

How do current and quick ratios measure liquidity?

Liquidity ratios assess short-term solvency by comparing resources available in the current period with current obligations. Current assets include inventories, trade receivables, current investments, cash and cash equivalents, short-term loans and advances, and other current assets such as prepaid expenses, advance tax and accrued income.

Current liabilities include short-term borrowings, trade payables, other current liabilities and short-term provisions. Trade receivables comprise debtors and bills receivable; trade payables comprise creditors and bills payable. Correct classification is necessary before calculating either liquidity ratio.

How is the current ratio calculated?

Current ratio = Current assets / Current liabilities. The excess of current assets over current liabilities provides a safety margin against uncertainty in realising assets and receiving funds.

A very low ratio can indicate difficulty in paying short-term debts. A very high ratio may show excessive investment or poor utilisation of current assets. A level around 2:1 is normally considered safe, but it is not a universal standard for every business.

What changes in the quick ratio?

Quick ratio = Quick assets / Current liabilities. Quick assets are those quickly convertible into cash. Exclude inventories and non-liquid current assets such as prepaid expenses and advance tax. The quick ratio is also called the acid-test ratio.

It supplements the current ratio with a stricter liquidity check. A quick ratio of 1:1 is normally advocated as safe. An unnecessarily low ratio creates risk, while a high ratio may indicate resources tied up in less profitable short-term investments.

Worked example 1. Inventories are ₹50,000, trade receivables ₹50,000, advance tax ₹4,000 and cash and cash equivalents ₹30,000. Trade payables are ₹1,00,000 and bank overdraft ₹4,000. Calculate current and quick ratios.

Answer: Current assets = ₹50,000 + ₹50,000 + ₹4,000 + ₹30,000 = ₹1,34,000. Current liabilities = ₹1,00,000 + ₹4,000 = ₹1,04,000. Current ratio = ₹1,34,000 / ₹1,04,000 ≈ 1.29:1.

Quick assets = ₹1,34,000 − ₹50,000 − ₹4,000 = ₹80,000. Quick ratio = ₹80,000 / ₹1,04,000 ≈ 0.77:1.

Note: Bank overdraft is included in current liabilities in these calculations. Excluding an item from quick assets does not remove a liability from the denominator.

How do transactions and missing figures affect the current ratio?

A transaction may alter current assets, current liabilities or both. Recalculate the two totals before judging the effect. The direction of change depends on the original relationship, so a rule inferred from a current ratio above one should not be applied without checking the starting figures.

What happens when the starting ratio is 2:1?

Worked example 2. Current assets are ₹50,000 and current liabilities ₹25,000. Examine each transaction independently, starting again with these balances each time.

Answer: The initial current ratio is ₹50,000 / ₹25,000 = 2:1. The following calculations show the separate effects.

Independent transaction	Revised calculation	Effect
Pay creditors ₹10,000 by cheque.	₹40,000 / ₹15,000 ≈ 2.67:1	Improves.
Purchase goods worth ₹10,000 on credit.	₹60,000 / ₹35,000 ≈ 1.71:1	Reduces.
Sell a computer with book value ₹4,000 for ₹3,000 cash.	₹53,000 / ₹25,000 = 2.12:1	Improves.
Sell goods costing ₹10,000 for ₹11,000 cash.	₹51,000 / ₹25,000 = 2.04:1	Improves.
Pay unclaimed dividend of ₹5,000.	₹45,000 / ₹20,000 = 2.25:1	Improves.

The computer sale adds ₹3,000 to current assets even though it makes a loss on disposal. The computer itself was a non-current asset. The goods sale removes inventory costing ₹10,000 and adds cash of ₹11,000, producing a net increase of ₹1,000 in current assets.

How can two ratios reveal missing balances?

Worked example 3. X Ltd. has a current ratio of 3.5:1 and quick ratio of 2:1. Inventories of ₹24,000 represent the entire difference between current assets and quick assets. Find current assets and current liabilities.

Answer: Let current liabilities be x. Current assets = 3.5x and quick assets = 2x. Thus 3.5x − 2x = ₹24,000, giving x = ₹16,000. Current assets = 3.5 × ₹16,000 = ₹56,000.

Quick assets = 2 × ₹16,000 = ₹32,000. Verification: ₹56,000 / ₹16,000 = 3.5:1 and ₹32,000 / ₹16,000 = 2:1.

How do solvency ratios explain long-term financial security?

Solvency ratios help long-term lenders assess the security of interest payments and repayment of principal. Debt-equity, debt to capital employed, proprietary, total assets to debt and interest coverage ratios approach this question through different relationships.

What belongs in debt and equity?

Debt-equity ratio = Long-term debts / Shareholders’ funds. Shareholders' funds include equity and preference share capital, reserves and surplus, money received against share warrants and share application money pending allotment. Use the appropriate long-term liabilities given in the question.

Working capital = Current assets − Current liabilities. Equity can also be found as non-current assets plus working capital less non-current liabilities. This alternative connects the asset side of the balance sheet with the long-term financing of the business.

A low debt-equity ratio gives lenders greater security. Greater debt increases the risk of difficulty in meeting obligations. A debt-equity ratio of 2:1 is normally considered safe, although the appropriate level may vary between industries.

From the owners' perspective, trading on equity may improve returns when the earnings rate on capital employed exceeds the interest rate payable. Greater use of debt therefore needs to be considered alongside both earning capacity and financial risk.

Which denominator does each ratio use?

Debt to capital employed ratio = Long-term debt / Capital employed. A lower proportion indicates greater security for lenders. On the capital-employed basis, debt to capital employed and the proprietary ratio add to one because debt and shareholders' funds together make up capital employed.

The alternative total-assets debt measure uses total debts, meaning long-term debt plus current liabilities, divided by total assets. Do not combine this numerator with the capital-employed denominator. Similarly, state clearly whether a proprietary ratio uses total assets or net assets.

Worked example 4. Share capital is ₹4,00,000, reserves and surplus ₹1,00,000, long-term borrowings ₹1,50,000 and current liabilities ₹50,000. Fixed assets are ₹4,00,000, non-current investments ₹1,00,000 and current assets ₹2,00,000. Calculate four solvency ratios, using total assets for the proprietary ratio.

Answer: Equity = ₹4,00,000 + ₹1,00,000 = ₹5,00,000. Total assets = ₹4,00,000 + ₹1,00,000 + ₹2,00,000 = ₹7,00,000. Capital employed = ₹5,00,000 + ₹1,50,000 = ₹6,50,000.

Debt-equity = ₹1,50,000 / ₹5,00,000 = 0.30:1. Total assets to debt = ₹7,00,000 / ₹1,50,000 ≈ 4.67:1. Proprietary ratio = ₹5,00,000 / ₹7,00,000 ≈ 0.71:1. Debt to capital employed = ₹1,50,000 / ₹6,50,000 ≈ 0.23:1.

A higher assets-to-debt ratio indicates greater asset coverage of long-term debt. If net assets replace total assets, the resulting net-assets coverage ratio is the reciprocal of debt to capital employed. The denominator and asset base must remain consistent.

How is interest coverage calculated from profit after tax?

Interest coverage ratio measures how many times profit available for interest covers interest payable on long-term debt. It assesses the security of interest payments, rather than expressing the proportion of debt within the capital structure.

Interest coverage ratio = Profit before interest and tax / Interest on long-term debts. A higher ratio indicates greater safety for interest payments. The numerator must include the profit available before interest has been deducted.

How do tax and interest get added back?

1. Identify whether the profit supplied is before or after tax.
2. If profit is after tax, recover profit before tax using the stated tax rate.
3. Calculate interest from the amount of long-term debt and its interest rate.
4. Add interest to profit before tax, then divide the resulting profit before interest and tax by interest.

Worked example 5. Net profit after tax is ₹60,000, long-term debt is ₹10,00,000 carrying interest at 15%, and the tax rate is 40%. Calculate interest coverage.

Answer: Profit before tax = ₹60,000 × 100 / (100 − 40) = ₹1,00,000. Interest = 15% × ₹10,00,000 = ₹1,50,000. Profit before interest and tax = ₹1,00,000 + ₹1,50,000 = ₹2,50,000.

Interest coverage = ₹2,50,000 / ₹1,50,000 ≈ 1.67 times.

Dividing profit after tax directly by interest would use the wrong numerator. PBIT, profit before interest and tax, restores the charges necessary to measure earnings available for servicing interest on long-term debt.

How does inventory turnover measure the use of inventory?

Activity ratios measure the speed with which resources are used in business. Inventory turnover shows how many times inventory is converted into revenue from operations during the accounting period. It relates inventory at cost to the cost of the goods sold.

Inventory turnover ratio = Cost of revenue from operations / Average inventory. Average inventory is the arithmetic mean of opening and closing inventory. Cost of revenue from operations can be obtained by deducting gross profit from revenue from operations.

How is the cost of operations reconstructed?

Where detailed trading figures are given, add opening inventory, net purchases and direct expenses, then subtract closing inventory. Wages and carriage inwards are included as direct expenses in the following calculation. Revenue itself is not the numerator of inventory turnover.

Worked example 6. Opening inventory is ₹18,000, closing inventory ₹22,000, net purchases ₹46,000, wages ₹14,000, carriage inwards ₹4,000 and revenue from operations ₹80,000. Calculate inventory turnover.

Answer: Cost of revenue from operations = ₹18,000 + ₹46,000 + ₹14,000 + ₹4,000 − ₹22,000 = ₹60,000. Average inventory = (₹18,000 + ₹22,000) / 2 = ₹20,000. Inventory turnover = ₹60,000 / ₹20,000 = 3 times.

Does faster turnover necessarily settle the assessment?

A low turnover may indicate poor buying or obsolete inventory. A high turnover is generally favourable but requires care: it may arise from buying in small lots or selling quickly at a low margin to obtain cash. Interpretation should therefore examine the reasons behind the speed.

Profit on revenue must also be distinguished from profit on cost. With average inventory ₹40,000 and turnover eight times, cost is ₹3,20,000. If profit is 20% of revenue, cost is 80% of revenue: revenue = ₹3,20,000 × 100 / 80 = ₹4,00,000 and gross profit = ₹80,000.

How do receivables and payables turnover explain credit activity?

Trade receivables turnover connects net credit revenue from operations with average trade receivables. It measures how frequently receivables turn into cash. A higher ratio indicates faster collection and helps in examining credit and collection policies.

Trade receivables turnover = Net credit revenue from operations / Average trade receivables. Include both debtors and bills receivable in opening and closing balances. Take debtors before deducting any provision for doubtful debts.

How is collection calculated?

Worked example 7. Total revenue from operations is ₹4,00,000. Cash revenue is 20% of total revenue. Opening trade receivables are ₹40,000 and closing trade receivables ₹1,20,000. Find receivables turnover.

Answer: Cash revenue = 20% × ₹4,00,000 = ₹80,000. Credit revenue = ₹4,00,000 − ₹80,000 = ₹3,20,000. Average receivables = (₹40,000 + ₹1,20,000) / 2 = ₹80,000. Turnover = ₹3,20,000 / ₹80,000 = 4 times.

Average collection period = Days or months in a year / Trade receivables turnover. The period translates a turnover figure into the time taken for collection. Use days when the answer is required in days and months when it is required in months.

How does payment turnover differ?

Trade payables turnover = Net credit purchases / Average trade payables. Average payables include opening and closing creditors and bills payable, with the total divided by two. Credit purchases belong in the numerator because payables arise through buying on credit.

Worked example 8. Credit purchases are ₹12,00,000. Opening creditors and bills payable are ₹3,00,000 and ₹1,00,000; closing creditors and bills payable are ₹1,30,000 and ₹70,000. Calculate payables turnover.

Answer: Average payables = (₹3,00,000 + ₹1,00,000 + ₹1,30,000 + ₹70,000) / 2 = ₹3,00,000. Payables turnover = ₹12,00,000 / ₹3,00,000 = 4 times.

Average payment period = Days or months in a year / Trade payables turnover. A lower turnover may reflect a longer period of supplier credit, or delayed payment. Delayed payment can harm the reputation of the business, so the cause must be investigated.

Note: When only year-end receivables or payables are available, use that balance as given. Do not divide it by two: it is not the sum of an opening and a closing balance.

How are capital employed, fixed assets and working capital turnover compared?

These ratios relate revenue from operations to different resources used in producing it. Capital employed turnover examines the utilisation of long-term funds as a whole. Fixed assets turnover and working capital turnover examine particular components of the resources employed.

How are the three asset bases used?

Worked example 9. Revenue from operations is ₹30,00,000. Capital employed is ₹18,00,000 and fixed assets ₹16,00,000. Current assets are ₹4,00,000 and current liabilities ₹2,00,000. Calculate the three turnover ratios.

Answer: Working capital = ₹4,00,000 − ₹2,00,000 = ₹2,00,000. Capital employed turnover = ₹30,00,000 / ₹18,00,000 ≈ 1.67 times. Fixed assets turnover = ₹30,00,000 / ₹16,00,000 ≈ 1.88 times. Working capital turnover = ₹30,00,000 / ₹2,00,000 = 15 times.

Higher turnover is generally a sign of efficient resource utilisation. The three answers differ because they divide revenue by different resource bases. Working capital is current assets less current liabilities; it must not be replaced by current assets alone.

These ratios supplement the inventory and credit turnover measures. Together, activity ratios connect the scale of operations with the resources supporting those operations, helping explain the efficiency with which assets and funds are used.

How do gross, operating and net profit ratios differ?

Profitability ratios examine earning capacity. Some relate profit to revenue from operations, while others relate earnings to invested funds. Profit margins use different levels of profit, so their expense and income boundaries must be kept distinct.

What does each margin include?

Gross profit provides the margin for meeting operating and non-operating expenses. A change in its ratio may result from a change in selling prices, cost of revenue, or both. A low gross margin may indicate unfavourable purchase and sales policies.

Operating expenses include office, administrative, selling and distribution expenses, depreciation and employee benefit expenses. Operating cost excludes non-operating items such as interest paid, loss on sale of assets, dividend received, loss by fire and speculation gains.

Operating profit ratio = 100 − Operating ratio. A lower operating ratio is favourable because operating cost absorbs a smaller share of revenue. Operating profit is revenue from operations less operating cost.

How are the margins calculated?

Worked example 10. Revenue from operations is ₹3,40,000, cost of revenue from operations ₹1,20,000, selling expenses ₹80,000 and administrative expenses ₹40,000. Find gross profit and operating ratios.

Answer: Gross profit = ₹3,40,000 − ₹1,20,000 = ₹2,20,000. Gross profit ratio = ₹2,20,000 / ₹3,40,000 × 100 ≈ 64.71%.

Operating cost = ₹1,20,000 + ₹80,000 + ₹40,000 = ₹2,40,000. Operating ratio = ₹2,40,000 / ₹3,40,000 × 100 ≈ 70.59%.

Net profit ratio reflects the overall efficiency of business by including operational and non-operational expenses and incomes. It is significant to investors, but it should not be substituted for the operating margin when the question concerns operating performance alone.

How do returns and per-share ratios help shareholders?

Return on capital employed, also called return on investment, measures the return generated by the long-term funds entrusted to a business. These include shareholders' funds, debentures and long-term loans. Capital employed can also be calculated as non-current assets plus working capital.

ROCE = Profit before interest and tax / Capital employed × 100. This ratio assesses the utilisation of long-term funds and helps compare profitability between firms. It also helps examine whether the return exceeds the interest rate paid.

How do shareholder measures change the profit base?

EPS measures earnings available for each equity share, so preference dividend is deducted from profit after tax. Book value uses equity shareholders' funds instead of earnings. Dividend payout shows the proportion of earnings distributed and reflects dividend policy.

The price-earnings ratio reflects investors' expectations about earnings growth and the reasonableness of the market price. It varies between industries and companies according to perceptions of their future. It must not be confused with the book value of a share.

How are the linked calculations completed?

Worked example 11. Equity share capital is ₹4,00,000 in shares of ₹10 each; 12% preference share capital is ₹1,00,000; general reserve is ₹1,84,000; and 10% debentures are ₹4,00,000. Profit after tax is ₹1,50,000, tax ₹50,000 and market price ₹34 per equity share.

Answer: Debenture interest = 10% × ₹4,00,000 = ₹40,000. PBIT = ₹1,50,000 + ₹50,000 + ₹40,000 = ₹2,40,000. Capital employed = ₹4,00,000 + ₹1,00,000 + ₹1,84,000 + ₹4,00,000 = ₹10,84,000. ROCE = ₹2,40,000 / ₹10,84,000 × 100 ≈ 22.14%.

Shareholders' funds = ₹4,00,000 + ₹1,00,000 + ₹1,84,000 = ₹6,84,000. Return on shareholders' funds = ₹1,50,000 / ₹6,84,000 × 100 ≈ 21.93%.

Preference dividend = 12% × ₹1,00,000 = ₹12,000. Equity earnings = ₹1,50,000 − ₹12,000 = ₹1,38,000. Equity shares = ₹4,00,000 / ₹10 = 40,000. EPS = ₹1,38,000 / 40,000 = ₹3.45.

Equity shareholders' funds = ₹6,84,000 − ₹1,00,000 = ₹5,84,000. Book value per share = ₹5,84,000 / 40,000 = ₹14.60. P/E ratio = ₹34 / ₹3.45 ≈ 9.86 times.

How can several ratios be combined to find missing figures?

Ratio formulae can be rearranged when a question gives relationships rather than every balance. First identify which amount each ratio connects. Then use the result from one relationship as the input to the next, keeping opening inventory, closing inventory and average inventory distinct.

How are inventory and liquidity linked?

Worked example 12. Inventory turnover is four times. Closing inventory exceeds opening inventory by ₹20,000. Revenue from operations is ₹3,00,000 and gross profit is 20% of revenue. Current liabilities are ₹40,000 and the quick ratio is 0.75:1. Inventory is the only non-quick current asset. Find current assets.

Answer: Gross profit = 20% × ₹3,00,000 = ₹60,000. Cost of revenue = ₹3,00,000 − ₹60,000 = ₹2,40,000. Average inventory = ₹2,40,000 / 4 = ₹60,000.

Let opening inventory be x. Then (x + x + ₹20,000) / 2 = ₹60,000. Opening inventory is ₹50,000 and closing inventory ₹70,000. Quick assets = 0.75 × ₹40,000 = ₹30,000. Current assets = ₹30,000 + ₹70,000 = ₹1,00,000.

The liquidity calculation uses closing inventory, while inventory turnover uses the average. The condition about non-quick assets is necessary: adding inventory alone to quick assets would be incomplete if other excluded current assets also existed.

Glossary

• Accounting ratio — A mathematical relationship between relevant accounting figures derived from the financial statements of a business.
• Liquidity — The ability of a business to pay its current obligations when they become due.
• Solvency — The ability of a business to meet its contractual obligations, particularly towards external stakeholders over the longer term.
• Quick assets — Current assets quickly convertible into cash, excluding inventory and non-liquid items such as prepaid expenses and advance tax.
• Working capital — The amount by which current assets exceed current liabilities in the business.
• Capital employed — Long-term funds comprising shareholders' funds and long-term debt, also measured as total assets less current liabilities.
• Trade receivables — Amounts represented by trade debtors and bills receivable arising through credit revenue from operations.
• Trade payables — Amounts represented by trade creditors and bills payable arising through credit purchases.
• Inventory turnover — The relationship between cost of revenue from operations and average inventory during the accounting period.
• Interest coverage — The number of times profit before interest and tax covers interest payable on long-term debt.
• Operating ratio — Operating cost expressed as a percentage of net revenue from operations.
• Earnings per share — Profit available to equity shareholders divided by the number of equity shares.
• Book value per share — Equity shareholders' funds divided by the number of equity shares in the company.
• Dividend payout ratio — Dividend per share divided by earnings per share, indicating the proportion of earnings distributed.
• Price-earnings ratio — Market price per share divided by earnings per share, reflecting investors' expectations about future earnings.

Common errors and misconceptions

• Misconception: Any two accounting figures produce a useful ratio. Correct: The figures must have a meaningful relationship; correct arithmetic alone does not establish usefulness.
• Misconception: A higher current ratio necessarily indicates better management. Correct: A very high ratio may reflect excessive investment or poor utilisation of current assets.
• Misconception: Quick assets equal current assets less inventory in every question. Correct: Also exclude non-liquid current assets such as prepaid expenses and advance tax when present.
• Misconception: Proprietary ratio has the same denominator in every calculation. Correct: It may use capital employed or total assets; identify the basis before calculating or comparing.
• Misconception: Inventory turnover uses sales revenue as its numerator. Correct: Use cost of revenue from operations and average inventory.
• Misconception: A single closing receivables balance must be halved. Correct: Use it as given when opening information is unavailable; averaging requires opening and closing figures.
• Misconception: Profit after tax can be used directly for interest coverage. Correct: Use profit before interest and tax divided by interest on long-term debt.
• Misconception: EPS equals profit after tax divided by equity shares even when preference dividend is payable. Correct: Deduct preference dividend to obtain profit available for equity shareholders.

Exam-style questions with model answers

Q1. Distinguish liquidity ratios from solvency ratios. [2 marks]

1. Liquidity ratios measure the ability to meet current obligations. They are essentially short-term measures, including the current and quick ratios.
2. Solvency ratios assess the ability to meet long-term obligations, including the security of interest and principal repayments. Debt-equity and interest coverage are examples.

Q2. State four limitations of ratio analysis. [4 marks]

1. Ratios inherit limitations of accounting data, including the effects of accounting conventions, policies and personal judgements on reported figures.
2. Changes in price levels are ignored by historical accounting records, reducing the usefulness of comparisons across different accounting years.
3. Ratios express monetary relationships and omit qualitative or non-monetary factors that may matter when judging business performance.
4. Different inventory valuation, depreciation and other accounting practices make comparisons between enterprises less reliable unless those differences are considered.

Q3. Inventories are ₹50,000, trade receivables ₹50,000, advance tax ₹4,000 and cash ₹30,000. Trade payables are ₹1,00,000 and bank overdraft ₹4,000. Calculate current and quick ratios, showing both asset bases. [4 marks]

1. Current assets include every listed asset: ₹50,000 + ₹50,000 + ₹4,000 + ₹30,000 = ₹1,34,000.
2. Current liabilities comprise trade payables and bank overdraft: ₹1,00,000 + ₹4,000 = ₹1,04,000. The overdraft remains in the denominator.
3. Current ratio = current assets / current liabilities = ₹1,34,000 / ₹1,04,000 ≈ 1.29:1.
4. Quick assets exclude inventory and advance tax: ₹1,34,000 − ₹50,000 − ₹4,000 = ₹80,000. Quick ratio = ₹80,000 / ₹1,04,000 ≈ 0.77:1.

Q4. Profit after tax is ₹60,000, the tax rate is 40%, and long-term debt of ₹10,00,000 bears interest at 15%. Calculate interest coverage with workings. [4 marks]

1. Profit after tax represents 60% of profit before tax. Therefore profit before tax = ₹60,000 × 100 / 60 = ₹1,00,000.
2. Annual interest on long-term debt = 15% × ₹10,00,000 = ₹1,50,000, using the given interest rate.
3. Profit before interest and tax = profit before tax + interest = ₹1,00,000 + ₹1,50,000 = ₹2,50,000.
4. Interest coverage = ₹2,50,000 / ₹1,50,000 ≈ 1.67 times. This measures how often profit available for interest covers that charge.

Q5. Opening inventory is ₹18,000, closing inventory ₹22,000, net purchases ₹46,000, wages ₹14,000, carriage inwards ₹4,000 and revenue ₹80,000. Calculate inventory turnover and explain its components and interpretation. [5 marks]

1. Cost of revenue from operations includes opening inventory, net purchases and direct expenses, less closing inventory. It equals ₹18,000 + ₹46,000 + ₹14,000 + ₹4,000 − ₹22,000 = ₹60,000.
2. Average inventory = (opening inventory + closing inventory) / 2 = (₹18,000 + ₹22,000) / 2 = ₹20,000.
3. Inventory turnover = cost of revenue from operations / average inventory = ₹60,000 / ₹20,000 = 3 times.
4. The numerator is cost, rather than the ₹80,000 revenue figure, because the formula relates cost of revenue to inventory.
5. The result indicates inventory turnover three times during the period. Interpretation requires care: low turnover may indicate obsolete inventory, while high turnover may reflect low-margin selling.

Q6. Revenue is ₹4,00,000, of which 20% is cash. Opening and closing receivables are ₹40,000 and ₹1,20,000. Credit purchases are ₹12,00,000. Opening creditors and bills payable are ₹3,00,000 and ₹1,00,000; closing balances are ₹1,30,000 and ₹70,000. Calculate receivables and payables turnover. [4 marks]

1. Cash revenue = 20% × ₹4,00,000 = ₹80,000. Therefore net credit revenue = ₹4,00,000 − ₹80,000 = ₹3,20,000.
2. Average receivables = (₹40,000 + ₹1,20,000) / 2 = ₹80,000. Receivables turnover = ₹3,20,000 / ₹80,000 = 4 times.
3. Average payables include both creditors and bills payable: (₹3,00,000 + ₹1,00,000 + ₹1,30,000 + ₹70,000) / 2 = ₹3,00,000.
4. Payables turnover = net credit purchases / average payables = ₹12,00,000 / ₹3,00,000 = 4 times, relating credit purchases to the corresponding payable balances.

Q7. Equity capital is ₹4,00,000 in ₹10 shares, 12% preference capital ₹1,00,000, general reserve ₹1,84,000 and 10% debentures ₹4,00,000. Profit after tax is ₹1,50,000, tax ₹50,000 and market price ₹34 per equity share. Calculate PBIT, capital employed, ROCE, EPS, book value per share and P/E. [6 marks]

1. Debenture interest = 10% × ₹4,00,000 = ₹40,000. Profit before interest and tax = ₹1,50,000 + ₹50,000 + ₹40,000 = ₹2,40,000.
2. Capital employed combines share capital, reserve and debentures: ₹4,00,000 + ₹1,00,000 + ₹1,84,000 + ₹4,00,000 = ₹10,84,000.
3. ROCE = PBIT / capital employed × 100 = ₹2,40,000 / ₹10,84,000 × 100 ≈ 22.14%.
4. Preference dividend = ₹12,000; equity earnings = ₹1,50,000 − ₹12,000 = ₹1,38,000. Equity shares = ₹4,00,000 / ₹10 = 40,000. EPS = ₹1,38,000 / 40,000 = ₹3.45.
5. Equity shareholders' funds exclude preference capital and equal ₹4,00,000 + ₹1,84,000 = ₹5,84,000. Book value per share = ₹5,84,000 / 40,000 = ₹14.60.
6. P/E = market price per share / EPS = ₹34 / ₹3.45 ≈ 9.86 times, relating the market quotation to earnings per equity share.

Key takeaways

• Accounting ratios relate meaningful financial figures; their usefulness depends on accurate accounts, consistent definitions and careful interpretation.
• Current and quick ratios assess short-term payment ability, with quick assets excluding inventories and other non-liquid current assets.
• Debt-equity and other solvency measures examine long-term financial security; identify the debt definition and asset base before calculating.
• Interest coverage uses profit before interest and tax, so restore both charges when starting from profit after tax.
• Inventory turnover uses cost of revenue and average inventory; receivables and payables turnover use credit revenue and credit purchases respectively.
• Operating ratio measures the cost share of revenue, while operating profit ratio equals one hundred minus that percentage.
• ROCE relates PBIT to capital employed, whereas return on shareholders' funds relates profit after tax to shareholders' funds.
• EPS deducts preference dividend from profit after tax; book value per share instead uses equity shareholders' funds.

Test yourself

Why is purchases divided by furniture not a useful performance ratio?

The figures lack a meaningful relationship for assessing business performance, even though their quotient can be calculated correctly.

Which items, besides inventory, may need to be excluded from quick assets?

Exclude non-liquid current assets such as prepaid expenses and advance tax when they appear among current assets.

What is the denominator in the debt-equity ratio?

Shareholders' funds form the denominator; the numerator is long-term debt, rather than current liabilities.

Should debtors be reduced by the provision for doubtful debts when calculating receivables turnover?

No. Take debtors before deducting the provision for doubtful debts, and include bills receivable in trade receivables.

What can a low payables turnover indicate?

It may reflect a long period of supplier credit or delayed payment, which can damage the business's reputation.

How is operating profit ratio obtained from operating ratio?

Subtract operating ratio from one hundred; the remainder represents operating profit as a percentage of revenue from operations.

Why does EPS deduct preference dividend?

EPS measures profit available for equity shareholders, so preference shareholders' dividend must first be deducted from profit after tax.

Which inventory balance is added to quick assets to obtain current assets?

Use closing inventory when adding inventory to quick assets; average inventory belongs in the inventory turnover calculation.