Ratio Analysis | ISC Class 12 Accounts Notes

This note covers the meaning and objectives of ratio analysis, its advantages and limitations, the four functional categories of accounting ratios (liquidity, solvency, activity and profitability), the formula, components and significance of each ratio named in the course, worked calculations and model answers to exam-style questions.

What is ratio analysis and why is it used?

A ratio is a mathematical number calculated with reference to the relationship between two or more numbers, and it can be expressed as a fraction, proportion, percentage or a number of times.

When a ratio is calculated using two accounting numbers taken from financial statements, it is called an accounting ratio.

For example, if the gross profit of a business is ₹10,000 and the revenue from operations is ₹1,00,000, the gross profit is 10% of the revenue from operations.

Ratio Analysis is an important tool of financial statement analysis. It helps the user of financial statements to know the areas of the business which need more attention, the potential areas which can be improved, a deeper analysis of the profitability, liquidity, solvency and efficiency levels of the business, information for cross-sectional comparison with industry standards, and information useful for making projections and estimates for the future.

A ratio must be calculated using numbers that are meaningfully related; a ratio calculated from unrelated figures, such as creditors and furniture, hardly has any relevance.

Advantages of ratio analysis

Properly conducted ratio analysis improves the understanding of the efficiency with which a business is run.

Its chief advantages are: it helps understand the efficacy of decisions taken by management; it simplifies complex accounting figures and establishes relationships between them; it is helpful in comparative analysis across several accounting periods; it identifies problem areas as well as bright areas of the business; it enables a SWOT (Strength-Weakness-Opportunity-Threat) analysis; and it allows intra-firm comparison (time series analysis), inter-firm comparison (cross-sectional analysis), and comparison against standards set for the firm or industry.

Limitations of ratio analysis

Since ratios are derived from financial statements, any weakness in those statements also affects the ratios.

The limitations arising from the nature of financial statements include: accounting data give an unwarranted impression of precision and finality, since profit is merely the accountant's opinion based on applying accounting policies; price-level changes are ignored because accounting is based on the stable money measurement principle; qualitative or non-monetary aspects are ignored, as accounting reflects only monetary information; variations in accounting practices between enterprises make cross-sectional comparison difficult; and forecasting future trends on the basis of historical analysis alone is not feasible.

The limitations of the ratios themselves are that they are a means and not an end; their role is essentially indicative and of whistle-blowing rather than providing a solution; there is a lack of standardised definitions of concepts used in ratio analysis (for example, there is no standard definition of liquid liabilities); there is no universally accepted yardstick specifying ideal levels, and industry averages are not always available in India; and ratios calculated on unrelated figures are a meaningless exercise.

What are the functional categories of accounting ratios?

Ratios are commonly classified by the purpose for which they are computed, into four functional categories.

Liquidity Ratios measure the ability of the business to pay amounts due to stakeholders as and when they fall due; these are essentially short-term in nature.

Solvency Ratios measure the ability of the business to meet its long-term contractual obligations, particularly to external stakeholders. Activity Ratios (or Turnover Ratios, also called Efficiency Ratios) measure the efficiency with which business resources are being utilised.

Profitability Ratios analyse profits in relation to revenue from operations or the funds (or assets) employed in the business.

How is the Current Ratio calculated?

Definition: Current Ratio. The proportion of current assets to current liabilities, expressed as Current Assets : Current Liabilities or as a fraction.

Current Ratio = Current Assets ÷ Current Liabilities

Current assets comprise current investments, inventories (excluding loose tools and spare parts), trade receivables, cash and bank balance, short-term loans and advances, advance tax, and other current assets, which are restricted to prepaid expenses and accrued income.

Current liabilities comprise short-term borrowings, trade payables, other current liabilities and short-term provisions. The current ratio should be reasonable; it should be neither very high nor very low.

A very high current ratio implies heavy investment in current assets, reflecting under-utilisation or improper utilisation of resources, while a low ratio puts the business at risk of being unable to pay short-term debt on time.

Normally, it is safe to have this ratio within the range of 2:1.

Worked example 1. Calculate the Current Ratio from the following: Inventories ₹50,000; Trade receivables ₹50,000; Advance tax ₹4,000; Cash and cash equivalents ₹30,000; Trade payables ₹1,00,000; Short-term borrowings (bank overdraft) ₹4,000.

Answer: Current Assets = Inventories + Trade receivables + Advance tax + Cash and cash equivalents = ₹50,000 + ₹50,000 + ₹4,000 + ₹30,000 = ₹1,34,000. Current Liabilities = Trade payables + Short-term borrowings = ₹1,00,000 + ₹4,000 = ₹1,04,000. Current Ratio = ₹1,34,000 ÷ ₹1,04,000 = 1.29:1.

How is the Quick Ratio calculated?

Definition: Quick Ratio. The ratio of quick (or liquid) assets to current liabilities, also called the Liquid Ratio or Acid-Test Ratio.

Quick Ratio = Quick Assets ÷ Current Liabilities

Quick assets are assets quickly convertible into cash; they exclude inventories and other current assets such as prepaid expenses and advance tax from current assets.

Because non-liquid current assets are excluded, this ratio is considered a better measure of liquidity than the current ratio and serves as a supplementary check on the liquidity position of the business.

It is normally considered safe to have a ratio of 1:1; an unnecessarily low ratio is risky, while a high ratio suggests unnecessary deployment of resources in less profitable short-term investments.

Worked example 2. Using the figures of Worked example 1 (Current Assets ₹1,34,000, Current Liabilities ₹1,04,000, Inventories ₹50,000, Advance tax ₹4,000), calculate the Quick Ratio.

Answer: Quick Assets = Current Assets − (Inventories + Advance tax) = ₹1,34,000 − (₹50,000 + ₹4,000) = ₹80,000. Quick Ratio = ₹80,000 ÷ ₹1,04,000 = 0.77:1.

What are the solvency ratios?

Solvency ratios are calculated to determine the ability of the business to service its debt in the long run. The ratios normally computed are the Debt-Equity Ratio, Proprietary Ratio, Debt to Total Assets Ratio and Interest Coverage Ratio.

Debt-Equity Ratio

Definition: Debt-Equity Ratio. The ratio measuring the relationship between long-term debt and shareholders' equity.

Debt-Equity Ratio = Long-term Debt ÷ Equity

Debt comprises long-term borrowings and long-term provisions. Equity (Shareholders' Funds) comprises share capital plus reserves and surplus; alternatively, Equity = Non-current assets + Working Capital − Non-current liabilities.

If the debt component of total long-term funds is small, outsiders feel more secure; a capital structure with less debt and more equity is considered favourable as it reduces the chances of bankruptcy.

Normally, it is considered to be safe if the debt-equity ratio is 2:1, though it may vary from industry to industry.

A low ratio reflects more security to the long-term lender; a high ratio is considered risky, though from the owners' viewpoint greater use of debt (trading on equity) may help ensure higher returns to them if the rate of earnings on capital employed is higher than the rate of interest payable.

Worked example 3. From the Balance Sheet of ABC Co. Ltd., Long-term borrowings ₹4,00,000, Other long-term liabilities ₹40,000, Long-term provisions ₹60,000, Share capital ₹12,00,000, Reserves and surplus ₹2,00,000, Money received against share warrants ₹1,00,000. Calculate the Debt-Equity Ratio.

Answer: Debt = ₹4,00,000 + ₹40,000 + ₹60,000 = ₹5,00,000. Equity = ₹12,00,000 + ₹2,00,000 + ₹1,00,000 = ₹15,00,000. Debt-Equity Ratio = ₹5,00,000 ÷ ₹15,00,000 = 0.33:1.

Proprietary Ratio and Debt to Total Assets Ratio

Proprietary Ratio = Shareholders' Funds ÷ Total Assets. It expresses the relationship of proprietors' (shareholders') funds to total assets.

Total Assets = Non-Current Assets + Current Assets, that is, Property, Plant and Equipment + Intangible Assets + Non-Current Investments + Long-Term Loans and Advances + Current Investments + Inventories (including Loose Tools and Spare Parts) + Trade Receivables + Cash and Bank Balance + Short-Term Loans and Advances + Other Current Assets.

A higher proportion of shareholders' funds financing the assets is a positive feature as it provides security to creditors.

The Debt to Total Assets Ratio = Long-term Debt ÷ Total Assets. It measures the proportion of a firm's total assets financed by long-term debt; a lower ratio indicates that assets have mainly been financed by owners' funds.

Interest Coverage Ratio

Interest Coverage Ratio = Net Profit before Interest and Tax ÷ Interest on Long-term Debt.

It deals with the servicing of interest on loans and expresses the relationship between profits available for payment of interest and the amount of interest payable. A higher ratio ensures safety of interest on debts. Fixed interest charges include interest on only long-term borrowings.

Worked example 4. Net Profit after tax ₹60,000; 15% Long-term debt ₹10,00,000; Tax rate 40%. Calculate the Interest Coverage Ratio.

Answer: Net Profit before tax = Net profit after tax × 100/(100 − Tax rate) = ₹60,000 × 100/60 = ₹1,00,000. Interest on Long-term Debt = 15% of ₹10,00,000 = ₹1,50,000.

Net profit before interest and tax = ₹1,00,000 + ₹1,50,000 = ₹2,50,000. Interest Coverage Ratio = ₹2,50,000 ÷ ₹1,50,000 = 1.67 times.

What are the activity (turnover) ratios?

Activity ratios indicate the speed at which the activities of the business are performed; they express the number of times assets employed, or any constituent of assets, is turned into revenue from operations during an accounting period.

A higher turnover ratio generally means better utilisation of assets and signifies improved efficiency and profitability, so these are also known as Efficiency Ratios.

Trade Receivables Turnover Ratio

Receivables Turnover = Net Credit Revenue ÷ Average Trade Receivables, where Credit Revenue from Operations = Revenue from Operations − Cash Revenue from Operations, and Average Trade Receivables = (Opening Debtors and Bills Receivable + Closing Debtors and Bills Receivable) ÷ 2.

Debtors should be taken before making any provision for doubtful debts. The liquidity position of the firm depends on the speed with which trade receivables are realised; a higher turnover means speedy collection.

The Average Collection Period = Number of days (or months) in a year ÷ Trade Receivables Turnover Ratio.

Worked example 5. Total Revenue from operations ₹4,00,000, of which Cash Revenue from operations is 20%. Trade receivables as at the start of the year ₹40,000, at the end of the year ₹1,20,000. Calculate the Trade Receivables Turnover Ratio.

Answer: Cash Revenue from operations = 20% of ₹4,00,000 = ₹80,000. Credit Revenue from operations = ₹4,00,000 − ₹80,000 = ₹3,20,000. Average Trade Receivables = (₹40,000 + ₹1,20,000) ÷ 2 = ₹80,000. Trade Receivables Turnover Ratio = ₹3,20,000 ÷ ₹80,000 = 4 times.

Trade Payables Turnover, Working Capital Turnover and Inventory Turnover Ratios

The Trade Payables Turnover Ratio = Net Credit Purchases ÷ Average Trade Payables, where Average Trade Payables = (Opening Creditors and Bills Payable + Closing Creditors and Bills Payable) ÷ 2.

It reveals the average payment period; a lower ratio means the credit allowed by suppliers is for a long period, or that payment to suppliers is delayed, which is not a good policy as it may affect the business's reputation.

The Average Payment Period = Number of days/months in a year ÷ Trade Payables Turnover Ratio.

The Working Capital Turnover Ratio = Revenue from Operations ÷ Working Capital, where Working Capital = Current Assets − Current Liabilities. High turnover of working capital and fixed assets implies efficient utilisation of resources, resulting in higher liquidity and profitability.

Inventory Turnover Ratio = Cost of Revenue from Operations ÷ Average Inventory, where Average Inventory = (Opening Inventory + Closing Inventory) ÷ 2.

Cost of Revenue from Operations = Revenue from Operations − Gross Profit. It can also be computed as Cost of Material Consumed (including direct expenses) + Change in inventories of Work-in-Progress and Finished Goods, or as Opening Inventory + Net Purchases + Direct Expenses − Closing Inventory.

It studies the frequency of conversion of inventory into revenue from operations; a low turnover may be due to bad buying or obsolete inventory and is a danger signal, while a high turnover is good but must be carefully interpreted, as it may result from buying in small lots or selling quickly at low margins to realise cash.

Worked example 6. Revenue from Operations ₹8,75,000; Purchases ₹4,20,000; Creditors ₹90,000; Bills payable ₹52,000; Trade debtors ₹59,000; Bills receivable ₹48,000. Opening balances of debtors and bills receivable are not available. Calculate the Trade Receivables Turnover Ratio, the Average Collection Period, the Trade Payables Turnover Ratio and the Average Payment Period.

Answer: Average Trade Receivables = ₹59,000 + ₹48,000 = ₹1,07,000, taken as it is because opening figures are not available. Trade Receivables Turnover Ratio = ₹8,75,000 ÷ ₹1,07,000 = 8.18 times. Average Collection Period = 365 ÷ 8.18 = 45 days. Average Trade Payables = ₹90,000 + ₹52,000 = ₹1,42,000. Trade Payables Turnover Ratio = ₹4,20,000 ÷ ₹1,42,000 = 2.96 times. Average Payment Period = 365 ÷ 2.96 = 123 days.

Worked example 7. Revenue from Operations ₹30,00,000. Share capital ₹10,00,000 (preference ₹4,00,000 and equity ₹6,00,000); Reserves and Surplus ₹4,00,000; 15% debentures ₹2,00,000; 14% loan ₹2,00,000; Creditors ₹1,40,000; Bills payable ₹50,000; Outstanding expenses ₹10,000; Plant and Machinery ₹8,00,000; Land and Building ₹5,00,000; Motor Car ₹2,00,000; Furniture ₹1,00,000; Inventory ₹1,80,000; Debtors ₹1,10,000; Bank ₹80,000; Cash ₹30,000. Calculate the Net Assets (Capital Employed) Turnover Ratio, the Fixed Assets Turnover Ratio and the Working Capital Turnover Ratio.

Answer: Capital Employed = Share Capital + Reserves and Surplus + Long-term Debts = (₹4,00,000 + ₹6,00,000) + ₹4,00,000 + (₹2,00,000 + ₹2,00,000) = ₹18,00,000. Fixed Assets = ₹8,00,000 + ₹5,00,000 + ₹2,00,000 + ₹1,00,000 = ₹16,00,000. Current Assets = ₹1,80,000 + ₹1,10,000 + ₹80,000 + ₹30,000 = ₹4,00,000 and Current Liabilities = ₹1,40,000 + ₹50,000 + ₹10,000 = ₹2,00,000, so Working Capital = ₹2,00,000. Net Assets Turnover Ratio = ₹30,00,000 ÷ ₹18,00,000 = 1.67 times. Fixed Assets Turnover Ratio = ₹30,00,000 ÷ ₹16,00,000 = 1.88 times. Working Capital Turnover Ratio = ₹30,00,000 ÷ ₹2,00,000 = 15 times.

Worked example 8. Inventory turnover ratio 4 times; inventory at the end is ₹20,000 more than inventory in the beginning; Revenue from Operations ₹3,00,000; gross profit ratio 20% of revenue from operations; current liabilities ₹40,000; quick ratio 0.75:1. Calculate the current assets.

Answer: Cost of Revenue from Operations = ₹3,00,000 − (₹3,00,000 × 20%) = ₹2,40,000. Average Inventory = ₹2,40,000 ÷ 4 = ₹60,000. As Average Inventory = (Opening Inventory + Closing Inventory) ÷ 2 and Closing Inventory = Opening Inventory + ₹20,000, ₹60,000 = Opening Inventory + ₹10,000, so Opening Inventory = ₹50,000 and Closing Inventory = ₹70,000. Liquid Assets = 0.75 × ₹40,000 = ₹30,000. Current Assets = Liquid Assets + Closing Inventory = ₹30,000 + ₹70,000 = ₹1,00,000.

Worked example 9. The current ratio is 2.5:1, current assets are ₹50,000 and current liabilities are ₹20,000. How much must the current assets decline to bring the ratio to 2:1?

Answer: For a ratio of 2:1 with current liabilities of ₹20,000, current assets must be 2 × ₹20,000 = ₹40,000. Present current assets are ₹50,000. Necessary decline = ₹50,000 − ₹40,000 = ₹10,000.

What are the profitability ratios?

Profitability ratios are calculated to analyse the earning capacity of the business, which results from the utilisation of resources employed in the business.

Gross Profit, Net Profit and Operating Ratios

Gross Profit Ratio = Gross Profit ÷ Revenue from Operations × 100. It indicates the margin on products sold and the margin available to cover operating and non-operating expenses.

Gross Profit = Revenue from Operations − Cost of Revenue from Operations (or Cost of Goods Sold). A change in the gross profit ratio may be due to a change in selling price or in cost of revenue from operations, or a combination of both; a low ratio may indicate unfavourable purchase and sales policy.

Net Profit Ratio = Net Profit ÷ Revenue from Operations × 100. Net Profit = Gross Profit + Other Income − Indirect Expenses − Provision for Tax. It is a measure of net profit margin and reflects the overall efficiency of the business; besides revealing profitability, it is the main variable used in computing Return on Investment.

The Operating Ratio = (Cost of Revenue from Operations + Operating Expenses) ÷ Revenue from Operations × 100. Operating expenses include employee benefit expenses, depreciation of tangible assets, selling and distribution expenses, and office and administrative expenses.

An alternative form deducts operating income: Operating Ratio = (Cost of Revenue from Operations + Operating Expenses − Operating Income) ÷ Revenue from Operations × 100. Operating Income includes commission received and cash discount received.

The Operating Profit Ratio = 100 − Operating Ratio, or alternatively, Net Operating Profit ÷ Revenue from Operations × 100.

Net Operating Profit = Net Profit after Tax + Provision for Tax + Non-Operating Expenses − Non-Operating Incomes, or Gross Profit − Operating Expenses + Operating Incomes.

Non-Operating Expenses include finance cost (interest on long-term borrowings), loss on sale of non-current assets, amortisation of intangible assets and writing off capital losses. Non-Operating Incomes include interest and dividend received on investments and profit on sale of non-current assets.

A lower operating ratio is a very healthy sign; the operating profit ratio throws light on operational efficiency and is useful for both inter-firm and intra-firm comparisons.

Return on Investment, Earnings per Share and Price Earning Ratio

Return on Investment = Profit before Interest and Tax ÷ Capital Employed × 100, where capital employed means long-term funds employed in the business, comprising shareholders' funds, debentures and long-term loans.

It measures return on capital employed and helps in assessing whether the firm earns a higher return on capital employed than the interest rate it pays.

Earnings per Share = Profit available for Equity Shareholders ÷ No. of Equity Shares, where profit available for equity shareholders = Profit after Tax − Dividend on preference shares.

The Price Earning Ratio = Market Price of a share ÷ Earnings per share; it reflects investors' expectations about growth in the firm's earnings and varies from industry to industry and firm to firm, depending on investor perception of future prospects.

Plot accounting years on the horizontal axis and the ratio value (%) on the vertical axis, with two lines, one for Return on Investment and one for Return on Shareholders' Funds; the gap between the lines shows whether borrowed funds are being used profitably (trading on equity).

Worked example 10. Equity Share Capital (shares of ₹10 each) ₹4,00,000; 12% Preference Share Capital ₹1,00,000; General Reserve ₹1,84,000; 10% Debentures ₹4,00,000; Current Liabilities ₹1,00,000; Fixed Assets ₹9,50,000; Current Assets ₹2,34,000. Net profit after tax was ₹1,50,000 and tax amounted to ₹50,000. The market price of a share is ₹34. Calculate Return on Investment and Return on Shareholders' Funds.

Answer: Profit before interest and tax = ₹1,50,000 + Debenture interest + Tax = ₹1,50,000 + ₹40,000 + ₹50,000 = ₹2,40,000. Capital Employed = Equity Share Capital + Preference Share Capital + Reserves + Debentures = ₹4,00,000 + ₹1,00,000 + ₹1,84,000 + ₹4,00,000 = ₹10,84,000. Return on Investment = ₹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%.

Worked example 11. 70,000 equity shares of ₹10 each (₹7,00,000); Net Profit after tax but before dividend ₹1,75,000; market price of a share ₹13. Calculate the Earnings per Share and the Price Earning Ratio.

Answer: Earnings per Share = ₹1,75,000 ÷ 70,000 = ₹2.50. Price Earning Ratio = ₹13 ÷ ₹2.50 = 5.20 times.

How are the components of financial statements classified for ratio computation?

Several components recur across the ratios above and need to be defined precisely.

Capital Employed = Shareholders' Funds + Non-current Liabilities − Non-trade Investments, or alternatively, Non-current Assets (excluding non-trade investments) + Working Capital, or Property, Plant and Equipment + Intangible Assets + Trade Investments + Working Capital.

Investments are taken as non-trade investments unless specified as trade investments. In the Return on Investment ratio, Net Profit before interest and tax does not include interest on non-trade investments.

It should also be noted that the Current Ratio includes net debtors (gross debtors minus provision for doubtful debts), while the Trade Receivables Turnover Ratio includes gross debtors.

Other Current Assets are restricted to prepaid expenses and accrued income.

Going beyond the syllabus

These ideas extend the unit and are not needed for the questions on it.

How are ratios classified by the financial statement they use?

Ratios may be classified traditionally according to the financial statement from which the determinants are drawn.

A ratio calculated using two figures from the Statement of Profit and Loss, such as the Gross Profit Ratio, is a Statement of Profit and Loss ratio.

A ratio calculated using two figures from the Balance Sheet, such as the Current Ratio, is a Balance Sheet ratio.

A ratio computed with one variable from the Statement of Profit and Loss and another from the Balance Sheet, such as the Trade Receivables Turnover Ratio, is a Composite Ratio.

This traditional classification is rarely used in practice compared with the functional classification into liquidity, solvency, activity and profitability ratios, which is based on the purpose for which a ratio is computed.

What is the Debt to Capital Employed Ratio?

The Debt to Capital Employed Ratio is Long-term Debt ÷ Capital Employed, where Capital Employed = Long-term debt + Shareholders' funds.

The total of the Debt to Capital Employed Ratio and the Proprietary Ratio, when both are computed on capital employed (net assets) rather than total assets, equals 1.

Plot the two ratios as adjacent segments of a single bar of length 1, one axis showing the proportion funded by debt and the other by owners' funds; the bar demonstrates that the two ratios together always sum to 1, so a low debt-funded segment means a high owner-funded segment and vice versa.

What is Return on Shareholders' Funds?

Return on Shareholders' Funds (RONW) = Profit after Tax ÷ Shareholders' Funds × 100.

What is the Total Assets to Debt Ratio?

The Total Assets to Debt Ratio measures the extent of the coverage of long-term debts by assets: Total Assets to Debt Ratio = Total Assets ÷ Long-term Debts.

A higher ratio indicates that assets have been mainly financed by owners' funds and that the long-term loan is adequately covered by assets. It is better to take net assets (capital employed) instead of total assets for computing this ratio also; in that case the ratio is the reciprocal of the Debt to Capital Employed Ratio.

This ratio primarily indicates the rate of external funds in financing the assets and the extent to which debts are covered by assets.

What is the Fixed Assets Turnover Ratio?

The Fixed Assets Turnover Ratio = Net Revenue from Operations ÷ Net Fixed Assets. It is one of the two turnover ratios into which the capital employed turnover ratio is analysed, the other being the Working Capital Turnover Ratio.

A high turnover of fixed assets is a good sign and implies efficient utilisation of resources, resulting in higher liquidity and profitability in the business.

Glossary

• Ratio Analysis: a technique of financial statement analysis that studies the relationship between two or more accounting numbers.
• Liquidity Ratios: ratios measuring the firm's ability to meet its short-term obligations as they become due.
• Solvency Ratios: ratios measuring the firm's ability to meet its long-term obligations to outsiders.
• Activity Ratios: ratios measuring the efficiency with which the firm's resources are utilised; also called turnover or efficiency ratios.
• Profitability Ratios: ratios measuring the earning capacity of the business in relation to revenue from operations or funds employed.
• Current Assets: current investments, inventories, trade receivables, cash and bank balance, short-term loans and advances, and other current assets.
• Current Liabilities: short-term borrowings, trade payables, other current liabilities and short-term provisions.
• Quick Assets: current assets excluding inventories and prepaid expenses and advance tax, being readily convertible into cash.
• Shareholders' Funds: share capital plus reserves and surplus, representing owners' equity in the business.
• Capital Employed: long-term funds employed in the business, comprising shareholders' funds and non-current liabilities, less non-trade investments.
• Working Capital: current assets minus current liabilities, representing funds available for day-to-day operations.
• Trading on Equity: using borrowed funds to earn a return for owners higher than the interest rate paid on that debt.
• Average Collection Period: the time taken to convert trade receivables into cash, computed by days in the year divided by the receivables turnover ratio.
• Inter-firm Comparison: comparing ratios of a firm with those of other business enterprises, also called cross-sectional analysis.
• Intra-firm Comparison: comparing a firm's ratios over a number of its own accounting periods, also called time series analysis.

Common errors and misconceptions

• Misconception: The current ratio should always be as high as possible. Correct: a very high current ratio implies heavy, under-utilised investment in current assets; normally it is considered safe within the range of 2:1.
• Misconception: Trade receivables are taken net of the provision for doubtful debts when computing the Trade Receivables Turnover Ratio. Correct: debtors are taken before making any provision for doubtful debts, whereas the Current Ratio includes net debtors.
• Misconception: Quick assets include inventories because inventories are a current asset. Correct: quick assets exclude inventories and items such as prepaid expenses and advance tax, as these are not quickly convertible into cash.
• Misconception: A higher inventory turnover ratio is always a sign of better performance. Correct: a high turnover is good but must be carefully interpreted, as it may be due to buying in small lots or selling quickly at a low margin.
• Misconception: Debt in the Debt-Equity Ratio includes all liabilities. Correct: debt here comprises only long-term borrowings and long-term provisions, not current liabilities.
• Misconception: Ratios alone provide a complete solution to a business problem. Correct: ratios are a means and not an end; their role is essentially indicative and of whistle-blowing.
• Misconception: Ratio analysis can be used without regard to the accounting policies underlying the financial statements. Correct: variations in accounting practices for inventory valuation, depreciation and similar items limit the validity of comparing ratios across firms.

Exam-style questions with model answers

Q1. State the formula for the Operating Profit Ratio and state any two items of non-operating expenses. [2 marks]

1. Operating Profit Ratio = Net Operating Profit ÷ Revenue from Operations × 100, or 100 minus the Operating Ratio.
2. Non-operating expenses include finance cost (interest on long-term borrowings) and loss on sale of non-current assets.

Q2. Define Operating Income and give two examples. [2 marks]

1. Operating income is income earned in the ordinary course of operations, deducted while computing the Operating Ratio in its alternative form.
2. Examples are commission received and cash discount received.

Q3. From the following information, calculate the Gross Profit Ratio and the Operating Ratio: Revenue from Operations ₹3,40,000; Cost of Revenue from Operations ₹1,20,000; Selling expenses ₹80,000; Administrative expenses ₹40,000. [4 marks]

1. Gross Profit = Revenue from Operations − Cost of Revenue from Operations = ₹3,40,000 − ₹1,20,000 = ₹2,20,000.
2. Gross Profit Ratio = ₹2,20,000 ÷ ₹3,40,000 × 100 = 64.71%.
3. Operating Cost = Cost of Revenue from Operations + Selling expenses + Administrative expenses = ₹1,20,000 + ₹80,000 + ₹40,000 = ₹2,40,000.
4. Operating Ratio = ₹2,40,000 ÷ ₹3,40,000 × 100 = 70.59%.

Q4. A company has Share Capital ₹4,00,000 and Reserves and Surplus ₹1,00,000. It has 13% Debentures of ₹1,50,000 and Current Liabilities of ₹50,000. Calculate the Debt-Equity Ratio and comment briefly on what it shows. [4 marks]

1. Debt = Long-term borrowings (13% Debentures) = ₹1,50,000.
2. Equity (Shareholders' Funds) = Share Capital + Reserves and Surplus = ₹4,00,000 + ₹1,00,000 = ₹5,00,000.
3. Debt-Equity Ratio = Debt ÷ Equity = ₹1,50,000 ÷ ₹5,00,000 = 0.3:1.
4. Since the ratio is well below the commonly used benchmark of 2:1, the capital structure has more equity than debt, which is favourable from a long-term lender's point of view as it reduces the chances of bankruptcy.

Q5. From the following information, calculate (i) Current Ratio, (ii) Liquid Ratio, (iii) Debt-Equity Ratio, and (iv) Interest Coverage Ratio: Inventory ₹1,00,000; Total Current Assets ₹1,60,000; Shareholders' Funds ₹4,00,000; 13% Debentures ₹3,00,000; Current Liabilities ₹1,00,000; Net Profit before Tax ₹3,51,000. [6 marks]

1. Current Ratio = Current Assets ÷ Current Liabilities = ₹1,60,000 ÷ ₹1,00,000 = 1.6:1.
2. Liquid Assets = Current Assets − Inventory = ₹1,60,000 − ₹1,00,000 = ₹60,000.
3. Liquid Ratio = Liquid Assets ÷ Current Liabilities = ₹60,000 ÷ ₹1,00,000 = 0.6:1.
4. Debt-Equity Ratio = Long-term Debts ÷ Shareholders' Funds = ₹3,00,000 ÷ ₹4,00,000 = 0.75:1.
5. Interest on 13% Debentures = 13% of ₹3,00,000 = ₹39,000. Net Profit before Interest and Tax = Net Profit before Tax + Interest = ₹3,51,000 + ₹39,000 = ₹3,90,000.
6. Interest Coverage Ratio = Net Profit before Interest and Tax ÷ Interest on Long-term Debt = ₹3,90,000 ÷ ₹39,000 = 10 times.

Q6. Explain five limitations of ratio analysis that arise from the limitations of the ratios themselves (not from the financial statements). [5 marks]

1. Ratios are a means and not the end in themselves; they are only indicative devices.
2. They lack the ability to resolve problems; their role is essentially indicative and of whistle-blowing, not of providing a solution.
3. There is a lack of standardised definitions of concepts used in ratio analysis, for example, there is no standard definition of liquid liabilities.
4. There is no universally accepted standard or ideal level for any ratio, and in India industry averages are also not always available.
5. A ratio calculated from unrelated figures, such as creditors and furniture, is a meaningless exercise and has no relevance to assessing efficiency or solvency.

Q7. From the following information, calculate the Trade Receivables Turnover Ratio and the Average Collection Period: Revenue from Operations ₹8,75,000; Trade debtors ₹59,000; Bills receivable ₹48,000. Opening balances of debtors and bills receivable are not available. [3 marks]

1. Average Trade Receivables = ₹59,000 + ₹48,000 = ₹1,07,000, taken as it is because opening figures are not available.
2. Trade Receivables Turnover Ratio = Net Credit Revenue from Operations ÷ Average Trade Receivables = ₹8,75,000 ÷ ₹1,07,000 = 8.18 times.
3. Average Collection Period = 365 ÷ Trade Receivables Turnover Ratio = 365 ÷ 8.18 = 45 days.

Q8. The current ratio of a company is 2.5:1, its current assets are ₹50,000 and its current liabilities are ₹20,000. Calculate how much the current assets must decline to bring the ratio to 2:1. [3 marks]

1. For a ratio of 2:1 with current liabilities of ₹20,000, the current assets must be 2 × ₹20,000 = ₹40,000.
2. The present level of current assets is ₹50,000.
3. Necessary decline = ₹50,000 − ₹40,000 = ₹10,000.

Q9. The debt-equity ratio of a company is 0.5:1, with external funds of ₹5,00,000 and internal funds of ₹10,00,000. Evaluate the effect of (i) a further issue of equity shares of ₹1,00,000 and (ii) the redemption of debentures of ₹1,00,000 on the ratio. [5 marks]

1. The original ratio is ₹5,00,000 ÷ ₹10,00,000 = 0.5:1.
2. A further issue of equity shares of ₹1,00,000 raises internal funds to ₹11,00,000, so the new ratio is ₹5,00,000 ÷ ₹11,00,000 = 0.45:1; the ratio decreases.
3. Redemption of debentures of ₹1,00,000 lowers long-term debt to ₹4,00,000, so the new ratio is ₹4,00,000 ÷ ₹10,00,000 = 0.4:1; the ratio decreases.
4. Both transactions reduce the proportion of debt in the capital structure, which gives more security to long-term lenders.
5. Cash received from debtors or purchase of goods on credit would leave the ratio unchanged, because neither affects long-term debt or shareholders' funds.

Key takeaways

• Ratio analysis studies the relationship between accounting numbers to assess liquidity, solvency, activity and profitability.
• Current Ratio = Current Assets ÷ Current Liabilities; normally considered safe within the range of 2:1.
• Quick Ratio excludes inventory and items such as prepaid expenses and advance tax from current assets; 1:1 is usually considered safe.
• Debt-Equity Ratio = Long-term Debt ÷ Equity; a lower ratio generally means more security for lenders.
• Gross Profit = Revenue from Operations − Cost of Revenue from Operations, and Net Profit = Gross Profit + Other Income − Indirect Expenses − Provision for Tax.
• Activity ratios, such as inventory and receivables turnover, measure how efficiently assets are converted into revenue from operations.
• Gross Profit Ratio, Net Profit Ratio and Operating Ratio each study profitability in relation to revenue from operations.
• Return on Investment compares profit before interest and tax with capital employed, while Earnings per Share and Price Earning Ratio relate profit and market price to the equity share.
• Ratios are a means, not an end; they are affected by the limitations of the underlying financial statements and by a lack of standardised definitions.

Test yourself

What two figures are compared to calculate the Current Ratio?

Current assets and current liabilities; Current Ratio = Current Assets ÷ Current Liabilities.

Why is the Quick Ratio considered a better measure of liquidity than the Current Ratio?

It excludes inventory and other non-liquid current assets such as prepaid expenses and advance tax, leaving only assets that are quickly convertible into cash.

What does a low Debt-Equity Ratio indicate to a long-term lender?

It indicates that the business relies more on owners' funds than on borrowed funds, giving the lender more security and reducing the chance of bankruptcy.

How is Average Trade Receivables calculated?

(Opening Debtors and Bills Receivable + Closing Debtors and Bills Receivable) ÷ 2; debtors are taken before any provision for doubtful debts.

What does a high Inventory Turnover Ratio always mean?

It is generally good but must be interpreted carefully, as it can arise from buying in small lots or selling quickly at a low margin.

How is the Operating Profit Ratio related to the Operating Ratio?

Operating Profit Ratio = 100 minus the Operating Ratio; it can also be calculated as Net Operating Profit ÷ Revenue from Operations × 100.

Name one limitation of ratio analysis that arises from the nature of financial statements.

Any one of: accounting data give an impression of precision that is not warranted; price-level changes are ignored; qualitative aspects are ignored; accounting practices vary between firms.