Chapter 5 Accounting Ratios Notes

Accounting Ratios

NCERT Solutions for Class 12 Chapter 5 Accounting Ratios

Meaning of Accounting Ratios

Accounting ratios are an important tool for financial statement analysis. A ratio is a mathematical number calculated as a reference to the relationship between two or more numbers. It can be expressed as a fraction, proportion, percentage, or number of times. When the number is calculated by referring to two accounting numbers derived from financial statements, it is termed as an accounting ratio.

Objectives of Ratio Analysis

• To identify areas of the business that need more attention
• To highlight potential areas for improvement
• To provide deeper analysis of profitability, liquidity, solvency, and efficiency
• To facilitate cross-sectional analysis by comparing performance with industry standards
• To assist in making future projections and estimates

Advantages of Ratio Analysis

• Helps understand the efficacy of business decisions
• Simplifies complex figures and establishes relationships
• Assists in comparative analysis over different periods
• Identifies problem areas and highlights bright spots in business
• Enables SWOT analysis by explaining changes in the business environment
• Facilitates various types of comparisons (intra-firm, inter-firm, and industry benchmarks)

Limitations of Ratio Analysis

• Depends on the accuracy of accounting data, which may reflect personal judgments and accounting conventions
• Ignores price-level changes, affecting the comparability over different periods
• Focuses on quantitative aspects, ignoring qualitative factors
• Variations in accounting practices may hinder valid cross-sectional analysis
• Forecasting based solely on historical analysis is not feasible
• Ratios are means to an end and may not provide solutions to problems
• Lack of standard definitions and universally accepted standards for ideal ratios
• Ratios based on unrelated figures can be meaningless

Types of Ratios

There are two main classifications of ratios: traditional classification and functional classification. The traditional classification is based on the financial statements to which the determinants of ratios belong. On this basis, ratios are classified as follows:

Traditional Classification

1. Statement of Profit and Loss Ratios

A ratio of two variables from the statement of profit and loss is known as a statement of profit and loss ratio. For example, the ratio of gross profit to revenue from operations is known as the gross profit ratio. It is calculated using both figures from the statement of profit and loss.

2. Balance Sheet Ratios

If both variables are from the balance sheet, it is classified as a balance sheet ratio. For example, the ratio of current assets to current liabilities is known as the current ratio. It is calculated using both figures from the balance sheet.

3. Composite Ratios

If a ratio is computed with one variable from the statement of profit and loss and another variable from the balance sheet, it is called a composite ratio. For example, the ratio of credit revenue from operations to trade receivables (known as the trade receivables turnover ratio) is calculated using one figure from the statement of profit and loss (credit revenue from operations) and another figure (trade receivables) from the balance sheet.

Although accounting ratios are calculated by taking data from financial statements, classification of ratios on the basis of financial statements is rarely used in practice. The basic purpose of accounting is to throw light on the financial performance (profitability), financial position (capacity to raise money and invest wisely), and changes occurring in financial position (possible explanation of changes in the activity level). Therefore, the alternative classification, based on the purpose for which a ratio is computed, is the most commonly used classification.

Functional Classification

1. Liquidity Ratios

To meet its commitments, a business needs liquid funds. The ability of the business to pay the amount due to stakeholders as and when it is due is known as liquidity, and the ratios calculated to measure it are known as 'Liquidity Ratios'. These are essentially short-term in nature.

2. Solvency Ratios

The solvency of a business is determined by its ability to meet its contractual obligations towards stakeholders, particularly towards external stakeholders. The ratios calculated to measure solvency position are known as 'Solvency Ratios'. These are essentially long-term in nature.

3. Activity (or Turnover) Ratios

These ratios are calculated to measure the efficiency of operations of a business based on effective utilisation of resources. Hence, they are also known as 'Efficiency Ratios'.

4. Profitability Ratios

These ratios are calculated to analyse the earning capacity of the business, which is the outcome of utilisation of resources employed in the business. The ratios include Gross Profit Ratio, Operating Ratio, Net Profit Ratio, Return on Investment (Capital Employed), Earnings per Share, Book Value per Share, Dividend per Share, and Price/Earning Ratio.

Liquidity Ratios

Liquidity ratios are calculated to measure the short-term solvency of a business, i.e., the firm's ability to meet its current obligations. These are analysed by looking at the amounts of current assets and current liabilities in the balance sheet.

The two main liquidity ratios are the Current Ratio and the Liquidity Ratio (Quick Ratio).

Current Ratio

The Current Ratio is the proportion of current assets to current liabilities. It indicates the ability of a business to pay its current liabilities with its current assets.

Current assets include current investments, inventories, trade receivables (debtors and bills receivables), 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 (creditors and bills payables), other current liabilities, and short-term provisions.

Liquidity Ratio (Quick Ratio)

The Liquidity Ratio, also known as the Quick Ratio, is a measure of the ability of a company to use its near cash or quick assets to extinguish or retire its current liabilities immediately.

This ratio provides a more stringent test of liquidity than the Current Ratio because it excludes inventories from current assets.

Solvency Ratios

Solvency ratios are financial metrics used to evaluate a company's ability to meet its long-term debt obligations. These ratios provide insight into the financial stability and health of a business by measuring the proportion of debt in the company's capital structure. Key solvency ratios include the Debt-Equity Ratio and the Debt to Capital Employed Ratio.

Debt-Equity Ratio

The Debt-Equity Ratio measures the relationship between long-term debt and shareholders' equity. It is a crucial indicator of financial leverage and risk. A lower ratio indicates greater security for creditors, while a higher ratio can suggest higher risk but potential for higher returns for shareholders if the company's earnings exceed the cost of debt.

Definition:

The Debt-Equity Ratio is calculated as follows:

Debt-Equity Ratio = Long-term Debts / Shareholders’ Funds

Formula:

Where:

• Long-term Debts: The total amount of long-term borrowings.
• Shareholders’ Funds: The sum of share capital, reserves and surplus, money received against share warrants, and share application money pending allotment.

Shareholders’ Funds (Equity) = Share capital + Reserves and Surplus + Money received against share warrants + Share application money pending allotment

Debt to Capital Employed Ratio

The Debt to Capital Employed Ratio indicates the proportion of long-term debt in relation to the total capital employed (both external and internal funds). This ratio helps assess the financial leverage and stability of a company.

Definition:

The Debt to Capital Employed Ratio is calculated as follows:

Debt to Capital Employed Ratio = Long-term Debt / Capital Employed (or Net Assets)

Formula:

Where:

• Long-term Debt: The total amount of long-term borrowings.
• Capital Employed: The sum of long-term debt and shareholders’ funds, or alternatively, net assets (total assets minus current liabilities).

Capital Employed = Long-term Debt + Shareholders’ Funds
Net Assets = Total Assets - Current Liabilities

Significance:

Both ratios are significant for understanding the financial structure and risk profile of a company. A low Debt to Capital Employed Ratio indicates a higher proportion of equity financing, providing greater security to lenders. A higher ratio may suggest higher risk but also potential benefits from financial leverage if managed effectively.

Financial Ratios

Trade Receivables Turnover Ratio

Definition: This ratio expresses the relationship between credit revenue from operations and trade receivables. It indicates how efficiently a company collects revenue from its credit sales.

Formula:
Trade Receivables Turnover Ratio = Net Credit Revenue from Operations / Average Trade Receivable
Where,
Average Trade Receivable = (Opening Debtors and Bills Receivable + Closing Debtors and Bills Receivable) / 2

Significance: A higher turnover ratio indicates faster collection of trade receivables, which contributes to a better liquidity position of the firm.

Trade Payables Turnover Ratio

Definition: This ratio indicates the pattern of payment of trade payables. It expresses the relationship between credit purchases and trade payables.

Formula:
Trade Payables Turnover Ratio = Net Credit Purchases / Average Trade Payable
Where,
Average Trade Payable = (Opening Creditors and Bills Payable + Closing Creditors and Bills Payable) / 2

Significance: This ratio reveals the average payment period. A lower ratio may indicate that the company is delaying payments to suppliers, which could affect its reputation.

Net Assets or Capital Employed Turnover Ratio

Definition: This ratio reflects the relationship between revenue from operations and net assets (capital employed) in the business. It measures how efficiently the company is using its net assets to generate revenue.

Formula:
Net Assets or Capital Employed Turnover Ratio = Revenue from Operations / Capital Employed

Significance: Higher turnover indicates better activity and profitability, implying efficient utilization of resources.

Profitability Ratios