Accounting Ratios

Introduction

The chapter 'Accounting Ratios' introduces ratio analysis as a fundamental and powerful tool for analyzing and interpreting the financial statements of a business. Financial statements such as the Balance Sheet and Profit & Loss Account provide a wealth of data about a company's financial position and performance. However, these statements in their raw form can be difficult to interpret and compare. Ratio analysis simplifies this data by expressing relationships between different financial statement items in the form of ratios. These ratios help stakeholders like management, investors, creditors, and analysts to assess the financial health, operational efficiency, and profitability of the business. By comparing ratios over different accounting periods or with other firms, one can identify trends, strengths, weaknesses, and areas needing improvement. This chapter lays the foundation for understanding various types of accounting ratios, their computation, interpretation, and limitations. **Table on page 5 (8 rows × 2 cols)** | NA Test your Understanding - I | | | --- | --- | | 1. State which of the following statements are True or False. | | | (a) | The only purpose of financial reporting is to keep the managers informed about the progress of operations. | | (b) | Analysis of data provided in the financial statements is termed as financial analysis. | | (c) | Long-term borrowings are concerned about the ability of a firm to discharge its obligations to pay interest and repay the principal amount. | | (d) (e) | A ratio is always expressed as a quotient of one number divided by another. | | | Ratios help in comparisons of a firm's results over a number of accounting periods as well as with other business enterprises. | | (f) | A ratio reflects quantitative and qualitative aspects of results. | **Table on page 14 (5 rows × 2 cols)** | Notes to Accounts | | | --- | --- | | 1. Share Capital | (Rs.) | | Equity Share Capital | 6,00,000 | | Preference Share Capital | 2.00,000 | | | 8,00,000 | **Table on page 15 (8 rows × 2 cols)** | | (Rs.) | | --- | --- | | 2. Tangible Assets: | | | Plant and Machinery | 5,00,000 | | Land and Building | 4,00,000 | | Motor Car | 1,50,000 | | Furniture | 50,000 | | | 11,00,000 | | | | **Table on page 17 (15 rows × 3 cols)** | Particulars | Note No. | (Rs.) | | --- | --- | --- | | I. Equity and Liabilities: 1. Shareholders' funds | | | | | | | | a) Share capital | | 4,00,000 | | b) Reserves and surplus | | 1,00,000 | | 2. Non-current Liabilities | | | | Long-term borrowings | | 1,50,000 | | 3. Current Liabilities | | 50,000 | | | | 7,00,000 | | II. Assets | | | | 1. Non-current Assets | | | | a) Fixed assets | | 4,00,000 | | b) Non-current investments | | 1,00,000 | | 2. Current Assets | | 2,00,000 | | ICERT | | 7,00,000 | **Table on page 22 (4 rows × 3 cols)** | Information | | Rs. | | --- | --- | --- | | Revenue from operations | = | 4,00,000 | | Average Inventory | = | 55,000 | | Gross Profit Ratio | = | 10% | **Table on page 23 (10 rows × 2 cols)** | Do it Yourself | | | --- | --- | | 1. Calculate the amount of gross profit: | | | Average inventory = | Rs. 80,000 | | Inventory turnover ratio = | 6 times | | Selling price = | 25% above cost | | 2. Calculate Inventory Turnover Ratio: | | | Annual Revenue from operations = | Rs. 2,00,000 | | Gross Profit = | 20% on cost of Revenue from operations | | Inventory in the beginning = | Rs. 38,500 | | Inventory at the end = | Rs. 41,500 | **Table on page 28 (11 rows × 4 cols)** | | Amount (Rs.) | | Amount (Rs.) | | --- | --- | --- | --- | | Preference shares capital | 4,00,000 | Plant and Machinery | 8,00,000 | | Equity share capital | 6,00,000 | Land and Building | 5,00,000 | | General reserve | 1,00,000 | Motor Car | 2,00,000 | | Balance in Statement of Profit and | 3,00,000 | Furniture | 1,00,000 | | Loss | | | | | 15% debentures | 2,00,000 | Inventory | 1,80,000 | | 14% Loan | 2,00,000 | Debtors | 1,10,000 | | Creditors | 1,40,000 | Bank | 80,000 | | Bills payable | 50,000 | Cash | 30,000 | | Outstanding expenses | 10,000 | | | **Table on page 29 (35 rows × 3 cols)** | | | Test your Understanding - III | | --- | --- | --- | | (i) | The | is useful in evaluating credit and collection policies. | | | A. | average payment period | | | B. | current ratio | | | C. | average collection period | | | D. | current asset turnover | | (ii) | The | measures the activity of a firm's inventory. | | | A. | average collection period | | | B. | inventory turnover | | | C. | liquid ratio | | | D. | current ratio | | (iii) | The | may indicate that the firm is experiencing stockouts and lost | | | sales. | | | | A. | average payment period | | | B. | inventory turnover ratio | | | C. | average collection period | | | D. | quick ratio | | (iv) | ABC Co. extends credit terms of 45 days to its customers. Its credit collection | | | | would be considered poor if its average collection period was. | | | | A. | 30 days | | | B. | 36 days | | | C. | 47 days | | | D. | 37 days | | (v) | | are especially interested in the average payment period, since it | | | provides them with a sense of the bill-paying patterns of the firm. | | | | A. | Customers :unselected: | | | B. | Stockholders | | | C. | Lenders and suppliers | | | D. | Borrowers and buyers | | (vi) | The | ratios provide the information critical to the long run operation | | | of the firm | | | | A. | liquidity | | | B. | activity | | | C. | solvency | | | D. | profitability | **Table on page 31 (4 rows × 2 cols)** | Salaries | 25,000 | | --- | --- | | Decrease in Inventory | 10,000 | | Return Outwards | 2,000 | | Wages | 5,000 | **Table on page 35 (4 rows × 4 cols)** | Share Capital : Equity (Rs.10) | Rs. 4,00,000 | Current Liabilities | Rs. 1,00,000 | | --- | --- | --- | --- | | 12% Preference | Rs. 1,00,000 | Fixed Assets | Rs. 9,50,000 | | General Reserve | Rs. 1,84,000 | Current Assets | Rs. 2,34,000 | | 10% Debentures | Rs. 4,00,000 | | | **Table on page 37 (8 rows × 2 cols)** | Particulars | (Rs.) | | --- | --- | | Inventory | 1,00,000 | | Total Current Assets :unselected: | 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 | | Cost of revenue from operations | 5,00,000 | **Table on page 39 (5 rows × 2 cols)** | Particulars | (Rs.) | | --- | --- | | 70,000 equity shares of Rs. 10 each | 7,00,000 | | Net Profit after tax but before dividend | 1,75,000 | | Market price of a share | 13 | | Dividend declared @ 15% | | **Table on page 40 (7 rows × 4 cols)** | 1. | Ratio Analysis | 8. | Shareholders' Funds (Equity) | | --- | --- | --- | --- | | 2. | Liquidity Ratios | 9. | Return on Net Worth | | 3. | Solvency Ratios | 10. | Average Collection Period | | 4. | Activity Ratios | 11. | Trade Receivables | | 5. | Profitability Ratios | 12 | Turnover Ratios | | 6. | Return on Investment (ROI) | 13 | Efficiency Ratios | | 7. | Quick Assets | 14 | Dividend Payout | **Table on page 42 (17 rows × 2 cols)** | Particulars | (Rs.) | | --- | --- | | I. Equity and Liabilities: | | | 1. Shareholders' funds | | | a) Share capital | 7,90,000 | | b) Reserves and surplus | 35,000 | | 2. Current Liabilities | | | Trade Payables | 72,000 | | Total | 8,97,000 | | II. Assets | | | 1. Non-current Assets | | | Fixed assets | | | - Tangible assets | 7,53,000 | | 2. Current Assets | | | a) Inventories | 55,800 | | b) Trade Receivables | 28,800 | | c) Cash and cash equivalents | 59,400 | | Total | 8,97,000 | **Table on page 42 (22 rows × 2 cols)** | Particulars | Amount (Rs.) | | --- | --- | | I. Equity and Liabilities | | | 1. Shareholders' funds | | | a) Share capital | 24,00,000 | | b) Reserves and surplus | 6,00,000 | | 2. Non-current liabilities | | | Long-term borrowings | 9,00,000 | | 3. Current liabilities | | | a) Short-term borrowings | 6,00,000 | | b) Trade payables | 23,40,000 | | c) Short-term provisions :unselected: | 60,000 | | Total | 69,00,000 | | II. Assets | | | 1. Non-current assets :unselected: | | | Fixed assets | | | - Tangible assets | 45,00,000 | | 2. Current Assets | | | a) Inventories | 12,00,000 | | b) Trade receivables | 9,00,000 | | c) Cash and cash equivalents | 2,28,000 | | d) Short-term loans and advances | 72,000 | | Total | 69,00,000 | **Table on page 44 (5 rows × 2 cols)** | Inventory in the beginning of the year | Rs. 10,000 | | --- | --- | | Inventory at the end of the year | Rs. 5,000 | | Carriage | Rs. 2,500 | | Revenue from Operations | Rs. 50,000 | | Purchases | Rs. 25,000 | **Table on page 45 (7 rows × 3 cols)** | | 2015-16 | 2016-17 | | --- | --- | --- | | Trade receivables on Apr. 01 | Rs. 4,00,000 | Rs. 5,00,000 | | Trade receivables on Mar. 31 | | Rs. 5,60,000 | | Stock in trade on Mar. 31 | Rs. 6,00,000 | Rs. 9,00,000 | | Revenue from operations | Rs. 3,00,000 | Rs. 24,00,000 | | (gross profit is 25% on cost of | | | | Revenue from operations) | | | **Table on page 45 (19 rows × 3 cols)** | Particulars | Note No. | (Rs.) | | --- | --- | --- | | I. Equity and Liabilities: | | | | 1. Shareholders' funds | | | | a) Share capital | | 10,00,000 | | b) Reserves and surplus | | 7,00,000 | | c) Money received against share warrants | | 2,00,000 | | 2. Non-current Liabilities Long-term borrowings | | 12,00,000 | | 3. Current Liabilities | | | | Trade payables | | 5,00,000 | | Total | | 36,00,000 | | II. Assets | | | | 1. Non-current Assets | | | | Fixed assets | | | | - Tangible assets | | 18,00,000 | | 2. Current Assets | | | | a) Inventories | | 4,00,000 | | b) Trade Receivables | | 9,00,000 | | c) Cash and cash equivalents | | 5,00,000 | | Total | | 36,00,000 | **Table on page 46 (15 rows × 2 cols)** | Return on investment | Rs. | | --- | --- | | Inventory in the beginning | 50,000 | | Inventory at the end | 60,000 | | Net Profit | 2,17,900 | | 10% Debentures | 2,50,000 | | Revenue from operations | 4,00,000 | | Gross Profit | 1,94,000 | | Cash and Cash Equivalents | 40,000 | | Money received against share warrants | 20,000 | | Trade Receivables | 1,00,000 | | Trade Payables | 1,90,000 | | Other Current Liabilities | 70,000 | | Share Capital | 2,00,000 | | Reserves and Surplus | | | (Balance in the Statement of Profit & Loss) | 0 |

• Ratio analysis is a technique to analyze financial statements using ratios.
• It helps in understanding financial position and performance clearly.
• Ratios enable comparison over time and between different businesses.
• Financial statements alone may not reveal meaningful insights without ratios.
• Ratio analysis is useful for internal management and external stakeholders.
• It simplifies complex financial data into understandable metrics.
• 📌 Ratio Analysis: Systematic use of ratios to interpret financial statements.
• 📌 Financial Statements: Reports like Balance Sheet and Profit & Loss Account showing financial data.

Objectives of Ratio Analysis

The primary objective of ratio analysis is to provide meaningful information about the financial position and performance of a business. It aims to assess various aspects such as operational efficiency, liquidity, solvency, profitability, and financial stability. By analyzing ratios, management can make informed decisions regarding resource allocation, cost control, and strategic planning. Investors use ratios to evaluate the return on their investments and the risk involved. Creditors assess the firm's ability to repay debts on time. Additionally, ratio analysis helps in identifying trends over different accounting periods and benchmarking against industry standards or competitors. It also aids in detecting early warning signals of financial distress or inefficiency, enabling corrective measures. Overall, ratio analysis serves as a diagnostic tool to evaluate the financial health and guide future actions. **Table on page 5 (8 rows × 2 cols)** | NA Test your Understanding - I | | | --- | --- | | 1. State which of the following statements are True or False. | | | (a) | The only purpose of financial reporting is to keep the managers informed about the progress of operations. | | (b) | Analysis of data provided in the financial statements is termed as financial analysis. | | (c) | Long-term borrowings are concerned about the ability of a firm to discharge its obligations to pay interest and repay the principal amount. | | (d) (e) | A ratio is always expressed as a quotient of one number divided by another. | | | Ratios help in comparisons of a firm's results over a number of accounting periods as well as with other business enterprises. | | (f) | A ratio reflects quantitative and qualitative aspects of results. |

• To evaluate financial position and performance of a business.
• To assess liquidity, solvency, profitability, and operational efficiency.
• To assist management in decision-making and planning.
• To help investors and creditors assess risk and returns.
• To identify trends and benchmark against industry standards.
• To detect financial strengths and weaknesses early.
• 📌 Liquidity: Ability to meet short-term obligations.
• 📌 Solvency: Ability to meet long-term debts and financial stability.