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Accounting Ratios

NCERT Class 12 · Accountancy Based on NCERT Class 12 Accountancy textbook · Free CBSE study kit

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Chapter Notes

Overview
This chapter introduces accounting ratios as a key tool for financial statement analysis, enabling users to assess a firm's liquidity, solvency, efficiency, and profitability. It explains the meaning, objectives, advantages, and limitations of ratio analysis, and provides detailed formulas and interpretations for various ratios. The one big idea a student must walk away with is that ratios are not ends in themselves but means to an end—they simplify complex financial data to reveal relationships, trends, and problem areas, but must be interpreted with an understanding of their limitations.
Key Concepts (18)
Accounting Ratio
A ratio calculated by referring to two accounting numbers derived from the financial statements, expressed as a fraction, proportion, percentage, or number of times.
e.g. Gross profit of Rs. 10,000 and Revenue from Operations of Rs. 1,00,000 gives a Gross Profit Ratio of 10%.
Ratio Analysis
A technique of financial statement analysis involving regrouping of data by application of arithmetical relationships to interpret the financial health of a business.
e.g. Using current ratio to check if a company can pay its short-term debts.
Liquidity Ratios
Ratios calculated to measure the short-term solvency of the business, i.e., the firm's ability to meet its current obligations.
e.g. Current Ratio and Quick Ratio.
Solvency Ratios
Ratios calculated to determine the ability of the business to service its debt in the long run, i.e., meet contractual obligations towards external stakeholders.
e.g. Debt-Equity Ratio and Interest Coverage Ratio.
Activity (or Turnover) Ratios
Ratios calculated for measuring the efficiency of operations of business based on effective utilisation of resources, also known as Efficiency Ratios.
e.g. Inventory Turnover Ratio and Trade Receivables Turnover Ratio.
Profitability Ratios
Ratios calculated to analyse the earning capacity of the business, i.e., profits in relation to revenue from operations or funds employed.
e.g. Gross Profit Ratio and Net Profit Ratio.
Current Ratio
The proportion of current assets to current liabilities, expressed as Current Assets : Current Liabilities.
e.g. Current Assets Rs. 1,34,000 and Current Liabilities Rs. 1,04,000 gives a Current Ratio of 1.29:1.
Quick (or Liquid) Ratio
The ratio of quick (or liquid) assets to current liabilities, also known as Acid-Test Ratio.
e.g. Quick Assets Rs. 80,000 and Current Liabilities Rs. 1,04,000 gives a Quick Ratio of 0.77:1.
Debt-Equity Ratio
The ratio measuring the relationship between long-term debt and shareholders' funds (equity).
e.g. Long-term Debts Rs. 5,00,000 and Equity Rs. 15,00,000 gives a Debt-Equity Ratio of 0.33:1.
Interest Coverage Ratio
A ratio that deals with the servicing of interest on loan, measuring the security of interest payable on long-term debts.
e.g. Net Profit before Interest and Tax Rs. 2,50,000 and Interest on long-term debt Rs. 1,50,000 gives an Interest Coverage Ratio of 1.67 times.
Inventory Turnover Ratio
The ratio that determines the number of times inventory is converted into revenue from operations during an accounting period.
e.g. Cost of Revenue from Operations Rs. 60,000 and Average Inventory Rs. 20,000 gives an Inventory Turnover Ratio of 3 times.
Trade Receivables Turnover Ratio
The ratio expressing the relationship between net credit revenue from operations and average trade receivables.
e.g. Net Credit Revenue from Operations Rs. 3,20,000 and Average Trade Receivables Rs. 80,000 gives a ratio of 4 times.
Trade Payables Turnover Ratio
The ratio indicating the pattern of payment of trade payables, expressing relationship between net credit purchases and average trade payables.
e.g. Net Credit Purchases Rs. 12,00,000 and Average Trade Payables Rs. 3,00,000 gives a ratio of 4 times.
Proprietary Ratio
The ratio expressing the relationship of shareholders' funds to net assets (capital employed).
e.g. Shareholders' Funds Rs. 15,00,000 and Capital Employed Rs. 20,00,000 gives a Proprietary Ratio of 0.75:1.
Total Assets to Debt Ratio
The ratio measuring the extent of coverage of long-term debts by total assets.
e.g. Total Assets Rs. 14,00,000 and Long-term Debts Rs. 1,50,000 gives a ratio of 9.33:1.
Working Capital Turnover Ratio
The ratio calculated as Net Revenue from Operations divided by Working Capital.
e.g. Revenue from Operations Rs. 30,00,000 and Working Capital Rs. 2,00,000 gives a ratio of 15 times.
Fixed Assets Turnover Ratio
The ratio calculated as Net Revenue from Operations divided by Net Fixed Assets.
e.g. Revenue from Operations Rs. 30,00,000 and Net Fixed Assets Rs. 16,00,000 gives a ratio of 1.88 times.
Capital Employed Turnover Ratio
The ratio reflecting the relationship between revenue from operations and capital employed (net assets).
e.g. Revenue from Operations Rs. 30,00,000 and Capital Employed Rs. 18,00,000 gives a ratio of 1.67 times.
Formulas & Equations (13)
Current Ratio = Current Assets / Current Liabilities
Reads as: Current Ratio equals Current Assets divided by Current Liabilities
Variables: Current Assets: includes current investments, inventories, trade receivables, cash and cash equivalents, short-term loans and advances, prepaid expenses, advance tax, accrued income (Rs.). Current Liabilities: includes short-term borrowings, trade payables, other current liabilities, short-term provisions (Rs.).
Use when: To measure short-term solvency and the degree to which current assets cover current liabilities.
⚠ Students include non-current assets like fixed assets in current assets, or exclude items like bank overdraft from current liabilities.
Quick Ratio = Quick Assets / Current Liabilities
Reads as: Quick Ratio equals Quick Assets divided by Current Liabilities
Variables: Quick Assets = Current Assets - (Inventories + Prepaid expenses + Advance tax) (Rs.). Current Liabilities (Rs.).
Use when: To measure the capacity of the business to meet short-term obligations without relying on inventory or prepaid expenses.
⚠ Students forget to deduct prepaid expenses and advance tax from current assets when calculating quick assets.
Debt-Equity Ratio = Long-term Debts / Shareholders' Funds
Reads as: Debt-Equity Ratio equals Long-term Debts divided by Shareholders' Funds
Variables: Long-term Debts: includes long-term borrowings, other long-term liabilities, long-term provisions (Rs.). Shareholders' Funds: Share capital + Reserves and Surplus + Money received against share warrants + Share application money pending allotment (Rs.).
Use when: To measure the degree of indebtedness and the security of long-term lenders.
⚠ Students include current liabilities in debt or forget to include reserves and surplus in shareholders' funds.
Debt to Capital Employed Ratio = Long-term Debt / Capital Employed
Reads as: Debt to Capital Employed Ratio equals Long-term Debt divided by Capital Employed
Variables: Long-term Debt (Rs.). Capital Employed = Long-term Debt + Shareholders' Funds, or Total Assets - Current Liabilities (Rs.).
Use when: To show the proportion of long-term debts in the total capital employed.
⚠ Students use total assets instead of capital employed (net assets) without adjusting for current liabilities.
Proprietary Ratio = Shareholders' Funds / Capital Employed (or Net Assets)
Reads as: Proprietary Ratio equals Shareholders' Funds divided by Capital Employed
Variables: Shareholders' Funds (Rs.). Capital Employed (Rs.).
Use when: To express the proportion of shareholders' funds in financing the assets.
⚠ Students use total assets instead of capital employed, leading to an incorrect ratio.
Total Assets to Debt Ratio = Total Assets / Long-term Debts
Reads as: Total Assets to Debt Ratio equals Total Assets divided by Long-term Debts
Variables: Total Assets: sum of non-current and current assets (Rs.). Long-term Debts (Rs.).
Use when: To measure the extent of coverage of long-term debts by assets.
⚠ Students include current liabilities in the denominator or use net assets instead of total assets.
Interest Coverage Ratio = Net Profit before Interest and Tax / Interest on Long-term Debts
Reads as: Interest Coverage Ratio equals Net Profit before Interest and Tax divided by Interest on Long-term Debts
Variables: Net Profit before Interest and Tax = Net Profit after Tax × (100/(100 - Tax rate)) + Interest (Rs.). Interest on Long-term Debts (Rs.).
Use when: To measure the number of times interest on long-term debts is covered by profits available for interest.
⚠ Students use Net Profit after Tax instead of Net Profit before Interest and Tax, ignoring tax and interest adjustments.
Inventory Turnover Ratio = Cost of Revenue from Operations / Average Inventory
Reads as: Inventory Turnover Ratio equals Cost of Revenue from Operations divided by Average Inventory
Variables: Cost of Revenue from Operations = Revenue from Operations - Gross Profit, or Opening Inventory + Net Purchases + Direct Expenses - Closing Inventory (Rs.). Average Inventory = (Opening Inventory + Closing Inventory) / 2 (Rs.).
Use when: To determine how many times inventory is converted into revenue from operations during a period.
⚠ Students use Revenue from Operations instead of Cost of Revenue from Operations in the numerator.
Trade Receivables Turnover Ratio = Net Credit Revenue from Operations / Average Trade Receivables
Reads as: Trade Receivables Turnover Ratio equals Net Credit Revenue from Operations divided by Average Trade Receivables
Variables: Net Credit Revenue from Operations = Total Revenue from Operations - Cash Revenue from Operations (Rs.). Average Trade Receivables = (Opening Debtors and Bills Receivable + Closing Debtors and Bills Receivable) / 2 (Rs.).
Use when: To evaluate the speed of collection from trade receivables.
⚠ Students use total revenue from operations instead of credit revenue, or forget to deduct provisions for doubtful debts (though debtors should be taken before provision).
Trade Payables Turnover Ratio = Net Credit Purchases / Average Trade Payables
Reads as: Trade Payables Turnover Ratio equals Net Credit Purchases divided by Average Trade Payables
Variables: Net Credit Purchases (Rs.). Average Trade Payables = (Opening Creditors and Bills Payable + Closing Creditors and Bills Payable) / 2 (Rs.).
Use when: To indicate the pattern of payment of trade payables.
⚠ Students use total purchases instead of credit purchases, or forget to include bills payable in trade payables.
Working Capital Turnover Ratio = Net Revenue from Operations / Working Capital
Reads as: Working Capital Turnover Ratio equals Net Revenue from Operations divided by Working Capital
Variables: Net Revenue from Operations (Rs.). Working Capital = Current Assets - Current Liabilities (Rs.).
Use when: To measure the efficiency of utilisation of working capital.
⚠ Students use capital employed instead of working capital, or calculate working capital incorrectly.
Fixed Assets Turnover Ratio = Net Revenue from Operations / Net Fixed Assets
Reads as: Fixed Assets Turnover Ratio equals Net Revenue from Operations divided by Net Fixed Assets
Variables: Net Revenue from Operations (Rs.). Net Fixed Assets: total fixed assets (e.g., plant, land, building, motor car, furniture) (Rs.).
Use when: To measure the efficiency of utilisation of fixed assets.
⚠ Students include intangible assets or investments in fixed assets, or use gross fixed assets without considering accumulated depreciation.
Capital Employed Turnover Ratio = Revenue from Operations / Capital Employed
Reads as: Capital Employed Turnover Ratio equals Revenue from Operations divided by Capital Employed
Variables: Revenue from Operations (Rs.). Capital Employed = Shareholders' Funds + Long-term Debts, or Total Assets - Current Liabilities (Rs.).
Use when: To reflect the relationship between revenue from operations and capital employed.
⚠ Students use total assets instead of capital employed, leading to an overestimated ratio.
How It Works
Calculation of Current Ratio
  1. Identify all current assets: current investments, inventories, trade receivables, cash and cash equivalents, short-term loans and advances, prepaid expenses, advance tax, accrued income.
  2. Identify all current liabilities: short-term borrowings, trade payables, other current liabilities, short-term provisions.
  3. Divide total current assets by total current liabilities to get the ratio.
  4. Interpret: A ratio of 2:1 is considered safe; higher may indicate under-utilisation, lower may indicate risk of default.
💡 Students often forget to include items like advance tax and accrued income in current assets, or exclude bank overdraft from current liabilities.
Calculation of Quick Ratio
  1. Calculate current assets as above.
  2. Deduct inventories, prepaid expenses, and advance tax from current assets to get quick assets.
  3. Divide quick assets by current liabilities.
  4. Interpret: A ratio of 1:1 is considered safe; lower is risky, higher suggests idle resources.
💡 Always deduct prepaid expenses and advance tax—students often only deduct inventory.
Calculation of Debt-Equity Ratio
  1. Identify long-term debts: long-term borrowings, other long-term liabilities, long-term provisions.
  2. Identify shareholders' funds: share capital (equity + preference), reserves and surplus, money received against share warrants, share application money pending allotment.
  3. Divide long-term debts by shareholders' funds.
  4. Interpret: A ratio of 2:1 is considered safe; higher is risky, lower provides more security to lenders.
💡 Do not include current liabilities in debt; include all reserves and surplus in equity.
Calculation of Interest Coverage Ratio
  1. Calculate Net Profit before Tax: Net Profit after Tax × (100/(100 - Tax rate)).
  2. Add interest on long-term debts to Net Profit before Tax to get Net Profit before Interest and Tax.
  3. Divide Net Profit before Interest and Tax by interest on long-term debts.
  4. Interpret: Higher ratio ensures safety of interest payments; lower ratio indicates risk.
💡 Always add back interest and adjust for tax—students often use Net Profit after Tax directly.
Calculation of Inventory Turnover Ratio
  1. Calculate Cost of Revenue from Operations: Revenue from Operations - Gross Profit, or Opening Inventory + Net Purchases + Direct Expenses (wages, carriage inwards) - Closing Inventory.
  2. Calculate Average Inventory: (Opening Inventory + Closing Inventory) / 2.
  3. Divide Cost of Revenue from Operations by Average Inventory.
  4. Interpret: Higher turnover means better inventory management; low turnover may indicate obsolete stock.
💡 Use Cost of Revenue from Operations, not Revenue from Operations, in the numerator.
Calculation of Trade Receivables Turnover Ratio
  1. Calculate Net Credit Revenue from Operations: Total Revenue from Operations - Cash Revenue from Operations.
  2. Calculate Average Trade Receivables: (Opening Debtors and Bills Receivable + Closing Debtors and Bills Receivable) / 2.
  3. Divide Net Credit Revenue from Operations by Average Trade Receivables.
  4. Interpret: Higher ratio means speedy collection; lower ratio indicates slow collection.
💡 Use only credit revenue, not total revenue; take debtors before provision for doubtful debts.
Calculation of Trade Payables Turnover Ratio
  1. Calculate Net Credit Purchases (if only total purchases given, assume as credit purchases).
  2. Calculate Average Trade Payables: (Opening Creditors and Bills Payable + Closing Creditors and Bills Payable) / 2.
  3. Divide Net Credit Purchases by Average Trade Payables.
  4. Interpret: Lower ratio may indicate delayed payment; higher ratio suggests prompt payment.
💡 Include both creditors and bills payable in trade payables.
Exam Traps — Don't Make These Mistakes
⚠ Using Revenue from Operations instead of Cost of Revenue from Operations in Inventory Turnover Ratio
✗ Inventory Turnover Ratio = Revenue from Operations / Average Inventory
→ The ratio measures how many times inventory is sold, which is based on cost, not selling price. Using revenue overstates the turnover.
✓ Inventory Turnover Ratio = Cost of Revenue from Operations / Average Inventory
⚠ Including all current assets in Quick Assets without deducting prepaid expenses and advance tax
✗ Quick Assets = Current Assets - Inventories
→ Prepaid expenses and advance tax are not quickly convertible into cash, so they must also be deducted to get true liquid assets.
✓ Quick Assets = Current Assets - (Inventories + Prepaid expenses + Advance tax)
⚠ Using Net Profit after Tax in Interest Coverage Ratio
✗ Interest Coverage Ratio = Net Profit after Tax / Interest on Long-term Debts
→ Interest is paid before tax, and tax is calculated after interest. Using profit after tax understates the coverage.
✓ Interest Coverage Ratio = Net Profit before Interest and Tax / Interest on Long-term Debts
⚠ Confusing Debt-Equity Ratio with Debt to Capital Employed Ratio
✗ Debt-Equity Ratio = Long-term Debt / Capital Employed
→ Debt-Equity Ratio uses only shareholders' funds in the denominator, while Debt to Capital Employed Ratio uses total capital employed (debt + equity).
✓ Debt-Equity Ratio = Long-term Debts / Shareholders' Funds; Debt to Capital Employed Ratio = Long-term Debt / Capital Employed
⚠ Using Total Assets instead of Capital Employed for Proprietary Ratio
✗ Proprietary Ratio = Shareholders' Funds / Total Assets
→ The ratio is defined as shareholders' funds to net assets (capital employed), which is total assets minus current liabilities. Using total assets overstates the base.
✓ Proprietary Ratio = Shareholders' Funds / Capital Employed (or Net Assets)
⚠ Forgetting to adjust for tax when calculating Net Profit before Interest and Tax
✗ Net Profit before Interest and Tax = Net Profit after Tax + Interest
→ Net Profit after Tax is after both interest and tax. Adding back interest gives profit before interest but after tax. You must first gross up for tax.
✓ Net Profit before Tax = Net Profit after Tax × (100/(100 - Tax rate)); then Net Profit before Interest and Tax = Net Profit before Tax + Interest
Compare & Contrast
Composition of numerator
Current Ratio
Quick Ratio
Current Ratio includes all current assets (including inventory and prepaid expenses), while Quick Ratio excludes inventory, prepaid expenses, and advance tax, focusing only on highly liquid assets.
Denominator used
Debt-Equity Ratio
Debt to Capital Employed Ratio
Debt-Equity Ratio uses Shareholders' Funds as denominator, while Debt to Capital Employed Ratio uses Capital Employed (Shareholders' Funds + Long-term Debts) as denominator.
Focus of measurement
Trade Receivables Turnover Ratio
Trade Payables Turnover Ratio
Trade Receivables Turnover Ratio measures how quickly a firm collects from its debtors (credit sales), while Trade Payables Turnover Ratio measures how quickly a firm pays its creditors (credit purchases).
Exam Focus
Marks pattern: 2 MCQs (1 mark each), 1 Short Answer (3 marks) on ratio calculation or interpretation, 1 Long Answer (5-6 marks) involving multiple ratio calculations from a balance sheet or case study.
Most asked: Current Ratio and Quick Ratio calculations and interpretation · Debt-Equity Ratio and Interest Coverage Ratio · Inventory Turnover Ratio and Trade Receivables Turnover Ratio · Effect of transactions on current ratio (improve/reduce/not change) · Calculation of ratios from given balance sheet and statement of profit and loss
Don't skip: Numerical problems involving calculation of multiple ratios (e.g., current ratio, quick ratio, debt-equity ratio, inventory turnover) from a single balance sheet; Analysis of effect of transactions on current ratio (improve/reduce/not change)
One-Line Revision (read aloud before the exam)
  1. Accounting ratio is a mathematical relationship between two accounting numbers derived from financial statements.
  2. Ratio analysis helps in understanding efficacy of decisions, simplifying complex figures, and enabling comparative analysis.
  3. Limitations of ratio analysis include ignoring price-level changes, qualitative aspects, and variations in accounting practices.
  4. Current Ratio = Current Assets / Current Liabilities; ideal is 2:1.
  5. Quick Ratio = Quick Assets / Current Liabilities; ideal is 1:1.
  6. Quick Assets = Current Assets - (Inventories + Prepaid expenses + Advance tax).
  7. Debt-Equity Ratio = Long-term Debts / Shareholders' Funds; ideal is 2:1.
  8. Interest Coverage Ratio = Net Profit before Interest and Tax / Interest on Long-term Debts.
  9. Inventory Turnover Ratio = Cost of Revenue from Operations / Average Inventory.
  10. Trade Receivables Turnover Ratio = Net Credit Revenue from Operations / Average Trade Receivables.
  11. Trade Payables Turnover Ratio = Net Credit Purchases / Average Trade Payables.
  12. Working Capital Turnover Ratio = Net Revenue from Operations / Working Capital.
  13. Proprietary Ratio = Shareholders' Funds / Capital Employed.
  14. Total Assets to Debt Ratio = Total Assets / Long-term Debts.
  15. Ratios are means to an end, not the end themselves; their role is indicative and of whistle-blowing.

MCQs — 10 Questions with Answers

Q1. Which of the following best defines an accounting ratio?

  • A. A mathematical relationship between two accounting numbers from financial statements, expressed as percentage, fraction, or times ✓
  • B. The total of all assets divided by the total of all liabilities
  • C. The net profit of the business divided by revenue from operations only
  • D. A fixed formula that always gives the same result for all businesses

Answer: A — An accounting ratio is a derived number showing the mathematical relationship between two correlated accounting figures and can be expressed in multiple forms.

Q2. What is the primary objective of ratio analysis in financial statement interpretation?

  • A. To calculate the exact value of a business for sale
  • B. To identify problem areas, reveal efficiency levels, and support decision-making by users ✓
  • C. To replace all other methods of financial analysis
  • D. To ensure that all businesses follow identical accounting policies

Answer: B — Ratio analysis helps identify areas needing attention, analyse profitability and efficiency, and provide information for comparisons and future projections.

Q3. Intra-firm comparison using ratios refers to:

  • A. Comparing the firm's performance with that of competitor firms
  • B. Comparing the same firm's ratios across multiple accounting periods ✓
  • C. Comparing the firm's ratios with industry benchmark standards
  • D. Comparing departments within the same firm only

Answer: B — Intra-firm comparison is time series analysis where a firm's own ratios are compared over several years to identify trends within the same business.

Q4. Which statement about the limitations of ratio analysis is correct?

  • A. Ratio analysis has no limitations if the accountant is highly skilled
  • B. Errors in financial statements will not affect the derived ratios
  • C. Any weakness in the original financial statements will propagate into the ratio analysis ✓
  • D. Ratios are always 100% accurate because they are based on mathematical calculations

Answer: C — Since ratios are derived from financial statements, any errors, weaknesses, or distortions in the basic data will automatically appear in the calculated ratios.

Q5. A ratio calculated between 'Purchases of Rs. 3,00,000' and 'Furniture of Rs. 1,00,000' would be:

  • A. Meaningful and useful for financial analysis, giving a ratio of 3
  • B. Meaningful because both figures come from the Balance Sheet
  • C. Meaningless because there is no logical relationship between these two figures ✓
  • D. Useful for assessing the firm's operational efficiency

Answer: C — For a ratio to be useful, the two numbers must be meaningfully correlated; Purchases and Furniture are unrelated operational aspects and produce a non-indicative ratio.

Q6. Which of the following is NOT an advantage of ratio analysis?

  • A. Helps simplify complex accounting figures and establish relationships
  • B. Enables identification of problem areas and bright spots in the business
  • C. Provides a single definitive conclusion about the firm's overall performance ✓
  • D. Supports trend analysis and future projections

Answer: C — Ratios are means to analysis, not ends in themselves; a single ratio or even multiple ratios cannot provide a definitive conclusion without trend analysis and contextual interpretation.

Q7. Inter-firm comparison using ratios is most useful for:

  • A. Assessing whether a firm's performance is better or worse compared to competitor firms or industry standards ✓
  • B. Calculating the exact profitability of the firm
  • C. Determining the firm's share price in the stock market
  • D. Ensuring all firms use the same accounting policies

Answer: A — Inter-firm comparison (cross-sectional analysis) compares one firm's ratios with competitors or industry benchmarks to assess relative performance and competitiveness.

Q8. Assertion (A): Ratio analysis helps management understand the efficacy of operating, investing, and financing decisions. Reason (R): Ratios are essential for identifying which decision types have improved business performance.

  • A. Both A and R are correct, and R is the correct explanation of A ✓
  • B. Both A and R are correct, but R is not the correct explanation of A
  • C. A is correct, but R is incorrect
  • D. Both A and R are incorrect

Answer: A — Ratio analysis evaluates whether operating, investing, and financing decisions improved performance, and this is precisely why ratios identify decision efficacy (both statements support each other).

Q9. Which of the following statements about accounting conventions and ratio reliability is correct?

  • A. Accounting data reflect only recorded facts; conventions and judgements do not affect ratios
  • B. Accounting data are a combination of recorded facts, conventions, and personal judgements, which materially affect profit and distort ratios ✓
  • C. All accounting conventions produce identical profit figures across all firms
  • D. Personal judgement in depreciation methods does not affect the reliability of profitability ratios

Answer: B — Accounting data mix recorded facts with conventions (e.g., depreciation methods, valuation policies) and personal judgements; these affect profit calculation and therefore ratio accuracy.

Q10. A firm's Gross Profit Ratio improved from 18% last year to 22% this year. Which statement best reflects how ratio analysis supports management decision-making?

  • A. The improvement guarantees the firm will be profitable forever
  • B. The firm's operational decisions this year were definitely correct
  • C. The ratio improvement indicates a bright spot needing analysis; management should investigate the cause and replicate this success, while also considering trends and industry benchmarks ✓
  • D. No further analysis is needed; a single ratio improvement proves the firm is well-managed

Answer: C — Ratio analysis reveals bright spots and areas to improve; the 22% GP ratio is a positive indicator, but proper interpretation requires trend analysis (multiple years), industry comparison, and investigation of underlying causes.

Flashcards

What is an accounting ratio?

A mathematical relationship between two or more accounting numbers derived from financial statements, expressed as a fraction, percentage, or number of times.

Name one objective of ratio analysis.

To identify problem areas and potential areas for improvement in business performance that require management attention.

What is intra-firm comparison?

Comparing a firm's ratios over multiple accounting periods (time series analysis) to observe trends within the same business.

What is inter-firm comparison?

Comparing one firm's ratios with ratios of competing businesses (cross-sectional analysis) to assess relative performance.

Why must numbers in a ratio be meaningfully correlated?

Because a ratio calculated from unrelated numbers (like Purchases to Furniture) has no relevance and serves no analytical purpose.

What is a major limitation of ratio analysis?

Any errors or weaknesses in the original financial statements will propagate into the derived ratios, making the analysis unreliable.

What does SWOT analysis help management understand?

Current threats and opportunities in the business by explaining changes and trends revealed through ratio analysis.

How do ratios help identify bright spots in a business?

By revealing areas that are performing better than expected, allowing management to polish and replicate those successful practices.

Why are ratios described as 'means to an end, not the end itself'?

Because ratios are tools for analysis and interpretation—their role is indicative (pointing out areas) rather than conclusive.

What accounting principle affects the reliability of ratios?

The use of accounting conventions and personal judgements (such as depreciation methods) which materially affect profit and distort ratio accuracy.

Important Board Questions

Define 'accounting ratio' and give one example of a meaningful ratio with a real scenario. [2 marks]

State that a ratio is a mathematical relationship between two correlated accounting numbers expressed as %, fraction, or 'times'. Example: Gross Profit Ratio = GP / Net Sales × 100 (e.g., Rs. 10,000 GP on Rs. 1,00,000 revenue = 10%).

Explain any three objectives of ratio analysis with justification for why each matters to business decision-makers. [5 marks]

Select three from: (1) identify problem areas needing attention, (2) reveal profitability/liquidity/efficiency levels, (3) enable trend analysis over time, (4) support cross-sectional comparison with competitors, (5) provide future projections. For each, justify why it aids decision-making (e.g., identifying problems → allows corrective action).

Explain the statement 'Ratios are means to an end, not the end in themselves' and discuss how this principle should guide interpretation of financial statement analysis. [6 marks]

Explain that ratios are diagnostic tools and indicators, not conclusive answers. State that a single ratio or even multiple ratios require contextual interpretation with trend analysis, industry benchmarks, and firm-specific factors to draw valid conclusions. Discuss the risks of relying on ratios alone (e.g., seasonal distortions, accounting policy differences) and why management must investigate underlying causes before making decisions.

Assertion-Reason Questions for Accounting Ratios

Q1. Assertion (A):

Accounting ratios are derived numbers whose accuracy depends entirely on the quality of the underlying financial statement data.

Reason (R):

Since ratios are calculated from financial statements, any errors or judgements in those statements will be reflected in the ratios, making the ratios unreliable.

Answer: A — Both A and R are true, and R is the correct explanation of A — Both statements are true, and the reason correctly explains the assertion. The chapter explicitly states that 'if the financial statements contain some errors, the derived numbers in terms of ratio analysis would also present an erroneous scenario.' This is a cause-and-effect relationship that directly supports the assertion.

Q2. Assertion (A):

Ratio analysis helps in identifying both problem areas and bright spots in a business, allowing management to address weaknesses and improve strengths.

Reason (R):

Ratios are mathematical tools that automatically calculate profit or loss without requiring interpretation or analysis.

Answer: C — A is true but R is false — The assertion is true—the chapter states ratios help identify problem and bright areas. However, the reason is false because ratios are not self-executing; they require interpretation and analysis by knowledgeable users to be meaningful. The reason misses the human element of ratio analysis.

Q3. Assertion (A):

Intra-firm comparison involves comparing a company's financial ratios from one year with those from previous years to identify trends.

Reason (R):

Intra-firm comparison is performed to assess how the firm's performance has changed over time, which helps in making future projections and understanding the company's trajectory.

Answer: A — Both A and R are true, and R is the correct explanation of A — Both statements are true, and the reason correctly explains why intra-firm comparison is valuable. The chapter describes intra-firm comparison as comparing 'with itself' over accounting periods, and states that 'knowledge of trend helps in making projections.' The reason provides the 'why' behind the assertion.

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Case-Based Questions (CBQ) for Accounting Ratios

Case Study:

Aakash Ltd., a manufacturing company, has a Current Ratio of 2:1 and a Quick Ratio of 1.5:1 as on 31st March 2026. Its current liabilities are ₹4,00,000. The company's inventory includes raw materials, work-in-progress, and finished goods.

Q1. What is the value of current assets of Aakash Ltd. as on 31st March 2026?

  • A. ₹6,00,000
  • B. ₹8,00,000 ✓
  • C. ₹4,00,000
  • D. ₹10,00,000

Answer: B

Q2. What is the value of liquid assets (quick assets) of the company as on 31st March 2026?

  • A. ₹4,00,000
  • B. ₹8,00,000
  • C. ₹6,00,000 ✓
  • D. ₹2,00,000

Answer: C

Q3. If the company prepaid insurance of ₹20,000, what would be its effect on the Current Ratio?

  • A. No change ✓
  • B. Increase
  • C. Decrease
  • D. Cannot be determined

Answer: A

Q4. The inventory of Aakash Ltd. as on 31st March 2026 is:

  • A. ₹4,00,000
  • B. ₹2,00,000 ✓
  • C. ₹1,00,000
  • D. ₹3,00,000

Answer: B

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Previous Year Questions (PYQ) for Accounting Ratios

Real CBSE board exam questions from past papers — free to attempt.

CBSE 2026 · Set 67/3/1 · 4 marks

From the following information, calculate the Return on Equity (ROE): Revenue from operations ₹30,00,000 Interest on Long-term debt ₹8% Long-term debt ₹10,00,000 Net profit after tax ₹2,40,000 Tax Rate 40%

CBSE 2026 · Set 67/3/2 · 4 marks

(a) Calculate the Return on Equity (ROE) from the following information: Equity Share Capital 30,00,000 8% Long-term debt 10,00,000 Net profit after tax 2,40,000 Tax Rate 40%

CBSE 2026 · Set 67/3/3 · 1 mark

The Current Ratio of Megh Raj Ltd. is 1.5 : 1. Which of the following transactions will reduce the ratio?

  • Sale of furniture of ₹18,000 at a loss of ₹2,000
  • Goods purchased on credit ₹75,000
  • Sale of goods costing ₹60,000 for ₹80,000
  • Payment of trade payables ₹40,000

CBSE 2026 · Set 67/3/3 · 4 marks

Calculate Debt Service Coverage Ratio: Long-term debt ₹30,00,000, Interest rate 8%, Long-term debt ₹10,00,000, Net profit after tax ₹2,40,000, Tax Rate 40%

CBSE 2026 · Set 67/3/3 · 4 marks

Calculate Cost of Revenue from Operations: Revenue from operations ₹15,00,000, Opening inventory ₹2,00,000, Gross profit is 25% of cost of revenue from operations, Closing inventory was 2 times the opening inventory

CBSE 2026 · Set 67/4/1 · 1 mark

The Debt-Equity Ratio of a company is 2 : 1. Which of the following transactions will increase the Debt-Equity Ratio?

  • Issue of Shares ₹2,00,000
  • Issue of 8% Debentures ₹5,00,000
  • Issue of Bonus shares ₹4,00,000
  • Payment to Creditors ₹1,00,000

CBSE 2026 · Set 67/4/1 · 1 mark

Which of the following statements are correct? I. A low current ratio endangers the business and puts it at risk of facing a situation, where it will not be able to pay its short-term debts on time. II. Trade payables turnover ratio expresses the relationship between net credit sales and average trade payables. III. Operating profit ratio plus Gross profit ratio = 100. IV. Inventory turnover ratio determines the number of times inventory is converted into revenue from operations during the accounting period under consideration. Options:

  • I and II
  • II and III
  • III and IV
  • I and IV

CBSE 2026 · Set 67/4/1 · 4 marks

Calculate Revenue from Operations from the following information: Average inventory ₹1,20,000; Inventory turnover ratio 8 times; Goods are sold at a profit of 20% on revenue from operations.

CBSE 2026 · Set 67/4/2 · 4 marks

(i) Calculate Revenue from Operations from the following information: Average inventory ₹1,20,000 Inventory turnover ratio 8 times Goods are sold at a profit of 20% on revenue from operations (ii) Calculate Trade Payables Turnover Ratio from the following information: Credit purchases during 2024-25: ₹24,00,000 Creditors on 1st April, 2024: ₹3,00,000 Bills Payables on 1st April, 2024: ₹2,00,000 Creditors on 31st March, 2025: ₹4,80,000 Bills Payables on 31st March, 2025: ₹2,20,000

CBSE 2026 · Set 67/4/3 · 1 mark

Which of the following statements are correct ? I. A low current ratio endangers the business and puts it at risk of facing a situation, where it will not be able to pay its short-term debts on time. II. Trade payables turnover ratio expresses the relationship between net credit sales and average trade payables. III. Operating profit ratio plus Gross profit ratio = 100. IV. Inventory turnover ratio determines the number of times inventory is converted into revenue from operations during the accounting period under consideration. Options:

  • I and II
  • II and III
  • III and IV
  • I and IV

CBSE 2026 · Set 67/5/1 · 4 marks

The debt-to-equity ratio of a company is 2 times. State with reason whether the following transactions will increase, decrease or not affect the ratio: (i) Cash sales ₹3,00,000 (ii) Issue of equity shares ₹10,00,000 (iii) Issue of 9% debentures ₹5,00,000 (iv) Credit purchase of goods ₹50,000

CBSE 2026 · Set 67/5/2 · 1 mark

The following information is obtained from the books of Devdutt Ltd.: Working capital 4,00,000; Trade Payables 50,000; Other Current liabilities 1,00,000. Current assets of Devdutt Ltd. are:

  • 2,50,000
  • 4,50,000
  • 5,00,000
  • 5,50,000

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