Chapter accounting-ratios: Accounting Ratios Long Questions | accountancy Class 12 CBSE

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Chapter accounting-ratios: Accounting Ratios Long Questions | accountancy Class 12 CBSE | ByteNotes.in

Long Answer

Medium difficulty • Structured explanation

Medium

Question 1

Long Form

Analyse the advantages of ratio analysis as a tool of financial statement analysis, covering at least five distinct benefits.

Helps understand efficacy of decisions: Ratio analysis helps determine whether operating, investing and financing decisions have been right and how far they have helped improve performance.
Simplifies complex figures and establishes relationships: Ratios condense complex accounting data, summarise financial information, and help assess managerial efficiency, creditworthiness and earning capacity.
Helpful in comparative analysis: When many years' ratios are kept side by side, they reveal trends in the business, enabling meaningful projections and estimates for the future.
Identification of problem areas and bright spots: Ratios pinpoint areas needing attention as well as areas performing well, guiding management to allocate effort and resources effectively.
Enables SWOT analysis and various comparisons: Ratios help management understand current threats and opportunities, and allow comparisons over time (intra-firm), across firms (inter-firm), and against industry standards.

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Long Answer

Hard difficulty • Structured explanation

Hard

Question 2

Long Form

Critically examine the limitations of ratio analysis, distinguishing between limitations arising from accounting data and limitations inherent in ratio analysis itself.

Limitations from accounting data — Historical basis and price-level changes: Ratios are derived from historical financial statements, which ignore inflation. Changes in price levels make comparisons across different years meaningless since accounting records use stable money measurement.
Limitations from accounting data — Subjectivity and non-monetary aspects: Accounting data reflect personal judgements and conventions; profit is merely an accountant's opinion. Ratios ignore qualitative factors like management quality, employee morale and market reputation.
Limitations from accounting data — Variations in accounting practices: Differing policies for inventory valuation, depreciation and treatment of intangibles across firms invalidate inter-firm comparisons, undermining cross-sectional analysis.
Limitations inherent in ratio analysis — Indicative role only: Ratios are means to an end, not ends in themselves. They merely whistle-blow about problems but do not provide solutions, and lack the ability to resolve identified issues.
Limitations inherent in ratio analysis — Lack of standardisation: There is no universal definition for many terms used (e.g., liquid liabilities) and no universally accepted ideal levels for ratios; industry averages are not available in India, making benchmarking difficult.

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Long Answer

Hard difficulty • Structured explanation

Hard

Question 3

Long Form

Compare and contrast liquidity ratios and solvency ratios in terms of their purpose, time horizon, and the specific ratios included under each category.

Purpose and time horizon: Liquidity ratios measure a firm's ability to meet short-term obligations as they fall due, making them short-term in nature. Solvency ratios measure the ability to meet long-term contractual obligations and service long-term debt, making them long-term in nature.
Liquidity ratios — Current Ratio: Measures coverage of current liabilities by current assets (ideal 2:1). Quick Ratio excludes illiquid current assets like inventory and prepaid expenses, giving a stricter test of liquidity (ideal 1:1), also called Acid-Test Ratio.
Solvency ratios — Debt-Equity and Proprietary Ratio: Debt-Equity Ratio (Long-term Debt/Shareholders' Funds, safe at 2:1) measures indebtedness. Proprietary Ratio (Shareholders' Funds/Capital Employed) measures owners' funding proportion; together they sum to 1.
Solvency ratios — Debt to Capital Employed and Total Assets to Debt: Debt to Capital Employed shows proportion of long-term debt in total capital. Total Assets to Debt Ratio measures asset coverage of long-term debt; higher ratio indicates greater security.
Solvency ratios — Interest Coverage: This ratio (PBIT/Interest) measures how many times interest is covered by profits. Liquidity ratios rely on balance sheet data alone; many solvency ratios involve profit and loss data combined with balance sheet data.

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Long Answer

Medium difficulty • Structured explanation

Medium

Question 4

Long Form

Explain the functional classification of accounting ratios. Describe the purpose and examples of each category in the classification.

Liquidity Ratios: Measure the ability of a business to meet short-term obligations. Calculated from balance sheet data. Include Current Ratio and Quick (Liquid/Acid-Test) Ratio. They assess whether the firm can pay its current liabilities from current assets.
Solvency Ratios: Long-term ratios assessing the firm's capacity to meet contractual obligations toward external stakeholders. Include Debt-Equity Ratio, Debt to Capital Employed Ratio, Proprietary Ratio, Total Assets to Debt Ratio and Interest Coverage Ratio.
Activity or Turnover Ratios: Measure the speed with which assets are converted into revenue from operations, indicating efficiency. Include Inventory Turnover, Trade Receivables Turnover, Trade Payables Turnover, Net Assets Turnover, Fixed Assets Turnover and Working Capital Turnover Ratios.
Profitability Ratios: Analyse earning capacity in relation to revenue from operations or assets/funds employed. Include Gross Profit Ratio, Operating Ratio, Operating Profit Ratio, Net Profit Ratio, ROI, Return on Shareholders' Funds, EPS, Book Value per Share, Dividend Payout Ratio and P/E Ratio.
The functional classification is preferred over the traditional classification (P&L ratios, Balance Sheet ratios, Composite ratios) in practice because it directly addresses the analytical purpose — profitability, liquidity, solvency or efficiency — rather than merely indicating the source of data.

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Long Answer

Medium difficulty • Structured explanation

Medium

Question 5

Long Form

Explain in detail the five solvency ratios discussed in the chapter, including their formulae and significance.

Debt-Equity Ratio = Long-term Debts / Shareholders' Funds. Measures degree of indebtedness. A low ratio reflects security for lenders; high ratio is risky but can enhance owners' returns through trading on equity. Safe level: 2:1.
Debt to Capital Employed Ratio = Long-term Debt / Capital Employed (= Long-term Debt + Shareholders' Funds). Shows proportion of long-term debt in total capital. Low ratio gives security to lenders; high ratio enables trading on equity.
Proprietary Ratio = Shareholders' Funds / Capital Employed. A higher ratio provides security to creditors. This ratio and Debt to Capital Employed Ratio always sum to 1, representing 100% of capital employed.
Total Assets to Debt Ratio = Total Assets / Long-term Debts. Measures the extent of coverage of long-term debts by assets. A higher ratio indicates assets are mainly funded by owners and loans are adequately covered.
Interest Coverage Ratio = Net Profit before Interest and Tax / Interest on long-term debts. Reveals the number of times interest is covered by available profits. A higher ratio ensures safety of interest payments to lenders.

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Long Answer

Hard difficulty • Structured explanation

Hard

Question 6

Long Form

Discuss all activity (turnover) ratios covered in the chapter, explaining what each measures and how high or low values should be interpreted.

Inventory Turnover Ratio = Cost of Revenue from Operations / Average Inventory. Measures frequency of inventory conversion. High ratio generally positive, but may signal buying in small lots; low ratio is a danger signal indicating bad buying or obsolete inventory.
Trade Receivables Turnover Ratio = Net Credit Revenue from Operations / Average Trade Receivables. Indicates speed of collection. Higher turnover means faster collection; helps compute Average Collection Period (365 / ratio). Debtors are taken before provision for doubtful debts.
Trade Payables Turnover Ratio = Net Credit Purchases / Average Trade Payables. Indicates payment pattern. Low ratio means longer credit period from suppliers, but may also mean delayed payment which can harm business reputation. Average Payment Period = 365 / ratio.
Net Assets / Capital Employed Turnover Ratio = Revenue from Operations / Capital Employed. Higher ratio means better activity and profitability. Analysed further through Fixed Assets Turnover (Revenue / Net Fixed Assets) and Working Capital Turnover (Revenue / Working Capital).
High turnover ratios across all categories — inventory, receivables, payables, fixed assets and working capital — collectively indicate efficient resource utilisation, resulting in higher liquidity and profitability; low turnover signals inefficiency or potential operational problems.

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Long Answer

Medium difficulty • Structured explanation

Medium

Question 7

Long Form

Explain the profitability ratios computed in relation to revenue from operations, including their formulae and what each reveals about financial performance.

Gross Profit Ratio = Gross Profit / Net Revenue from Operations × 100. Indicates gross margin and availability of funds to cover operating and non-operating expenses. A change may signal altered selling prices or cost of production. A higher ratio is always desirable.
Operating Ratio = (Cost of Revenue from Operations + Operating Expenses) / Net Revenue from Operations × 100. Expresses cost of operations (excluding financial charges) as a proportion of revenue. Lower operating ratio is a healthy sign indicating operational efficiency.
Operating Profit Ratio = 100 minus Operating Ratio, or Operating Profit / Revenue from Operations × 100. Reveals operating margin; useful for both intra-firm and inter-firm comparisons to evaluate operational efficiency.
Net Profit Ratio = Net Profit (PAT) / Revenue from Operations × 100. Based on all-inclusive profit concept including non-operational incomes and expenses. Reflects overall efficiency and is the main variable in computing Return on Investment.
Together these four ratios form a graduated picture: gross profit ratio shows trading efficiency; operating ratio shows operating cost control; operating profit ratio shows operating return; net profit ratio shows total profitability after all incomes and expenses.

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Long Answer

Hard difficulty • Structured explanation

Hard

Question 8

Long Form

Analyse the profitability ratios related to shareholders and investors — ROI, Return on Net Worth, EPS, Book Value per Share, Dividend Payout Ratio and P/E Ratio — explaining each with its formula.

Return on Investment (ROI) = Profit before Interest and Tax / Capital Employed × 100. Capital employed = shareholders' funds + long-term debts. Measures overall utilisation of all long-term funds; useful for inter-firm comparison and for checking if earnings exceed interest rate payable.
Return on Net Worth (RONW) = Profit after Tax / Shareholders' Funds × 100. Should be higher than ROI to confirm that shareholders' funds are employed profitably. Assesses whether shareholders' investment generates reasonable return.
Earnings per Share (EPS) = Profit available for equity shareholders / Number of equity shares, where profit available = PAT minus preference dividend. Important for equity shareholders and stock market valuation; helps assess dividend-paying capacity.
Book Value per Share = Equity shareholders' funds / Number of equity shares. Equity shareholders' funds = total shareholders' funds minus preference share capital. Indicates the intrinsic value of equity holding and influences market price.
Dividend Payout Ratio = Dividend per Share / EPS. Reflects dividend policy and earnings retained for growth. Price/Earning Ratio = Market Price / EPS. Reflects investor expectations about future growth; varies across industries and companies depending on growth prospects.

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Long Answer

Hard difficulty • Structured explanation

Hard

Question 9

Long Form

Explain the effect of the following transactions on the current ratio when the existing current ratio is greater than 1 (e.g., 2:1): (i) payment of current liability; (ii) purchase of goods on credit; (iii) sale of fixed asset for cash; (iv) cash collected from trade debtors; (v) issue of equity shares for cash.

Payment of current liability (e.g., Rs. 10,000 cash to creditors): Reduces both current assets (cash) and current liabilities equally. When ratio > 1:1, equal reduction in both components improves the ratio (e.g., Rs. 40,000/Rs. 15,000 = 2.67:1 vs 2:1). Effect: Improves current ratio.
Purchase of goods on credit: Increases both inventories (current assets) and trade payables (current liabilities) equally. When ratio > 1:1, equal increase in both components reduces the ratio (e.g., Rs. 60,000/Rs. 35,000 = 1.71:1 vs 2:1). Effect: Reduces current ratio.
Sale of fixed asset for cash: Increases current assets (cash received) with no change in current liabilities (fixed asset is non-current). Regardless of original ratio, this improves the current ratio. Effect: Improves current ratio.
Cash collected from trade debtors: Only changes the composition of current assets (trade receivables decrease, cash increases) with no change in total current assets or current liabilities. Effect: No change in current ratio.
Issue of equity shares for cash: Increases current assets (cash) with no change in current liabilities (equity is part of shareholders' funds, a long-term source). Effect: Improves current ratio.

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Long Answer

Hard difficulty • Structured explanation

Hard

Question 10

Long Form

Explain the effect of the following transactions on the Debt-Equity Ratio when it is currently 0.5:1: (i) issue of equity shares; (ii) redemption of debentures; (iii) cash received from debtors; (iv) sale of goods on cash basis; (v) purchase of goods on credit.

Issue of equity shares: Increases shareholders' funds (equity) without affecting long-term debt. This reduces the debt-equity ratio (e.g., from 0.5:1 to 0.45:1 as denominator increases). Effect: Decreases the ratio.
Redemption of debentures: Reduces long-term debt (numerator) without affecting shareholders' funds (equity). This reduces the debt-equity ratio (e.g., from 0.5:1 to 0.4:1). Effect: Decreases the ratio.
Cash received from debtors: Affects only the composition of current assets (receivables convert to cash). Neither long-term debt nor shareholders' funds change. Effect: No change in debt-equity ratio.
Sale of goods on cash basis: Revenue transaction affecting profitability, but the current period profit is part of reserves; however, this transaction per se does not change long-term debt or pre-existing equity. Effect: No immediate change in debt-equity ratio.
Purchase of goods on credit: Increases trade payables (a current liability), not long-term debt, with no change to shareholders' funds. Since debt-equity ratio considers only long-term debts, this transaction has no effect. Effect: No change in debt-equity ratio.

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Chapter accounting-ratios: Accounting Ratios | Long Questions

Analyse the advantages of ratio analysis as a tool of financial statement analysis, covering at least five distinct benefits.

Critically examine the limitations of ratio analysis, distinguishing between limitations arising from accounting data and limitations inherent in ratio analysis itself.

Compare and contrast liquidity ratios and solvency ratios in terms of their purpose, time horizon, and the specific ratios included under each category.

Explain the functional classification of accounting ratios. Describe the purpose and examples of each category in the classification.

Explain in detail the five solvency ratios discussed in the chapter, including their formulae and significance.

Discuss all activity (turnover) ratios covered in the chapter, explaining what each measures and how high or low values should be interpreted.

Explain the profitability ratios computed in relation to revenue from operations, including their formulae and what each reveals about financial performance.

Analyse the profitability ratios related to shareholders and investors — ROI, Return on Net Worth, EPS, Book Value per Share, Dividend Payout Ratio and P/E Ratio — explaining each with its formula.

Explain the effect of the following transactions on the Debt-Equity Ratio when it is currently 0.5:1: (i) issue of equity shares; (ii) redemption of debentures; (iii) cash received from debtors; (iv) sale of goods on cash basis; (v) purchase of goods on credit.

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