Chapter accounting-ratios: Accounting Ratios | Summary

Ratio analysis is an indispensable part of interpretation of financial statements. Its objectives include: knowing areas needing attention, identifying potential areas for improvement, providing deeper analysis of profitability, liquidity, solvency and efficiency, enabling cross-sectional analysis by comparing with industry standards, and providing information useful for making projections and estimates for the future.

The advantages of ratio analysis include: helping understand the efficacy of operating, investing and financing decisions; simplifying complex accounting figures and establishing relationships; being helpful in comparative analysis and identifying trends; identifying problem areas as well as bright spots; enabling SWOT analysis; and allowing various comparisons — intra-firm (time series), inter-firm (cross-sectional), and with industry standards.

Limitations arising from the nature of financial statements include: limitations of accounting data (which reflect recorded facts, accounting conventions and personal judgements); ignoring price-level changes (financial accounting assumes stable money measurement); ignoring qualitative or non-monetary aspects; variations in accounting practices across enterprises; and difficulty in forecasting future trends based only on historical analysis.

Additional limitations of ratios themselves include: ratios are means and not the end; lack of ability to resolve problems (they only indicate issues); lack of standardised definitions of concepts used; lack of universally accepted standard levels or ideal ratios (industry averages are not available in India); and the problem of ratios based on unrelated figures being meaningless.

There is a two-way classification of ratios: traditional classification (based on financial statements) and functional classification (based on purpose). Traditional classification includes: Statement of Profit and Loss Ratios (both variables from P&L, e.g., gross profit ratio), Balance Sheet Ratios (both variables from balance sheet, e.g., current ratio), and Composite Ratios (one variable each from P&L and balance sheet, e.g., trade receivables turnover ratio).

The functional classification, which is more commonly used in practice, consists of: Liquidity Ratios (short-term in nature, measure ability to meet current obligations), Solvency Ratios (long-term in nature, measure ability to meet long-term contractual obligations), Activity or Turnover Ratios (measure efficiency of operations based on resource utilisation), and Profitability Ratios (analyse profits in relation to revenue from operations or funds employed).

Liquidity ratios measure the short-term solvency of the business — the firm's ability to meet its current obligations. Current Ratio is the proportion of current assets to current liabilities (formula: Current Assets / Current Liabilities). Current assets include inventories, trade receivables, cash and cash equivalents, short-term loans and advances, prepaid expenses, advance tax and accrued income. Current liabilities include short-term borrowings, trade payables, other current liabilities and short-term provisions. The ideal current ratio is normally considered to be 2:1.

The Quick or Liquid Ratio is the ratio of quick assets to current liabilities (Quick Assets / Current Liabilities). Quick assets are current assets minus inventories and other non-liquid current assets such as prepaid expenses and advance tax. It is also called the Acid-Test Ratio and is a supplementary check on liquidity. The ideal quick ratio is considered to be 1:1. A very low ratio is risky; a very high ratio suggests deployment of resources in less profitable short-term investments.

Solvency ratios are calculated to determine the ability of the business to service its debt in the long run. Debt-Equity Ratio measures the relationship between long-term debt and shareholders' funds (Long-term Debts / Shareholders' Funds). A safe debt-equity ratio is considered to be 2:1. Debt to Capital Employed Ratio relates long-term debt to capital employed (Long-term Debt / Capital Employed). Proprietary Ratio expresses shareholders' funds as a proportion of net assets (Shareholders' Funds / Capital Employed). A higher proprietary ratio provides more security to creditors.

Total Assets to Debt Ratio measures coverage of long-term debts by total assets (Total Assets / Long-term Debts). A higher ratio indicates assets are mainly financed by owners' funds. Interest Coverage Ratio measures security of interest payable on long-term debts (Net Profit before Interest and Tax / Interest on long-term debts). A higher ratio ensures safety of interest payments. The sum of Debt to Capital Employed Ratio and Proprietary Ratio always equals 1.

Activity ratios indicate the speed at which activities of the business are being performed. They express the number of times assets employed are turned into sales during an accounting period. Higher turnover ratios mean better utilisation of assets and improved efficiency and profitability. Key activity ratios include: Inventory Turnover Ratio (Cost of Revenue from Operations / Average Inventory) which studies frequency of inventory conversion; Trade Receivables Turnover Ratio (Net Credit Revenue from Operations / Average Trade Receivables) which indicates speed of collection; and Trade Payables Turnover Ratio (Net Credit Purchases / Average Trade Payables) which reveals average payment period.

The Net Assets or Capital Employed Turnover Ratio (Revenue from Operations / Capital Employed) reflects how effectively capital is deployed. It is further analysed using Fixed Assets Turnover Ratio (Net Revenue from Operations / Net Fixed Assets) and Working Capital Turnover Ratio (Net Revenue from Operations / Working Capital). Average Collection Period is calculated as 365 / Trade Receivables Turnover Ratio, and Average Payment Period as 365 / Trade Payables Turnover Ratio.

Profitability ratios are calculated to analyse the earning capacity of the business. Gross Profit Ratio (Gross Profit / Net Revenue from Operations × 100) indicates gross margin on products sold and margin available to cover operating expenses. Operating Ratio [(Cost of Revenue from Operations + Operating Expenses) / Net Revenue from Operations × 100] analyses cost of operation in relation to revenue; a lower operating ratio is a healthy sign. Operating Profit Ratio is computed as 100 minus the Operating Ratio, or directly as Operating Profit / Revenue from Operations × 100. Net Profit Ratio (Net Profit / Revenue from Operations × 100) reflects overall efficiency of the business.

Return on Investment or Capital Employed (Profit before Interest and Tax / Capital Employed × 100) measures overall utilisation of funds and is useful for inter-firm comparison. Return on Shareholders' Funds or Return on Net Worth (Profit after Tax / Shareholders' Funds × 100) assesses whether investment generates reasonable return. Earnings Per Share (Profit available for equity shareholders / Number of equity shares) is important from equity shareholders' perspective. Book Value Per Share (Equity shareholders' funds / Number of equity shares) gives an idea about the value of equity holding. Dividend Payout Ratio (Dividend per share / Earnings per share) reflects dividend policy, and Price/Earnings Ratio (Market Price of a share / Earnings per share) reflects investor expectations.

Accounting ratios are powerful tools of financial statement analysis that help stakeholders assess the profitability, liquidity, solvency and efficiency of a business. The four main categories — liquidity, solvency, activity and profitability ratios — together provide a comprehensive picture of a firm's financial health. While ratio analysis simplifies complex financial data and enables meaningful comparisons across time periods and firms, it must be used with awareness of its limitations such as dependence on historical data, price-level changes, and lack of standardised definitions.

From an examination perspective, Chapter 5 is one of the most numerically intensive chapters in Class 12 Accountancy. Board exams consistently test the ability to compute ratios from balance sheets and profit and loss accounts, interpret their significance, analyse the effect of transactions on ratios, and work backwards to find missing figures using ratio formulas. Students must memorise all formulas precisely, understand what each component includes or excludes, and practice interpretation of results alongside calculation.