Class 12 Accountancy Notes
Unit – 9: Ratio Analysis
Q.N.1. what do you mean by ratio analysis? What are the objectives and advantages of such analysis? Also point out the limitations of ratio analysis. 2012, 2012, 2018, 2020
Answer: A Ratio is an arithmetical expression of relationship
between two related or interdependent items. If such ratios are calculated on
the basis of accounting information, then they are called accounting ratios.
Simply, accounting ratio is an expression of relationship between two accounting
terms or variables or two set of accounting heads or group of items stated in
financial statement. It is one of the techniques of financial analysis which is
used to evaluate the operating efficiency and financial position of a business
concern.
According to J. Betty,” The term accounting
ratio is used to describe significant relationships which exist between figures
shown in a balance sheet and in a profit and loss account.”
Objectives
of Ratio analysis 2018
1. To know
the weak areas of the business which need more attention.
2. To know
about the potential areas which can be improved with the effort in the desired
direction.
3. To provide
a deeper analysis of the profitability, liquidity, solvency and efficiency
levels in the business.
4. To provide
information for decision making.
5. To provide
information for inter-firm and intra-firm comparison.
Advantages
and Uses of Ratio Analysis
1. Helpful in
analysis of financial situation: It helps the management to know about the financial
strength and weakness of the business concern. Bankers, Investors, Creditors
etc. analyse financial statements with the help of ratios.
2. Useful in
judging the operating efficiency of business: Accounting ratios are useful in
evaluating the operating results financial health of an enterprise. This is
done by evaluating liquidity, solvency, profitability etc.
3. Helpful in
inter-firm and intra-firm comparison: Ratio analysis helps in comparing the
performance of business with that of other firms and of industry in general.
This comparison is called inter-firm comparison. Ratio analysis also helps in
comparing results of different units belonging to the same firm. This
comparison is called intra-firm comparison.
4. Simplifies
the accounting information: It simplifies and summarises the accounting figures
to make them understandable to the users. It gives a brief idea about the whole
story of changes in the financial condition of a business.
5. Useful for
forecasting: Ratios are helpful in business planning and forecasting. What
should be the course of action in the future can be decided with the help of
trend percentage.
Limitations of Ratio Analysis
1. False Result: Ratios are
calculated from the financial statements, so the reliability of ratio is
dependent upon the correctness of the financial statements. If financial
statements are misleading, then the accounting ratios also gives a false
pictures.
2. Ignores Price Level Changes: Change is
price level affects the comparability of ratios. A change in the price level
makes the ratio analysis of different accounting years invalid because
accounting records ignores change in value of money.
3. Qualitative aspect Ignored: Since the
financial statements are based on quantitative aspects only, the quality aspect
such as quality of management, quality of labour force etc., are ignored while
calculating accounting ratios. Under such circumstances, the conclusions
derived from ratio analysis would be misleading.
4. Lack of standard ratio: The
financial and economic scenario is dynamic; therefore, it is very difficult to
evolve a standard ratio acceptable for all time. There is almost no single
standard ratio which is acceptable in every scenario.
5. Not free from Bias: Financial
statements are largely affected by the personal judgment of the accountant in
selecting accounting policies, therefore accounting ratios are also not free
from this limitations. If the personal judgement of the analyst is biased, then
the conclusion drawn will be misleading.
Q.N.2. What are the types of Ratios according
to traditional classification? 2016,
2017
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ALSO READ (AHSEC ASSAM BOARD CLASS 12):
1. AHSEC CLASS 12 ACCOUNTANCY CHAPTERWISE NOTES
2. AHSEC CLASS 12 ACCOUNTANCY IMPORTANT QUESTION (THEORY)
3. AHSEC CLASS 12 ACCOUNTANCY IMPORTANT QUESTION BANK (PRACTICAL)
4. AHSEC CLASS 12 ACCOUNTANCY PAST EXAM PAPERS (FROM 2012 TILL DATE)
5. AHSEC CLASS 12 ACCOUNTANCY SOLVED QUESTION PAPERS (FROM 2012 TILL DATE)
6. AHSEC CLASS 12 ACCOUNTANCY CHAPTERWISE MCQS
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Ans: CLASSIFICATION OF RATIOS
The
ratios are used for different purposes, for different users and for different
analysis. The ratios can be classified as under:
a) Traditional
classification
b) Functional
classification
c) Classification
from user‘s point of view
1) Traditional classification: As per
this classification, the ratios readily suggest through their names, their
respective resources. From this point of view, the ratios are classified as
follows.
a) Balance Sheet Ratio: This ratio
is also known as financial ratios. The ratios which express relationships
between two items or group of items mentioned in the balance sheet at the end
of the year. Example: Current
ratio, Liquid ratio, Stock to Working Capital ratio, Capital Gearing ratio,
Proprietary ratio, etc.
b) Revenue Statement Ratio: This ratio
is also known as income statement ratio which expresses the relationship
between two items or two groups of items which are found in the income
statement of the year. Example: Gross
Profit ratio, Operating ratio, Expenses Ratio, Net Profit ratio, Stock Turnover
ratio, Operating Profit ratio.
c) Combined Ratio: These ratios show the relationship
between two items or two groups of items, of which one is from balance sheet
and another from income statement (Trading A/c and Profit & Loss A/c and
Balance Sheet). Example: Return
on Capital Employed, Return on Proprietors' Fund ratio, Return on Equity
Capital ratio, Earning per Share ratio, Debtors' Turnover ratio, Creditors
Turnover ratio.
2)
Functional Classification of Ratios: The accounting
ratios can also be classified according their functions as follows:
a) Liquidity Ratios: These ratios show relationship between
current assets and current liabilities of the business enterprise. Example: Current Ratio, Liquid Ratio.
b) Leverage Ratios: These ratios show relationship between
proprietor's fund and debts used in financing the assets of the business
organization. Example: Capital
gearing ratio, debt-equity ratio, and proprietary ratio. This ratio measures
the relationship between proprietors fund and borrowed funds.
c) Efficiency/Activity Ratio: This ratio
is also known as turnover ratio or productivity ratio or efficiency and
performance ratio. These ratios show relationship between the sales and the
assets. These are designed to indicate the effectiveness of the firm in using
funds, degree of efficiency, and its standard of performance of the
organization. Example : Stock
Turnover Ratio, Debtors' Turnover Ratio, Turnover Assets Ratio, Stock working
capital Ratio, working capital Turnover Ratio, Fixed Assets Turnover Ratio. 2017
d)
Profitability Ratio (2019): These
ratios show relationship between profits and sales and profit &
investments. It reflects overall efficiency of the organizations, its ability
to earn reasonable return on capital employed and effectiveness of investment
policies. Example : i) Profits
and Sales : Operating Ratio, Gross Profit Ratio, Operating Net Profit Ratio,
Expenses Ratio etc. ii) Profits and Investments : Return on Investments, Return
on Equity Capital etc.
e) Coverage Ratios: These ratios show relationship between
profit in hand and claims of outsiders to be paid out of profits. Example: Dividend Payout Ratio, Debt
Service Ratio and Debt Service Coverage Ratio.
3)
Classification from the view point of user: Ratio from the users' point of view is
classified as follows:
a) Shareholders' point of view: These
ratios serve the purposes of shareholders. Shareholders, generally expect the
reasonable return on their capital. They are interested in the safety of
shareholders investments and interest on it. Example: Return on proprietor's funds, Return on capital, Earning
per share.
b) Long term creditors: Normally
leverage ratios provide useful information to the long term creditors which
include debenture holders, vendors of fixed assets, etc. The creditors
interested to know the ability of repayment of principal sum and periodical
interest payments as and when they become due. Example: Debt equity ratio, return on capital employed,
proprietary ratio.
c) Short term creditors: The
short-term creditors of the company are basically interested to know the
ability of repayment of short-term liabilities as and when they become due.
Therefore, the creditors has important place on the liquidity aspects of the
company's assets. Example: a)
Liquidity Ratios - Current Ratio, Liquid Ratio. b) Debtors Turnover Ratio. c)
Stock working capital Ratio.
d) Management: Management is interested to use
borrowed funds to improve the earnings. Example:
Return on capital employed, Turnover Ratio, Operating Ratio, Expenses
Ratio.
Q.N.3. Explain the meaning and method of
calculation of some specific ratios.
Ans: a) Current Ratio: Current
ratio is calculated in order to work out firm’s ability to pay off its
short-term liabilities. This ratio is also called working capital ratio. This
ratio explains the relationship between current assets and current liabilities
of a business. It is calculated by applying the following formula:
Current
Ratio = Current Assets/Current Liabilities
Current
Assets include Cash in hand, Cash at Bank, Sundry Debtors, Bills Receivable,
Stock of Goods, Short-term Investments, Prepaid Expenses, Accrued Incomes etc.
Current
Liabilities includes Sundry Creditors, Bills Payable, Bank Overdraft,
Outstanding Expenses etc.
Objective
and Significance: Current ratio shows the short-term financial position of the
business. This ratio measures the ability of the business to pay its current
liabilities. The ideal current ratio is supposed to be 2:1. In case, if this
ratio is less than 2:1, the short-term financial position is not supposed to be
very sound and in case, if it is more than 2:1, it indicates idleness of working
capital.
b) Liquid Ratio: Liquid
ratio shows short-term solvency of a business. It is also called acid-test
ratio and quick ratio. It is calculated in order to know whether or not current
liabilities can be paid with the help of quick assets quickly. Quick assets
mean those assets, which are quickly convertible into cash.
Liquid
Ratio = Liquid Assets/Current Liabilities
Liquid
assets include Cash in hand, Cash at Bank, Sundry Debtors, Bills Receivable,
Short-term investments etc. In other words, all current assets are liquid
assets except stock and prepaid expenses.
Current
liabilities include Sundry Creditors, Bills Payable, Bank Overdraft,
Outstanding Expenses etc.
Objective
and Significance: Liquid ratio is calculated to work out the liquidity of a business.
This ratio measures the ability of the business to pay its current liabilities
in a real way. The ideal liquid ratio is supposed to be 1:1. In case, this
ratio is less than 1:1, it shows a very weak short-term financial position and
in case, it is more than 1:1, it shows a better short-term financial position.
c) Gross Profit Ratio: Gross
Profit Ratio shows the relationship between Gross Profit of the concern and its
Net Sales. Gross Profit Ratio can be calculated in the following manner: 2019
Gross
Profit Ratio = Gross Profit/Net Sales x 100
Where
Gross Profit = Net Sales – Cost of Goods Sold
Cost
of Goods Sold = Opening Stock + Net Purchases + Direct Expenses – Closing Stock
And
Net Sales = Total Sales – Sales Return
Objective
and Significance: Gross Profit Ratio provides guidelines to the concern whether
it is earning sufficient profit to cover administration and marketing expenses
and is able to cover its fixed expenses. This ratio can also be used in
stock-inventory control. Maintenance of steady gross profit ratio is important
.Any fall in this ratio would put the management in difficulty in the
realisation of fixed overheads of the business.
d) Net Profit Ratio: Net
Profit Ratio shows the relationship between Net Profit of the concern and Its
Net Sales. Net Profit Ratio can be calculated in the following manner:
Net
Profit Ratio = Net Profit/Net Sales x 100
Where,
Net Profit = Gross Profit – Selling and Distribution Expenses – Office and
Administration Expenses – Financial Expenses – Non Operating Expenses + Non
Operating Incomes.
And
Net Sales = Total Sales – Sales Return
Objective
and Significance: In order to work out overall efficiency of the concern Net
Profit ratio is calculated. This ratio is helpful to determine the operational
ability of the concern. While comparing the ratio to previous years’ ratios,
the increment shows the efficiency of the concern.
e) Operating Profit Ratio: Operating
Profit Ratio shows the relationship between Operating Profit and Net Sales.
Operating Profit Ratio can be calculated in the following manner: 2019
Operating
Profit Ratio = (Operating Profit/Net Sales) x 100
Where
Operating Profit = Gross Profit – Operating Expenses
Or
Operating Profit = Net Profit + Non Operating Expenses – Non Operating Incomes
And
Net Sales = Total Sales – Sales Return
Objective
and Significance: Operating Profit Ratio indicates the earning capacity of the
concern on the basis of its business operations and not from earning from the
other sources. It shows whether the business is able to stand in the market or
not.
f) Operating Ratio: Operating
Ratio matches the operating cost to the net sales of the business. Operating
Cost means Cost of goods sold plus Operating Expenses.
Operating
Ratio = Operating Cost/Net Sales x 100
Where
Operating Cost = Cost of goods sold + Operating Expenses
(Operating
Expenses = Selling and Distribution Expenses, Office and Administration
Expenses, Repair and Maintenance.)
Cost
of Goods Sold = Opening Stock + Net Purchases + Direct Expenses – Closing Stock
Or
Cost of Goods Sold = Net sales – Gross Profit
Objective
and Significance: Operating Ratio is calculated in order to calculate the
operating efficiency of the concern. As this ratio indicates about the
percentage of operating cost to the net sales, so it is better for a concern to
have this ratio in less percentage. The less percentage of cost means higher
margin to earn profit.
g) Return on Investment or Return on
Capital Employed: This ratio shows the relationship between the
profit earned before interest and tax and the capital employed to earn such
profit.
Return
on Capital Employed = Net Profit before Interest, Tax and Dividend/Capital
Employed x 100
Where
Capital Employed = Share Capital (Equity + Preference) + Reserves and Surplus +
Long-term Loans – Fictitious Assets
Or
Capital
Employed = Fixed Assets + Current Assets – Current Liabilities
Objective
and Significance: Return on capital employed measures the profit, which a firm
earns on investing a unit of capital. The profit being the net result of all
operations, the return on capital expresses all efficiencies and inefficiencies
of a business. This ratio has a great importance to the shareholders and
investors and also to management. To shareholders it indicates how much their
capital is earning and to the management as to how efficiently it has been
working. This ratio influences the market price of the shares. The higher the
ratio, the better it is.
h) Return on Equity: Return on
equity is also known as return on shareholders’ investment. The ratio
establishes relationship between profit available to equity shareholders with
equity shareholders’ funds.
Return
on Equity = Net Profit after Interest, Tax and Preference Dividend/Equity
Shareholders’ Funds x 100
Where
Equity Shareholders’ Funds = Equity Share Capital + Reserves and Surplus –
Fictitious Assets
Objective
and Significance: Return on Equity judges the profitability from the point of
view of equity shareholders. This ratio has great interest to equity
shareholders. The return on equity measures the profitability of equity funds
invested in the firm. The investors favour the company with higher ROE.
i) Earnings Per Share: Earnings
per share is calculated by dividing the net profit (after interest, tax and
preference dividend) by the number of equity shares.
Earnings
Per Share = Net Profit after Interest, Tax and Preference Dividend/No. Of
Equity Shares
Objective
and Significance: Earning per share helps in determining the market price of
the equity share of the company. It also helps to know whether the company is
able to use its equity share capital effectively with compare to other
companies. It also tells about the capacity of the company to pay dividends to
its equity shareholders.
j) Price-earning Ratio: Price
earning ratio establishes the relationship between market prices and earning
per share. It is computed as:
Price-earning ratio = Market price / Earning per share
The purpose of this ratio is to make comparison with the other companies in the same business. It helps in forecasting the market value of the shares.
k) Debt-Equity Ratio: Debt
equity ratio shows the relationship between long-term debts and shareholders
funds’. It is also known as ‘External-Internal’ equity ratio.
Debt
Equity Ratio = Debt/Equity
Where
Debt (long term loans) include Debentures, Mortgage Loan, Bank Loan, Public
Deposits, Loan from financial institution etc.
Equity
(Shareholders’ Funds) = Share Capital (Equity + Preference) + Reserves and
Surplus – Fictitious Assets
Objective
and Significance: This ratio is a measure of owner’s stock in the business.
Proprietors are always keen to have more funds from borrowings because:
(i)
Their stake in the business is reduced and subsequently their risk too
(ii)
Interest on loans or borrowings is a deductible expenditure while computing
taxable profits. Dividend on shares is not so allowed by Income Tax
Authorities.
The
normally acceptable debt-equity ratio is 2:1.
l) Proprietary Ratio:
Proprietary Ratio establishes the relationship between proprietors’ funds and
total tangible assets. This ratio is also termed as ‘Net Worth to Total Assets’
or ‘Equity-Assets Ratio’.
Proprietary
Ratio = Proprietors’ Funds/Total Assets
Where
Proprietors’ Funds = Shareholders’ Funds = Share Capital (Equity + Preference)
+ Reserves and Surplus – Fictitious Assets
Total
Assets include only Fixed Assets and Current Assets. Any intangible assets
without any market value and fictitious assets are not included.
Objective
and Significance: This ratio indicates the general financial position of the
business concern. This ratio has a particular importance for the creditors who
can ascertain the proportion of shareholder’s funds in the total assets of the
business. Higher the ratio, greater the satisfaction for creditors of all types.
m) Capital Turnover Ratio: Capital
turnover ratio establishes a relationship between net sales and capital
employed. The ratio indicates the times by which the capital employed is used
to generate sales. It is calculated as follows:
Capital
Turnover Ratio = Net Sales/Capital Employed
Where
Net Sales = Sales – Sales Return
Capital
Employed = Share Capital (Equity + Preference) + Reserves and Surplus +
Long-term Loans – Fictitious Assets.
Objective
and Significance: The objective of capital turnover ratio is to calculate how
efficiently the capital invested in the business is being used and how many
times the capital is turned into sales. Higher the ratio, better the efficiency
of utilisation of capital and it would lead to higher profitability.
n) Fixed Assets Turnover Ratio: Fixed
assets turnover ratio establishes a relationship between net sales and net
fixed assets. This ratio indicates how well the fixed assets are being
utilised.
Fixed
Assets Turnover Ratio = Net Sales/Net Fixed Assets
In
case Net Sales are not given in the question cost of goods sold may also be
used in place of net sales. Net fixed assets are considered cost less
depreciation.
Objective
and Significance: This ratio expresses the number to times the fixed assets are
being turned over in a stated period. It measures the efficiency with which
fixed assets are employed. A high ratio means a high rate of efficiency of
utilisation of fixed asset and low ratio means improper use of the assets.
o) Working Capital Turnover Ratio: Working
capital turnover ratio establishes a relationship between net sales and working
capital. This ratio measures the efficiency of utilisation of working capital.
Working
Capital Turnover Ratio = Net Sales or Cost of Goods Sold/Net Working Capital
Where
Net Working Capital = Current Assets – Current Liabilities
Objective
and Significance: This ratio indicates the number of times the utilisation of
working capital in the process of doing business. The higher is the ratio, the
lower is the investment in working capital and the greater are the profits.
However, a very high turnover indicates a sign of over-trading and puts the
firm in financial difficulties. A low working capital turnover ratio indicates
that the working capital has not been used efficiently.
p) Stock Turnover Ratio: Stock
turnover ratio is a ratio between cost of goods sold and average stock. This
ratio is also known as stock velocity or inventory turnover ratio.
Stock
Turnover Ratio = Cost of Goods Sold/Average Stock
Where
Average Stock = [Opening Stock + Closing Stock]/2
Cost
of Goods Sold = Opening Stock + Net Purchases + Direct Expenses – Closing Stock
Objective
and Significance: Stock is a most important component of working capital. This
ratio provides guidelines to the management while framing stock policy. It
measures how fast the stock is moving through the firm and generating sales. It
helps to maintain a proper amount of stock to fulfill the requirements of the
concern. A proper inventory turnover makes the business to earn a reasonable
margin of profit.
q) Debtors’ Turnover Ratio: Debtors
turnover ratio indicates the relation between net credit sales and average
accounts receivables of the year. This ratio is also known as Debtors’
Velocity.
Debtors
Turnover Ratio = Net Credit Sales/Average Accounts Receivables
Where
Average Accounts Receivables = [Opening Debtors and B/R + Closing Debtors and
B/R]/2
Credit
Sales = Total Sales – Cash Sales-Return Inward
Objective
and Significance: This ratio indicates the efficiency of the concern to collect
the amount due from debtors. It determines the efficiency with which the trade
debtors are managed. Higher the ratio, better it is as it proves that the debts
are being collected very quickly.
r) Debt Collection Period: Debt
collection period is the period over which the debtors are collected on an
average basis. It indicates the rapidity or slowness with which the money is
collected from debtors.
Debt
Collection Period = 12 Months or 365 Days/Debtors Turnover Ratio
Or
Debt Collection Period = Average Trade
Debtors/Average Net Credit Sales per day
Or
365 days or 12 months x Average
Debtors/Credit Sales (360 days can also be used instead of 365 days)
Objective
and Significance: This ratio indicates how quickly and efficiently the debts
are collected. The shorter the period the better it is and longer the period
more the chances of bad debts. Although no standard period is prescribed
anywhere, it depends on the nature of the industry.
s) Creditor’ Turnover Ratio: Creditors
turnover ratio indicates the relation between net credit purchase and average
accounts payable of the year. This ratio is also known as Creditors’ Velocity.
Creditors’
Turnover Ratio = Net Credit Purchase/Average Accounts Payables
Where
Average Accounts Payables = [Opening Creditors and B/P + Closing Creditors and
B/P]/2
Credit
Purchase = Total Purchase– Cash Purchase-Return Outward
Objective
and Significance: This ratio indicates the payment period of the concern. Lower
the ratio better is the liquidity position of the firm and higher the ratios,
the lesser is the liquid position of the firm.
t) Average Payment Period: Average
Payment period is the period within which creditors are paid off. It indicates
the liquidity of the firm in paying creditors. It is calculated as:
Average
Payment Period = 12 Months or 365 Days/Creditors Turnover Ratio
Or
365 days or 12 months x Average Accounts Payables/Credit Purchase (360 days can also be used instead of 365 days)