AHSEC - 12: Ratio Analysis Important Notes for March 2022 - 23 Exam | Accountancy Notes Class 12

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)