Class 12 Accountancy · Chapter 10 NotesAccounting Ratios

Accounting ratios are essential tools used to analyse financial statements. They help in assessing the financial health of a business by comparing different financial figures. Ratios provide insights into a company's liquidity, solvency, efficiency, and profitability. They are calculated by dividing one financial figure by another, resulting in a ratio that can be expressed as a fraction, proportion, percentage, or a number of times. For example, the gross profit ratio is calculated by dividing the gross profit by the revenue from operations. Ratios are derived from accounting numbers and their efficacy depends on the accuracy of these numbers.

• Ratios exhibit relationships between accounting numbers
• They are derived from financial statements and depend on the accuracy of the data
• Ratios should be calculated using meaningfully correlated figures

Liquidity ratios measure a company's ability to meet its short-term obligations. They indicate how quickly a business can convert its assets into cash to pay off its current liabilities. The two primary liquidity ratios are the current ratio and the quick or liquid ratio. The current ratio is the proportion of current assets to current liabilities, while the quick ratio excludes inventory and other non-liquid current assets from the current assets. These ratios help assess the short-term solvency of a business and ensure it can meet its immediate financial obligations.

• Current Ratio = Current Assets / Current Liabilities
• Quick Ratio = Quick Assets / Current Liabilities
• Quick Assets = Current Assets - (Inventory + Other Non-Liquid Current Assets)

Profitability ratios analyse the earning capacity of a business, which is a result of the efficient utilisation of resources. These ratios help in assessing the financial performance of a company by comparing profit to various financial figures. Key profitability ratios include the gross profit ratio, operating ratio, operating profit ratio, net profit ratio, return on investment (ROI), return on net worth (RONW), earnings per share (EPS), book value per share, dividend payout ratio, and price/earning ratio. These ratios provide insights into the overall efficiency and profitability of the business, helping investors and stakeholders make informed decisions.

• Gross Profit Ratio = (Gross Profit / Revenue from Operations) × 100
• Net Profit Ratio = (Net Profit / Revenue from Operations) × 100
• Return on Investment (ROI) = (Profit Before Interest and Tax / Capital Employed) × 100

Solvency ratios determine a company's ability to meet its long-term obligations. These ratios are crucial for assessing the financial stability and long-term viability of a business. Key solvency ratios include the debt-equity ratio, debt to capital employed ratio, proprietary ratio, total assets to debt ratio, and interest coverage ratio. These ratios help in evaluating the company's ability to service its debt and ensure long-term financial health. For example, the debt-equity ratio measures the relationship between long-term debt and equity, indicating the level of financial leverage and risk.

• Debt-Equity Ratio = Long-term Debts / Shareholders' Funds
• Interest Coverage Ratio = (Net Profit Before Interest and Tax) / (Interest on Long-term Debts)
• Proprietary Ratio = Shareholders' Funds / Capital Employed

Efficiency ratios, also known as activity or turnover ratios, measure the speed at which a business performs its activities. These ratios indicate how efficiently a company utilises its assets to generate sales. Key efficiency ratios include inventory turnover, trade receivables turnover, trade payables turnover, investment turnover, fixed assets turnover, and working capital turnover. These ratios provide insights into the operational efficiency of the business, helping in identifying areas for improvement and optimising resource utilisation.

• Inventory Turnover Ratio = (Cost of Revenue from Operations) / (Average Inventory)
• Trade Receivables Turnover Ratio = (Net Credit Revenue from Operations) / (Average Trade Receivables)
• Working Capital Turnover Ratio = (Revenue from Operations) / (Working Capital)

Analysing and interpreting ratios is crucial for making informed financial decisions. Ratios provide valuable insights into a company's financial health, efficiency, and profitability. By comparing ratios over time (intra-firm comparison) and with other companies (inter-firm comparison), stakeholders can assess the performance and identify areas for improvement. Ratios should be interpreted carefully, considering the industry standards and the specific context of the business. They help in understanding the efficacy of decisions, simplifying complex figures, and identifying problem areas, enabling better financial management and strategic planning.

• Ratios help in simplifying complex accounting figures
• They provide a deeper analysis of profitability, liquidity, solvency, and efficiency
• Ratios enable comparative analysis within a firm and between different firms