Chapter 5 – Accounting Ratios NCERT SOLUTION CLASS 12TH ACCOUNTS | EDUGROWN NOTES

Short Answer Type Question:

Q.1 What do you mean by Ratio Analysis?

ANSWER: Ratio Analysis is a technique of financial analysis. It describes the relationship between various items of Balance Sheet and Income Statements. It helps us in ascertaining profitability, operational efficiency, solvency, etc. of a firm. It may be expressed as a fraction, proportion, percentage and in times. It enables budgetary controls by assessing qualitative relationship among different financial variables. Ratio Analysis provides vital information to various accounting users regarding the financial position and viability and performance of a firm. It also lays down the basic framework for decision making and policy designing by management.

Q.2 What are the various types of ratios?

ANSWER: Accounting ratios are classified in the following two ways.

I. Traditional Classification

II. Functional Classification

I. Traditional Classification: This classification is based on the financial statements, i.e. Profit and Loss Account and Balance Sheet. The Traditional Classification further bifurcates accounting ratios on the basis of the accounts to which the elements of a ratio belong. On the basis of accounts of financial statements, the Traditional Classification bifurcate accounting ratios as:

a. Income Statement Ratios: These are those ratios whose all the elements belong only to the Trading and Profit and Loss Account, like Gross Profit Ratio, etc.

b. Balance Sheet Ratios: These are those ratios whose all the elements belong only to the Balance Sheet, like Current Ratio, Debt Equity Ratio, etc.

c. Composite Ratios: These are those ratios whose elements belong both to the Trading and Profit and Loss Account as well as to the Balance Sheet, like Debtors Turnover Ratio, etc.

II. Functional Classification: This classification reflects the functional need and the purpose of calculating ratio. The basic rationale to compute ratio is to ascertain liquidity, solvency, financial performance and profitability of a business. Consequently, the Functional Classification classifies various accounting ratios as:

a. Liquidity Ratio: These ratios are calculated to determine short term solvency.

b. Solvency Ratio: These ratios are calculated to determine long term solvency.

c. Activity Ratio: These ratios are calculated for measuring the operational efficiency and efficacy of the operations. These ratios relate to sales or cost of goods sold.

d. Profitability Ratio: These ratios are calculated to assess the financial performance and the financial viability of the business.

Q.3 What relationships will be established to study:

a. Inventory Turnover

b. Trade Receivables Turnover

c. Trade Payables Turnover

d. Working Capital Turnover

ANSWER:

a. Inventory Turnover Ratio: This ratio is computed to determine the efficiency with which the stock is used. This ratio is based on the relationship between cost of goods sold and average stock kept during the year.

b. Debtors Turnover Ratio or Trade Receivables Turnover Ratio: This ratio is computed to determine the rate at which the amount is collected from the debtors. It establishes the relationship between net credit sales and average accounts receivables.

c. Trade Payables Turnover Ratio: This ratio is known as Creditors Turnover Ratio. It is computed to determine the rate at which the amount is paid to the creditors. It establishes the relationship between net credit purchases and average accounts payables.

d. Working Capital Turnover Ratio: This ratio is computed to determine how efficiently the working capital is utilised in making sales. It establishes the relationship between net sales and working capital.

Q.4 The liquidity of a business firm is measured by its ability to satisfy its long-term obligations as they become due. What are the ratios used for this purpose?

ANSWER: The liquidity of a business firm is measured by its ability to pay its long term obligations. The long term obligations include payments of principal amount on the due date and payments of interests on the regular basis. Long term solvency of any business can be calculated on the basis of the following ratios.

a. Debt-Equity Ratio– It depicts the relationship between the borrowed fund and owner’s funds. The lower the debt-equity ratio higher will be the degree of security to the lenders. A low debt-equity ratio implies that the company can easily meet its long term obligations.

b. Total Assets to Debt Ratio- It shows the relationship between the total assets and the long term loans. A high Total Assets to Debt Ratio implies that more assets are financed by the owner’s fund and the company can easily meet its long-term obligations. Thus, a higher ratio implies more security to the lenders.

c. Interest Coverage Ratio– This ratio depicts the relationship between amount of profit utilised for paying interest and amount of interest payable. A high Interest Coverage Ratio implies that the company can easily meet all its interest obligations out of its profit.

Q.5 The average age of inventory is viewed as the average length of time inventory is held by the firm for which explain with reasons.

ANSWER: Inventory Turnover Ratio: This ratio is computed to determine the efficiency with which the stock is used. This ratio is based on the relationship between cost of goods sold and average stock kept during the year.

It shows the rate with which the stock is turned into sales or the number of times the stock in turned into sales during the year. In other words, this ratio reveals the average length of time for which the inventory is held by the firm.

LONG ANSWER TYPE QUESTIONS:

Q.1 Who are the users of financial ratio analysis? Explain the significance of ratio analysis to them.
  ANSWER: Financial ratios help their users to take various managerial decisions. In this context there are four categories of users who are interested in financial ratios. These are the management, investors, long term creditors and short term creditors. The significance of ratios to the above mentioned users is as follows
(i) Management :Management calculate ratios for taking various managerial decisions. Management is always interested in future growth of the organisation. In this regard management design various policy measures and draft future plans. Management wish to know how effectively the resources are being utilised conseguently, they are interested in Activity Ratios and Profitability Ratios like Net Profit Ratio, Debtors Turnover Ratio, Fixed Assets Turnover Ratios, etc. ‘
(ii) Equity Investors :The prime concern of investors before investing in shares is to ensure the security of their principle and return on investment. It is a well known fact that the security of the funds is directly related to the profitability and operational efficiency of the business. In this way they are interested in knowing Earnings per Share, Return on Investment and Return on Equity.
(iii) Long Term Creditors: Long term creditors are those creditors who provide funds for more than one year, so they are interested in long term solvency of the firm and in assessing the ability of the firm to pay interest on time. In this way they are interested in calculating Long term Solvency Ratios like, Debt-Equity Ratio, Proprietory Ratio, Total Assets to Debt Ratio, Interest Coverage Ratio, etc.
(iv) Short Term Creditors :Short term creditors are those creditors who provide financial assistance through short term credit (Generally less than one year). That’s why short-term creditors are interested in timely payment of their debts in short run. In this way they are always interested in Liquidity Ratios like, Current Ratio, Quick Ratios etc. These ratios reveal the current financial position of the business. It is always observed that short term obligations are paid through current assest.

Q.2 What are liquidity ratios? Discuss the importance of current and liquid ratio.
ANSWER:  Liquidity ratios are calculated to determine the short-term solvency of the business. Analysis of current position of liquid funds determines* the ability of the business to pay the amount due as per commitment to stakeholders. Included in this category are current ratio, Quick ratio and Cash Fund Ratios.

Current Ratio/Working Capital Ratio: This ratio establish relationship between current assets and current liabilities. The standard for this ratio is 2 : 1. It means a ratio 2 : 1 is considered favourable. It is calculated by dividing the total of the current assets by total of the current liabilities. The formula for the current ratio is as follows
Current Ratio = Current Assets/Current Liabilities Or
Current Assets : Current Liabilities
Importance of Current Ratio Current Ratio Provides a measure of degree to which current assets cover current liabilities. The excess of current assets over current liabilities provides a measure of safety margin available against uncertainty in realisation of current assets and flow of funds. However, it must be interpreted carefully because window-dressing is possible by manipulating the components of current assets and current liabilities, e.g., it can be manipulated by making payment to creditors. A very high current ratio is not a good sign as it reflects under utilisation or improper utilisation of resources.
Liquid/Acid Test/Quick Ratio This ratio establishes relationship between Quick assets and Current liabilities. Quick assets are those assets which can get converted into cash easily in case of emergency. Out of current assets it is believed that stock, and prepaid expenses are not possible to convert in cash quickly. The standard for this ratio is 1:1. It means if quick assets are just equal to the current liabilities they will be considered favourable with the view point of company’s credibility. The formula for the quick ratio is as follows

Importance of Current Ratio: Current Ratio Provides a measure of degree to which current assets cover current liabilities. The excess of current assets over current liabilities provides a measure of safety margin available against uncertainty in realisation of current assets and flow of funds. However, it must be interpreted carefully because window-dressing is possible by manipulating the components of current assets and current liabilities, e.g., it can be manipulated by making payment to creditors. A very high current ratio is not a good sign as it reflects under utilisation or improper utilisation of resources.
Liquid/Acid Test/Quick Ratio:This ratio establishes relationship between Quick assets and Current liabilities. Quick assets are those assets which can get converted into cash easily in case of emergency. Out of current assets it is believed that stock, and prepaid expenses are not possible to convert in cash quickly. The standard for this ratio is 1:1. It means if quick assets are just equal to the current liabilities they will be considered favourable with the view point of company’s credibility. The formula for the quick ratio is as follows

Importance of Quick Ratio :It helps in determining whether a firm has sufficient funds if it has to pay all its current liabilities immediately. Because of exclusion of non-liquid current assets, it is considered better than current ratio as a measure of liquidity position of the business. Standard for liquid ratio is 1:1. Sometimes quick ratio is calculated on the basis of quick liability instead of current liabilities. Quick liabilities are calculated by ignoring bank overdraft, if any. It means to get the figure of quick liabilities from current liabilities; bank overdraft is deducted from current liabilities.

Q.3 How would you study the solvency position of the firm?
ANSWER: The solvency position of any firm is determined and measured with the help of solvency ratios. In this way we can say that the ratios which throw light on the debt servicing ability of the businesses in the long run are known as solvency ratios. Solvency of a concern can be measured in two ways first to check the security of Debt and second is to check the security of return on Debt. For calculating the security of debt we calculate Debt-Equity Ratio, Proprietory Ratio, Fixed Assets – Proprietory Fund Ratio, etc. And for calculating Security of Return on Debt we calculate Interest Coverage Ratio. A brief description of the above mentioned ratios is as follows

Debt Equity Ratio :Debt Equity Ratio indicates the relationship between the external equities or outsiders funds and the internal equities or shareholders funds. It is also known as external internal equity ratio. It is determined to ascertain soundness of the long term financial policies of the company.

Proprietory Ratio/ Total Assets to Debt Ratio: Total assets to Debt Ratio or Proprietory Ratio are a variant of the debt equity ratio. It is also known as equity ratio or net worth to total assets ratio. This ratio relates the shareholder’s funds to total assets. Proprietory/Equity Ratio indicates the long-term or future solvency position of the business. Formula of Proprietary/Equity Ratio

Shareholder’s funds include equity share capital plus all reserves and surpluses items. Total assets include all assets, including Goodwill. Some authors exclude goodwill from total assets. In that case the total shareholder’s funds are to be divided by total tangible assets. The total liabilities may also be used as the denominator in the above formula.

Fixed Assets to Proprietor’s Fund Ratio: Fixed Assets to Proprietor’s Fund Ratio establish a relationship between fixed assets and shareholders’ funds. The purpose of this ratio is to indicate the percentage of the owner’s funds invested in fixed assets. The formula for calculating this ratio is as follows

The fixed assets are considered at their book value and the proprietor’s funds consist of the same items as internal equities in the case of debt equity ratio.

Interest Coverage Ratio :This ratio deals only with servicing of return on loan as interest. This ratio depicts the relationship between amount of profit utilise for paying interest and amount of interest payable. A high Interest Coverage Ratio implies that the company can easily meet all its interest obligations out of its profit.

Q.4 What are important profitability ratios? How are they worked out? ‘
ANSWER:  Profitability Ratios Profitability ratios measure the results of business operations or overall performance and effectiveness of the firm. Some of the most Important and popular profitability ratios are as under
Gross Profit Ratio: Gross Profit Ratio (GP ratio) is the ratio of gross profit to net sales expressed as a percentage. It expresses the relationship between gross profit and sales. The basic components for the calculation of gross profit ratio are gross profit and net sales. Net sales mean sales minus sales returns.

Gross profit would be the difference between net sales and cost of goods sold. Cost of goods sold in the case of a trading concern would be equal to opening stock plus purchase, minus closing stock plus all direct expenses relating to purchases. In the case of manufacturing concern, it would be equal to the sum of the cost of raw materials, wages, direct expenses and all manufacturing expenses. In other words, generally the expenses charged to profit and loss account or operating expenses are excluded from the calculation of cost of goods sold.
Following formula is used to calculate gross profit ratios

Net Profit Ratio :Net Profit Ratio is the ratio of net profit to net sales. It is expressed as percentage. The two basic components of the net profit ratio are the net profit and sales. The net profits are obtained after deducting income-tax and, generally, non-operating expenses and incomes are excluded from the net profits for calculating this ratio. Thus, incomes such as interest on investments outside the business, profit on sales of fixed assets and losses on sales of fixed assets, etc are excluded.

Operating Profit Ratio :Operating Profit Ratio is the ratio of operating profit to net sales. There are many non operating expenses and incomes included in the profit and loss account which has nothing to do with the operations of the business such as loss by fire, loss by theft etc. On the other had in credit side of the P&L account, there are so many incomes
which can be considered as operating incomes such as dividend, bank interest, rent etc. In this way net profit ratio will not tell the truth about the profit of the organisation. Hence operating profit ratio will be helpful in that case. The formula for calculating operating ratio is as follows

Operating Ratio :Operating ratio is the ratio of cost of goods sold plus operating expenses to net sales. It is generally expressed in percentage, Operating ratio measures the cost of operations per dollar of sales. This is closely related to the ratio of operating profit to net sales. The two basic components for the calculation of operating ratio are operating cost (cost of goods sold plus operating expenses) and net sales. Operating expenses normally include (a) administrative and office expenses and (b) selling and distribution expenses. The formula for calculating the operating ratio is as follows

Q.5 Financial ratio analysis are conducted by four groups of analysts : managers, equity investors, long term creditors and short term creditors. What is the primary emphasis of each of these groups in evaluating ratios?
ANSWER:  This is very much true that the financial ratio analysis is conducted by four groups of analysts : managers, equity investors, long term creditors and short term creditors. The primary emphasis of each of these groups in evaluating these ratios are as follows
(i) Management: Management calculate ratios for taking various managerial decisions. Management is always interested in future growth of the organisation. In this regard management design various policy measures and draft future plans. Management wish to know how effectively the resources are being utilised Consequently, they are interested in Activity Ratios and Profitability Ratios like Net Profit Ratio, Debtors Turnover Ratio, Fixed Assets Turnover Ratios, etc.
(ii) Equity Investors: The prime concern of investors before investing in shares is to ensure the security of their principle and return on investment. It is a well known fact that the security of the funds is directly related to the profitability and operational efficiency of the business. In this way they are interested in knowing Earnings per Share, Return on Investment and Return on Equity.
(iii) Long Term Creditors: Long term creditors are those creditors who provide funds for more than one year, so they are interested in long term solvency of the firm and in assessing the ability of the firm to pay interest on time. In this way they are interested in calculating Long term Solvency Ratios like, Debt-Equity Ratio, Proprietory Ratio, Total Assets to Debt Ratio, Interest Coverage Ratio, etc.
(iv) Short Term Creditors: Short term creditors are those creditors who provide financial assistance through short term credit (Generally less than one year). That’s why short term creditors are interested in timely payment of their debts in short run. In this way, they are always interested in Liquidity Ratios like, Current Ratio, Quick Ratios etc. These ratios reveal the current financial position of the business. It is always observed that short term obligations are paid through current assest.

Q.6 The current ratio provides a better measure of overall liquidity only when a firm’s inventory cannot easily be converted into cash. If inventory is liquid, the quick ratio is a preferred measure of overall liquidity. Explain.
ANSWER:  The above mentioned statement is true. There are two different ways to measure the liquidity of a firm first through current ratio of the firm and second through quick ratio of the firm. The second one is considered the more refine form of measuring the liquidity of the firm.
The current ratio ‘explains the relationship between current assets and current liabilities. If current assets are quite capable to pay the current liability the liquidity of the concerned firm will be considered good. But here generally one question arises there are certain assets which cannot be converted into cash quickly such as stock and prepaid expenses.
As far as the matter of prepaid expenses is concerned it’s ok but what about the stock if we measure the liquidity on the basis of conversion of current assets in cash there are many firms where conversion of stock is not possible into cash frequently say e.g., heavy machinery manufacturing companies, locomotive companies, etc. This is because, the heavy stocks like machinery, heavy tools etc. cannot be easily sold off. In this case it is always advisable to follow the current ratio for measuring the liquidity of a firm.

But on the other hand, in case of those firms where the stock can be easily realised or sold off consideration of stock should be avoided and to measure the liquidity of that firm Quick ratio should be calculated, e.g., the inventories of a service sector company are very liquid as there are no stocks kept for sale, so in that case liquid ratio must be followed for measuring the liquidity of the firm.
We can understand from the above mentioned statement in the light of another example where stock contribute the major portion in current assets in that case to find out the liquidity of that firm stock cannot be avoided to measure the liquidity of the firm. On the other hand where stock contributes a reasonably less amount it can be avoided and liquidity of that firm can be measured with the help of quick ratio. On the other hand where there is a lot of fluctuation in the price of stock it is always advisable to compute quick ratio and avoid the stock figure because it will reduce the authenticity of liquidity measure.