Introduction - Ratio Analysis | Crash Course of Accountancy - Class 12 - Commerce PDF Download

 Page 1


 
     
 
 
 
Ratio 
Ratio is an arithmetical expression of relationship between two related or interdependent items. 
 
Accounting Ratio 
The ratios calculated on the basis of accounting information are termed as Accounting Ratios. So, Accounting ratios are 
those which are based on financial statements and express an arithmetical relation between various accounting variables. 
 
OBJECTIVES OF RATIO ANALYSIS 
1. To locate the areas of the business which need more attention. 
2. To determine the potential areas which can be improved with the effort in the desired direction. 
3. To provide a deeper analysis of profitability, liquidity, solvency and efficiency levels in the business. 
4. To provide information for making cross-sectional analysis, i.e. to compare the performance with the best industry 
standards. 
5. To provide information useful for making estimates and preparing the plans for the future. 
 
 
Advantages of Accounting Rations 
1. Helpful in Analysis of Financial Statements 
2. Simplification of Accounting Data 
3. Helpful in Comparative Study 
4. Helpful in Locating the Weak Spots of the Business 
5. Helpful in Forecasting 
6. Estimate about the Trend of the Business 
 
Limitations of Accounting Ratios 
1. False Accounting Data Gives False Ratios 
2. Comparison not Possible if Different Firms Adopt Different Accounting Policies 
3. Ratio Analysis Becomes Less Effective Due to Price Level Changes 
4. Ratios may be Misleading in the Absence of Absolute date 
5. Limited Use of a Single Ratio 
6. Window-dressing 
 
CLASSIFICATION OF RATIOS 
Liquidity Ratios  Solvency Ratios  Activity Ratios    Profitability Ratios 
— Current Ratio — Debt to Equity Ratio — Inventory Turnover Ratio   — Gross Profit Ratio 
— Quick Ratio — Total Assets to Debt — Trade Receivables Turnover Ratio  — Operating Ratio 
 — Proprietary Ratio — Trade Payables Turnover Ratio  — Operating Profit Ratio 
 — Interest Coverage Ratio — Working Capital Turnover Ratio 
 
— Net Profit Ratio 
     — Return on Investment 
 
 LIQUIDITY RATIO  
? The ability of the business to pay the amount due to stakeholders as and when it is due is known as liquidity and 
the ratios calculated to measure it are termed as Liquidity Ratios.  
? They assess the short-term solvency of the business, i.e. ability of the firm to meet its short-term obligations. 
Liquidity Ratios include two main ratios: 
(i) Current Ratio (ii) Quick Ratio 
 
1. Current Ratio / working capital ratio =  Current Assets 
                      Current Liabilities 
? Current Assets= T   trade receivables (debtors + b/r) less provisions   
I   inventory (raw materials+ work in progress+ finished goods) excluding stores, spare parts and loose 
tools. 
         S   short term loans and advances  
         C  current investments/ short term investments/ marketable securities (always ignore trade  
investments) 
         C  cash and cash equivalents (cash+ cash at bank+ cheques in hand) 
Page 2


 
     
 
 
 
Ratio 
Ratio is an arithmetical expression of relationship between two related or interdependent items. 
 
Accounting Ratio 
The ratios calculated on the basis of accounting information are termed as Accounting Ratios. So, Accounting ratios are 
those which are based on financial statements and express an arithmetical relation between various accounting variables. 
 
OBJECTIVES OF RATIO ANALYSIS 
1. To locate the areas of the business which need more attention. 
2. To determine the potential areas which can be improved with the effort in the desired direction. 
3. To provide a deeper analysis of profitability, liquidity, solvency and efficiency levels in the business. 
4. To provide information for making cross-sectional analysis, i.e. to compare the performance with the best industry 
standards. 
5. To provide information useful for making estimates and preparing the plans for the future. 
 
 
Advantages of Accounting Rations 
1. Helpful in Analysis of Financial Statements 
2. Simplification of Accounting Data 
3. Helpful in Comparative Study 
4. Helpful in Locating the Weak Spots of the Business 
5. Helpful in Forecasting 
6. Estimate about the Trend of the Business 
 
Limitations of Accounting Ratios 
1. False Accounting Data Gives False Ratios 
2. Comparison not Possible if Different Firms Adopt Different Accounting Policies 
3. Ratio Analysis Becomes Less Effective Due to Price Level Changes 
4. Ratios may be Misleading in the Absence of Absolute date 
5. Limited Use of a Single Ratio 
6. Window-dressing 
 
CLASSIFICATION OF RATIOS 
Liquidity Ratios  Solvency Ratios  Activity Ratios    Profitability Ratios 
— Current Ratio — Debt to Equity Ratio — Inventory Turnover Ratio   — Gross Profit Ratio 
— Quick Ratio — Total Assets to Debt — Trade Receivables Turnover Ratio  — Operating Ratio 
 — Proprietary Ratio — Trade Payables Turnover Ratio  — Operating Profit Ratio 
 — Interest Coverage Ratio — Working Capital Turnover Ratio 
 
— Net Profit Ratio 
     — Return on Investment 
 
 LIQUIDITY RATIO  
? The ability of the business to pay the amount due to stakeholders as and when it is due is known as liquidity and 
the ratios calculated to measure it are termed as Liquidity Ratios.  
? They assess the short-term solvency of the business, i.e. ability of the firm to meet its short-term obligations. 
Liquidity Ratios include two main ratios: 
(i) Current Ratio (ii) Quick Ratio 
 
1. Current Ratio / working capital ratio =  Current Assets 
                      Current Liabilities 
? Current Assets= T   trade receivables (debtors + b/r) less provisions   
I   inventory (raw materials+ work in progress+ finished goods) excluding stores, spare parts and loose 
tools. 
         S   short term loans and advances  
         C  current investments/ short term investments/ marketable securities (always ignore trade  
investments) 
         C  cash and cash equivalents (cash+ cash at bank+ cheques in hand) 
 
     
 
         O other current assets (prepaid expenses/unexpired amounts+ payment in advance + accrued  
incomes) 
? Current Liabilities= STB (short term borrowings- bank overdraft+ matured debentures/loan) 
                                   STP (short term provisions – provision for taxation [C.Y.]+ proposed dividends) 
                                   TP   (trade payables= creditors + b/p) 
                                   OCL (other current liabilities= outstanding expenses+ unearned incomes+ unclaimed dividend+  
unpaid dividends+ calls in advance) 
? Ideal ratio is 2:1. 
? Both 'Very High' and 'Very Low' Current Ratio are not good for a firm. 
? 'Very High' Current Ratio may lead to Low Profitability: A very high current ratio may be due to excessive investment 
in the current assets, which may result in idle funds. It leads to lower profitability as idle funds do not earn anything. 
? Very Low' Current Ratio may cause Risk to Solvency: A very low current ratio may be due to inadequate investment 
in the current assets, which may result in low liquidity. It may threaten the solvency of the enterprise. 
 
2. Quick ratio/ acid test ratio/ liquid ratio=   Quick  Assets/liquid assets  
                              Current Liabilities 
? Quick  Assets=    T   trade receivables (debtors + b/r) less provisions   
         S   short term loans and advances  
         C current investments/ short term investments/ marketable securities (always ignore trade 
investments) 
         C cash and cash equivalents (cash+ cash at bank+ cheques in hand) 
? Current Liabilities= STB (short term borrowings- bank overdraft+ matured debentures/loan) 
                                   STP (short term provisions – provision for taxation [C.Y.]+ proposed dividends) 
                                   TP   (trade payables= creditors + b/p) 
                                   OCL (other current liabilities= outstanding expenses+ unearned incomes+ unclaimed dividend+ 
unpaid dividends+ calls in advance) 
? Ideal ratio is 1:1. 
An unnecessarily low ratio will be very risky and a high ratio suggests unnecessarily deployment of resources in 
otherwise less profitable short-term investments. 
? Quick  Assets = Current Assets – inventory(closing)- prepaid expenses/+ payment in advance 
? Working capital = Current Assets – Current Liabilities 
 
Distinction between Current Ratio and Quick Ratio 
Basis Current Ratio Quick Ratio 
1. Meaning It establishes the relationship between It establishes the relationship 
between 
 current assets and current liabilities. liquid assets and current liabilities. 
2. Objective It aims to asses ability of the firm to meet It aims to asses the ability of the firm 
to 
 its current liabilities within 12 months 
from 
meet its current liabilities 
immediately. 
 the date of Balance Sheet or within the  
 period of operating cycle.  
3. Ideal Ratio 2:1 is considered as an ideal ratio. 1:1 is considered as an ideal ratio. 
   
4. Formula Current Assets = Current Ratio  / Current 
Liabilities = 
Quick Ratio = Quick Assets / Current 
Liabilities   
SUMMARY OF ACCOUNTING RATIOS 
LIQUIDITY RATIOS 
Name of the Ratio Formula Significance 
1. Current Ratio Ideal 
Ratio = 2:1 
Current Assets / Current Liabilities = …. : …. This ratio indicates the firm's ability to meet its 
short – term liabilities on time. It helps in assessing 
short – term solvency of the enterprise. It shows 
the number of times current assets are in excess of 
the current liabilities. 
Page 3


 
     
 
 
 
Ratio 
Ratio is an arithmetical expression of relationship between two related or interdependent items. 
 
Accounting Ratio 
The ratios calculated on the basis of accounting information are termed as Accounting Ratios. So, Accounting ratios are 
those which are based on financial statements and express an arithmetical relation between various accounting variables. 
 
OBJECTIVES OF RATIO ANALYSIS 
1. To locate the areas of the business which need more attention. 
2. To determine the potential areas which can be improved with the effort in the desired direction. 
3. To provide a deeper analysis of profitability, liquidity, solvency and efficiency levels in the business. 
4. To provide information for making cross-sectional analysis, i.e. to compare the performance with the best industry 
standards. 
5. To provide information useful for making estimates and preparing the plans for the future. 
 
 
Advantages of Accounting Rations 
1. Helpful in Analysis of Financial Statements 
2. Simplification of Accounting Data 
3. Helpful in Comparative Study 
4. Helpful in Locating the Weak Spots of the Business 
5. Helpful in Forecasting 
6. Estimate about the Trend of the Business 
 
Limitations of Accounting Ratios 
1. False Accounting Data Gives False Ratios 
2. Comparison not Possible if Different Firms Adopt Different Accounting Policies 
3. Ratio Analysis Becomes Less Effective Due to Price Level Changes 
4. Ratios may be Misleading in the Absence of Absolute date 
5. Limited Use of a Single Ratio 
6. Window-dressing 
 
CLASSIFICATION OF RATIOS 
Liquidity Ratios  Solvency Ratios  Activity Ratios    Profitability Ratios 
— Current Ratio — Debt to Equity Ratio — Inventory Turnover Ratio   — Gross Profit Ratio 
— Quick Ratio — Total Assets to Debt — Trade Receivables Turnover Ratio  — Operating Ratio 
 — Proprietary Ratio — Trade Payables Turnover Ratio  — Operating Profit Ratio 
 — Interest Coverage Ratio — Working Capital Turnover Ratio 
 
— Net Profit Ratio 
     — Return on Investment 
 
 LIQUIDITY RATIO  
? The ability of the business to pay the amount due to stakeholders as and when it is due is known as liquidity and 
the ratios calculated to measure it are termed as Liquidity Ratios.  
? They assess the short-term solvency of the business, i.e. ability of the firm to meet its short-term obligations. 
Liquidity Ratios include two main ratios: 
(i) Current Ratio (ii) Quick Ratio 
 
1. Current Ratio / working capital ratio =  Current Assets 
                      Current Liabilities 
? Current Assets= T   trade receivables (debtors + b/r) less provisions   
I   inventory (raw materials+ work in progress+ finished goods) excluding stores, spare parts and loose 
tools. 
         S   short term loans and advances  
         C  current investments/ short term investments/ marketable securities (always ignore trade  
investments) 
         C  cash and cash equivalents (cash+ cash at bank+ cheques in hand) 
 
     
 
         O other current assets (prepaid expenses/unexpired amounts+ payment in advance + accrued  
incomes) 
? Current Liabilities= STB (short term borrowings- bank overdraft+ matured debentures/loan) 
                                   STP (short term provisions – provision for taxation [C.Y.]+ proposed dividends) 
                                   TP   (trade payables= creditors + b/p) 
                                   OCL (other current liabilities= outstanding expenses+ unearned incomes+ unclaimed dividend+  
unpaid dividends+ calls in advance) 
? Ideal ratio is 2:1. 
? Both 'Very High' and 'Very Low' Current Ratio are not good for a firm. 
? 'Very High' Current Ratio may lead to Low Profitability: A very high current ratio may be due to excessive investment 
in the current assets, which may result in idle funds. It leads to lower profitability as idle funds do not earn anything. 
? Very Low' Current Ratio may cause Risk to Solvency: A very low current ratio may be due to inadequate investment 
in the current assets, which may result in low liquidity. It may threaten the solvency of the enterprise. 
 
2. Quick ratio/ acid test ratio/ liquid ratio=   Quick  Assets/liquid assets  
                              Current Liabilities 
? Quick  Assets=    T   trade receivables (debtors + b/r) less provisions   
         S   short term loans and advances  
         C current investments/ short term investments/ marketable securities (always ignore trade 
investments) 
         C cash and cash equivalents (cash+ cash at bank+ cheques in hand) 
? Current Liabilities= STB (short term borrowings- bank overdraft+ matured debentures/loan) 
                                   STP (short term provisions – provision for taxation [C.Y.]+ proposed dividends) 
                                   TP   (trade payables= creditors + b/p) 
                                   OCL (other current liabilities= outstanding expenses+ unearned incomes+ unclaimed dividend+ 
unpaid dividends+ calls in advance) 
? Ideal ratio is 1:1. 
An unnecessarily low ratio will be very risky and a high ratio suggests unnecessarily deployment of resources in 
otherwise less profitable short-term investments. 
? Quick  Assets = Current Assets – inventory(closing)- prepaid expenses/+ payment in advance 
? Working capital = Current Assets – Current Liabilities 
 
Distinction between Current Ratio and Quick Ratio 
Basis Current Ratio Quick Ratio 
1. Meaning It establishes the relationship between It establishes the relationship 
between 
 current assets and current liabilities. liquid assets and current liabilities. 
2. Objective It aims to asses ability of the firm to meet It aims to asses the ability of the firm 
to 
 its current liabilities within 12 months 
from 
meet its current liabilities 
immediately. 
 the date of Balance Sheet or within the  
 period of operating cycle.  
3. Ideal Ratio 2:1 is considered as an ideal ratio. 1:1 is considered as an ideal ratio. 
   
4. Formula Current Assets = Current Ratio  / Current 
Liabilities = 
Quick Ratio = Quick Assets / Current 
Liabilities   
SUMMARY OF ACCOUNTING RATIOS 
LIQUIDITY RATIOS 
Name of the Ratio Formula Significance 
1. Current Ratio Ideal 
Ratio = 2:1 
Current Assets / Current Liabilities = …. : …. This ratio indicates the firm's ability to meet its 
short – term liabilities on time. It helps in assessing 
short – term solvency of the enterprise. It shows 
the number of times current assets are in excess of 
the current liabilities. 
 
    
 
2. Quick Ratio or 
Liquid Ratio or 
Acid – Test Ratio 
Ideal Ratio =1:1 
Liquid or Quick Assets /  Current Liabilities  
= ….. : …… 
This ratio determine ability of the firm to meet its 
current liabilities immediately. It is a better 
measure of liquidity as it considers only those 
assets which can be easily and readily converted 
into cash. 
Important Points 
1. Current Assets=Current Investments + Inventories (except Loose Tools, Stores and Spares)+Trade Receivables (Sundry 
Debtors and Bills Receivable less Provision for Doubtful Debts) + Cash and Cash Equivalents (Cash in hand, Cash at bank, 
Cheques/Drafts in hand, etc.) + Short – term loans and advances + Other current assets (Prepaid Expenses + Accrued 
Incomes + Advance Tax) 
2. Current Liabilities = Short – term Borrowings + Trade Payables (Sundry Creditors and Bills Payable) + Other Current 
Liabilities (Current maturities of Long – term debts, interest accrued but not due, interest accrued and due, outstanding 
expenses, unclaimed dividend, calls – in – advance, etc.) + Short – term Provisions (Provision for Tax, Proposed Dividend, 
Provision for Employee Benefits) 
3. Quick Assets = Current Assets – Inventories – Prepaid Expenses – Advance Tax 
4. Working Capital = Current Assets – Current Liabilities 
 
SOLVENCY RATIO  
1. Debt equity ratio = debt / borrowed funds/ Non-current liabilities 
    Equity / owner funds / shareholders fund 
? Debt /non-current liabilities= long term borrowings (loans+ debentures+ public deposits)   
Long term provisions (all employees and workers related provisions like provident 
fund, Gratuity ) 
? Equity / shareholders fund =  share capital (equity+ preference) 
     Reserves and surplus (sssccpo- S security premium) 
S sinking fund/D.R.R. 
  S Surplus in the statement of p&l a/c 
                 C capital Reserve 
                  C capital redemption reserve 
                  P P&L a/c or P&L appropriation a/c {if its Dr. balance its minus and cr. Balance  
its plus} 
 O other reserves (general reserves)    
? Ideal ratio is 2:1. 
? A high ratio means that the enterprise is depending more on external debts as compared to shareholders' funds. It 
indicates that external equities are at higher risks. 
? On the other hand, a low Debt to Equity Ratio means that the enterprise is depending more on shareholders' funds 
than external debts. It indicates that external equities are at a lower risk and have higher safety. 
 
2. Total assets to debt ratio = Total assets  
     Debt  
? Total assets = Non-current assets + current assets 
? A high ratio means higher safety margin for lenders, whereas, low ratio indicates lower safety margin for the 
lenders. 
 
3. Proprietary ratio = equity  
                          Total Assets  
? A higher ratio is generally taken as an indicator of sound financial position from long – term point of view, because 
it means that a large proportion of total assets has been financed by the equity and firm is less dependent on 
external sources of finance. 
 
4. Interest coverage Ratio = net profit before interest and tax 
Fixed interest charges  
? net profit before interest and tax = net profit after interest and tax X 100     +   fixed interest charges  
               (100 – tax rate ) 
? fixed interest charges = coupon rate or the interest rate on debt  
? like 10 % debentures = 2,00,000 then interest will be Rs.20,000 
? A high ratio is considered better for the lenders as it means higher safety margin. 
Page 4


 
     
 
 
 
Ratio 
Ratio is an arithmetical expression of relationship between two related or interdependent items. 
 
Accounting Ratio 
The ratios calculated on the basis of accounting information are termed as Accounting Ratios. So, Accounting ratios are 
those which are based on financial statements and express an arithmetical relation between various accounting variables. 
 
OBJECTIVES OF RATIO ANALYSIS 
1. To locate the areas of the business which need more attention. 
2. To determine the potential areas which can be improved with the effort in the desired direction. 
3. To provide a deeper analysis of profitability, liquidity, solvency and efficiency levels in the business. 
4. To provide information for making cross-sectional analysis, i.e. to compare the performance with the best industry 
standards. 
5. To provide information useful for making estimates and preparing the plans for the future. 
 
 
Advantages of Accounting Rations 
1. Helpful in Analysis of Financial Statements 
2. Simplification of Accounting Data 
3. Helpful in Comparative Study 
4. Helpful in Locating the Weak Spots of the Business 
5. Helpful in Forecasting 
6. Estimate about the Trend of the Business 
 
Limitations of Accounting Ratios 
1. False Accounting Data Gives False Ratios 
2. Comparison not Possible if Different Firms Adopt Different Accounting Policies 
3. Ratio Analysis Becomes Less Effective Due to Price Level Changes 
4. Ratios may be Misleading in the Absence of Absolute date 
5. Limited Use of a Single Ratio 
6. Window-dressing 
 
CLASSIFICATION OF RATIOS 
Liquidity Ratios  Solvency Ratios  Activity Ratios    Profitability Ratios 
— Current Ratio — Debt to Equity Ratio — Inventory Turnover Ratio   — Gross Profit Ratio 
— Quick Ratio — Total Assets to Debt — Trade Receivables Turnover Ratio  — Operating Ratio 
 — Proprietary Ratio — Trade Payables Turnover Ratio  — Operating Profit Ratio 
 — Interest Coverage Ratio — Working Capital Turnover Ratio 
 
— Net Profit Ratio 
     — Return on Investment 
 
 LIQUIDITY RATIO  
? The ability of the business to pay the amount due to stakeholders as and when it is due is known as liquidity and 
the ratios calculated to measure it are termed as Liquidity Ratios.  
? They assess the short-term solvency of the business, i.e. ability of the firm to meet its short-term obligations. 
Liquidity Ratios include two main ratios: 
(i) Current Ratio (ii) Quick Ratio 
 
1. Current Ratio / working capital ratio =  Current Assets 
                      Current Liabilities 
? Current Assets= T   trade receivables (debtors + b/r) less provisions   
I   inventory (raw materials+ work in progress+ finished goods) excluding stores, spare parts and loose 
tools. 
         S   short term loans and advances  
         C  current investments/ short term investments/ marketable securities (always ignore trade  
investments) 
         C  cash and cash equivalents (cash+ cash at bank+ cheques in hand) 
 
     
 
         O other current assets (prepaid expenses/unexpired amounts+ payment in advance + accrued  
incomes) 
? Current Liabilities= STB (short term borrowings- bank overdraft+ matured debentures/loan) 
                                   STP (short term provisions – provision for taxation [C.Y.]+ proposed dividends) 
                                   TP   (trade payables= creditors + b/p) 
                                   OCL (other current liabilities= outstanding expenses+ unearned incomes+ unclaimed dividend+  
unpaid dividends+ calls in advance) 
? Ideal ratio is 2:1. 
? Both 'Very High' and 'Very Low' Current Ratio are not good for a firm. 
? 'Very High' Current Ratio may lead to Low Profitability: A very high current ratio may be due to excessive investment 
in the current assets, which may result in idle funds. It leads to lower profitability as idle funds do not earn anything. 
? Very Low' Current Ratio may cause Risk to Solvency: A very low current ratio may be due to inadequate investment 
in the current assets, which may result in low liquidity. It may threaten the solvency of the enterprise. 
 
2. Quick ratio/ acid test ratio/ liquid ratio=   Quick  Assets/liquid assets  
                              Current Liabilities 
? Quick  Assets=    T   trade receivables (debtors + b/r) less provisions   
         S   short term loans and advances  
         C current investments/ short term investments/ marketable securities (always ignore trade 
investments) 
         C cash and cash equivalents (cash+ cash at bank+ cheques in hand) 
? Current Liabilities= STB (short term borrowings- bank overdraft+ matured debentures/loan) 
                                   STP (short term provisions – provision for taxation [C.Y.]+ proposed dividends) 
                                   TP   (trade payables= creditors + b/p) 
                                   OCL (other current liabilities= outstanding expenses+ unearned incomes+ unclaimed dividend+ 
unpaid dividends+ calls in advance) 
? Ideal ratio is 1:1. 
An unnecessarily low ratio will be very risky and a high ratio suggests unnecessarily deployment of resources in 
otherwise less profitable short-term investments. 
? Quick  Assets = Current Assets – inventory(closing)- prepaid expenses/+ payment in advance 
? Working capital = Current Assets – Current Liabilities 
 
Distinction between Current Ratio and Quick Ratio 
Basis Current Ratio Quick Ratio 
1. Meaning It establishes the relationship between It establishes the relationship 
between 
 current assets and current liabilities. liquid assets and current liabilities. 
2. Objective It aims to asses ability of the firm to meet It aims to asses the ability of the firm 
to 
 its current liabilities within 12 months 
from 
meet its current liabilities 
immediately. 
 the date of Balance Sheet or within the  
 period of operating cycle.  
3. Ideal Ratio 2:1 is considered as an ideal ratio. 1:1 is considered as an ideal ratio. 
   
4. Formula Current Assets = Current Ratio  / Current 
Liabilities = 
Quick Ratio = Quick Assets / Current 
Liabilities   
SUMMARY OF ACCOUNTING RATIOS 
LIQUIDITY RATIOS 
Name of the Ratio Formula Significance 
1. Current Ratio Ideal 
Ratio = 2:1 
Current Assets / Current Liabilities = …. : …. This ratio indicates the firm's ability to meet its 
short – term liabilities on time. It helps in assessing 
short – term solvency of the enterprise. It shows 
the number of times current assets are in excess of 
the current liabilities. 
 
    
 
2. Quick Ratio or 
Liquid Ratio or 
Acid – Test Ratio 
Ideal Ratio =1:1 
Liquid or Quick Assets /  Current Liabilities  
= ….. : …… 
This ratio determine ability of the firm to meet its 
current liabilities immediately. It is a better 
measure of liquidity as it considers only those 
assets which can be easily and readily converted 
into cash. 
Important Points 
1. Current Assets=Current Investments + Inventories (except Loose Tools, Stores and Spares)+Trade Receivables (Sundry 
Debtors and Bills Receivable less Provision for Doubtful Debts) + Cash and Cash Equivalents (Cash in hand, Cash at bank, 
Cheques/Drafts in hand, etc.) + Short – term loans and advances + Other current assets (Prepaid Expenses + Accrued 
Incomes + Advance Tax) 
2. Current Liabilities = Short – term Borrowings + Trade Payables (Sundry Creditors and Bills Payable) + Other Current 
Liabilities (Current maturities of Long – term debts, interest accrued but not due, interest accrued and due, outstanding 
expenses, unclaimed dividend, calls – in – advance, etc.) + Short – term Provisions (Provision for Tax, Proposed Dividend, 
Provision for Employee Benefits) 
3. Quick Assets = Current Assets – Inventories – Prepaid Expenses – Advance Tax 
4. Working Capital = Current Assets – Current Liabilities 
 
SOLVENCY RATIO  
1. Debt equity ratio = debt / borrowed funds/ Non-current liabilities 
    Equity / owner funds / shareholders fund 
? Debt /non-current liabilities= long term borrowings (loans+ debentures+ public deposits)   
Long term provisions (all employees and workers related provisions like provident 
fund, Gratuity ) 
? Equity / shareholders fund =  share capital (equity+ preference) 
     Reserves and surplus (sssccpo- S security premium) 
S sinking fund/D.R.R. 
  S Surplus in the statement of p&l a/c 
                 C capital Reserve 
                  C capital redemption reserve 
                  P P&L a/c or P&L appropriation a/c {if its Dr. balance its minus and cr. Balance  
its plus} 
 O other reserves (general reserves)    
? Ideal ratio is 2:1. 
? A high ratio means that the enterprise is depending more on external debts as compared to shareholders' funds. It 
indicates that external equities are at higher risks. 
? On the other hand, a low Debt to Equity Ratio means that the enterprise is depending more on shareholders' funds 
than external debts. It indicates that external equities are at a lower risk and have higher safety. 
 
2. Total assets to debt ratio = Total assets  
     Debt  
? Total assets = Non-current assets + current assets 
? A high ratio means higher safety margin for lenders, whereas, low ratio indicates lower safety margin for the 
lenders. 
 
3. Proprietary ratio = equity  
                          Total Assets  
? A higher ratio is generally taken as an indicator of sound financial position from long – term point of view, because 
it means that a large proportion of total assets has been financed by the equity and firm is less dependent on 
external sources of finance. 
 
4. Interest coverage Ratio = net profit before interest and tax 
Fixed interest charges  
? net profit before interest and tax = net profit after interest and tax X 100     +   fixed interest charges  
               (100 – tax rate ) 
? fixed interest charges = coupon rate or the interest rate on debt  
? like 10 % debentures = 2,00,000 then interest will be Rs.20,000 
? A high ratio is considered better for the lenders as it means higher safety margin. 
 
    
 
              
Notes:  
1. Debt = Long-term Borrowings + Long-term Provisions  
2. Equity = Equity Share Capital + Preference Share Capital + Reserves & Surplus.  
3. Equity = Non-Current Assets + Working Capital - Non-Current Liabilities  
4. Equity = Share Capital + Reserves & Surplus.  
5. Equity = Shareholders' Funds + Preference Share Capital  
6. Equity = Capital Employed - Debt  
7. Equity = Non-Current Assets + Current Assets - Current Liabilities - Non-Current Liabilities  
8. Equity = Total Assets - Total Debt 
9. Total assets = total liabilities  
10. Total assets / total liabilities= shareholders fund+ non c.l. + c.l. 
11.  Total debt = long term debt + current debt  
12.  Total liabilities = long term liabilities + current liabilities 
SOLVENCY RATIOS 
Name of Ratio Formula Significance  
1. Debt to Equity 
Ratio 
Ideal Ratio = 2:1 
Debt /  Equity  = ....... 
 
This ratio is calculated to assess the long – term financial 
soundness of the enterprise. It indicates the extent to which 
the enterprise depends on external funds for its business. 
2. Total Assets to 
Debt Ratio 
Total Assets /  Debt  = ........ 
 
This ratio measures the extent to which debt is covered by the 
assets, i.e. it measures the safety margin available to the 
lenders of long – term debts. A high ratio means higher safety 
margin for lenders, whereas, low ratio indicates lower safety 
margin. 
3. Proprietary 
Ratio 
Proprietors' Funds (Equity)  / Total 
Assets = ...... 
 
This ratio aims to measure the proportion of total assets, which 
have been funded by the owners or shareholders. A high ratio 
is generally taken as an indicator of sound financial position as 
it means that a large proportion of total assets has been 
financed by equity. 
4. Interest 
Coverage Ratio 
Profit before interest and Tax /  
Interest on Long – term Debt = 
...Times 
 
This ratio indicates how many times the interest charges are 
covered by the profits out of which interest will be paid. This 
ratio measures the margin of safety for long – term lenders. A 
high ratio is considered better for the lenders as it means 
higher safety margin. 
Important Points 
1. Debt = Long – term Borrowings (Debentures, Mortgage Loan, Term Loans from Banks and other financial institutions, 
Public Deposits, etc.) + Long – term Provisions (Provision for Employee Benefits, Provision for Provident fund, Provision 
for Warranty Claims, etc.) 
2. Equity = Share Capital (Equity Share Capital, Preference Share Capital) + Reserves and Surplus (Capital Reserve, 
Securities Premium Reserve, General Reserve, etc.) 
3. Total Assets = Non – Current Assets (Fixed Assets (Tangible and Intangible Assets), Non – Current Investments, Long 
– term Loans and Advances) + Current Assets (Inventories (including Loose Tools, Stores and Spares), Trade Receivables 
(Sundry Debtors and Bills Receivable less Provision for Doubtful Debts), Cash and Cash Equivalents, Short – term loans 
and advances, Other current assets (Prepaid expenses + Accrued Incomes + Advance tax)} 
4. Profit before Interest and Tax = Profit after Interest and after Tax + Tax + Interest on Long – term Debt*. 
5. *Interest on Long – term Debt: It includes interest on long – term debt such as interest on Debentures, Mortgage 
Loan, Term Loans, Public Deposits, etc. 
 
ACTIVITY OR TURNOVER RATIO   
1. Inventory turnover ratio=  Cost of revenue from operations  
             Average inventory   
? Cost of revenue from operations = Revenue from operations – gross profit    
Or   
  Cost of revenue from operations = op inventory – cl. Inventory + purchases – purchase return + direct 
expenses  
  op inventory – cl. Inventory= change in stock 
  purchases – purchase return = net purchases  
  direct expenses =  all expenses of trading a/c dr. side like wages , carriage , freight, octroi etc 
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Ratio 
Ratio is an arithmetical expression of relationship between two related or interdependent items. 
 
Accounting Ratio 
The ratios calculated on the basis of accounting information are termed as Accounting Ratios. So, Accounting ratios are 
those which are based on financial statements and express an arithmetical relation between various accounting variables. 
 
OBJECTIVES OF RATIO ANALYSIS 
1. To locate the areas of the business which need more attention. 
2. To determine the potential areas which can be improved with the effort in the desired direction. 
3. To provide a deeper analysis of profitability, liquidity, solvency and efficiency levels in the business. 
4. To provide information for making cross-sectional analysis, i.e. to compare the performance with the best industry 
standards. 
5. To provide information useful for making estimates and preparing the plans for the future. 
 
 
Advantages of Accounting Rations 
1. Helpful in Analysis of Financial Statements 
2. Simplification of Accounting Data 
3. Helpful in Comparative Study 
4. Helpful in Locating the Weak Spots of the Business 
5. Helpful in Forecasting 
6. Estimate about the Trend of the Business 
 
Limitations of Accounting Ratios 
1. False Accounting Data Gives False Ratios 
2. Comparison not Possible if Different Firms Adopt Different Accounting Policies 
3. Ratio Analysis Becomes Less Effective Due to Price Level Changes 
4. Ratios may be Misleading in the Absence of Absolute date 
5. Limited Use of a Single Ratio 
6. Window-dressing 
 
CLASSIFICATION OF RATIOS 
Liquidity Ratios  Solvency Ratios  Activity Ratios    Profitability Ratios 
— Current Ratio — Debt to Equity Ratio — Inventory Turnover Ratio   — Gross Profit Ratio 
— Quick Ratio — Total Assets to Debt — Trade Receivables Turnover Ratio  — Operating Ratio 
 — Proprietary Ratio — Trade Payables Turnover Ratio  — Operating Profit Ratio 
 — Interest Coverage Ratio — Working Capital Turnover Ratio 
 
— Net Profit Ratio 
     — Return on Investment 
 
 LIQUIDITY RATIO  
? The ability of the business to pay the amount due to stakeholders as and when it is due is known as liquidity and 
the ratios calculated to measure it are termed as Liquidity Ratios.  
? They assess the short-term solvency of the business, i.e. ability of the firm to meet its short-term obligations. 
Liquidity Ratios include two main ratios: 
(i) Current Ratio (ii) Quick Ratio 
 
1. Current Ratio / working capital ratio =  Current Assets 
                      Current Liabilities 
? Current Assets= T   trade receivables (debtors + b/r) less provisions   
I   inventory (raw materials+ work in progress+ finished goods) excluding stores, spare parts and loose 
tools. 
         S   short term loans and advances  
         C  current investments/ short term investments/ marketable securities (always ignore trade  
investments) 
         C  cash and cash equivalents (cash+ cash at bank+ cheques in hand) 
 
     
 
         O other current assets (prepaid expenses/unexpired amounts+ payment in advance + accrued  
incomes) 
? Current Liabilities= STB (short term borrowings- bank overdraft+ matured debentures/loan) 
                                   STP (short term provisions – provision for taxation [C.Y.]+ proposed dividends) 
                                   TP   (trade payables= creditors + b/p) 
                                   OCL (other current liabilities= outstanding expenses+ unearned incomes+ unclaimed dividend+  
unpaid dividends+ calls in advance) 
? Ideal ratio is 2:1. 
? Both 'Very High' and 'Very Low' Current Ratio are not good for a firm. 
? 'Very High' Current Ratio may lead to Low Profitability: A very high current ratio may be due to excessive investment 
in the current assets, which may result in idle funds. It leads to lower profitability as idle funds do not earn anything. 
? Very Low' Current Ratio may cause Risk to Solvency: A very low current ratio may be due to inadequate investment 
in the current assets, which may result in low liquidity. It may threaten the solvency of the enterprise. 
 
2. Quick ratio/ acid test ratio/ liquid ratio=   Quick  Assets/liquid assets  
                              Current Liabilities 
? Quick  Assets=    T   trade receivables (debtors + b/r) less provisions   
         S   short term loans and advances  
         C current investments/ short term investments/ marketable securities (always ignore trade 
investments) 
         C cash and cash equivalents (cash+ cash at bank+ cheques in hand) 
? Current Liabilities= STB (short term borrowings- bank overdraft+ matured debentures/loan) 
                                   STP (short term provisions – provision for taxation [C.Y.]+ proposed dividends) 
                                   TP   (trade payables= creditors + b/p) 
                                   OCL (other current liabilities= outstanding expenses+ unearned incomes+ unclaimed dividend+ 
unpaid dividends+ calls in advance) 
? Ideal ratio is 1:1. 
An unnecessarily low ratio will be very risky and a high ratio suggests unnecessarily deployment of resources in 
otherwise less profitable short-term investments. 
? Quick  Assets = Current Assets – inventory(closing)- prepaid expenses/+ payment in advance 
? Working capital = Current Assets – Current Liabilities 
 
Distinction between Current Ratio and Quick Ratio 
Basis Current Ratio Quick Ratio 
1. Meaning It establishes the relationship between It establishes the relationship 
between 
 current assets and current liabilities. liquid assets and current liabilities. 
2. Objective It aims to asses ability of the firm to meet It aims to asses the ability of the firm 
to 
 its current liabilities within 12 months 
from 
meet its current liabilities 
immediately. 
 the date of Balance Sheet or within the  
 period of operating cycle.  
3. Ideal Ratio 2:1 is considered as an ideal ratio. 1:1 is considered as an ideal ratio. 
   
4. Formula Current Assets = Current Ratio  / Current 
Liabilities = 
Quick Ratio = Quick Assets / Current 
Liabilities   
SUMMARY OF ACCOUNTING RATIOS 
LIQUIDITY RATIOS 
Name of the Ratio Formula Significance 
1. Current Ratio Ideal 
Ratio = 2:1 
Current Assets / Current Liabilities = …. : …. This ratio indicates the firm's ability to meet its 
short – term liabilities on time. It helps in assessing 
short – term solvency of the enterprise. It shows 
the number of times current assets are in excess of 
the current liabilities. 
 
    
 
2. Quick Ratio or 
Liquid Ratio or 
Acid – Test Ratio 
Ideal Ratio =1:1 
Liquid or Quick Assets /  Current Liabilities  
= ….. : …… 
This ratio determine ability of the firm to meet its 
current liabilities immediately. It is a better 
measure of liquidity as it considers only those 
assets which can be easily and readily converted 
into cash. 
Important Points 
1. Current Assets=Current Investments + Inventories (except Loose Tools, Stores and Spares)+Trade Receivables (Sundry 
Debtors and Bills Receivable less Provision for Doubtful Debts) + Cash and Cash Equivalents (Cash in hand, Cash at bank, 
Cheques/Drafts in hand, etc.) + Short – term loans and advances + Other current assets (Prepaid Expenses + Accrued 
Incomes + Advance Tax) 
2. Current Liabilities = Short – term Borrowings + Trade Payables (Sundry Creditors and Bills Payable) + Other Current 
Liabilities (Current maturities of Long – term debts, interest accrued but not due, interest accrued and due, outstanding 
expenses, unclaimed dividend, calls – in – advance, etc.) + Short – term Provisions (Provision for Tax, Proposed Dividend, 
Provision for Employee Benefits) 
3. Quick Assets = Current Assets – Inventories – Prepaid Expenses – Advance Tax 
4. Working Capital = Current Assets – Current Liabilities 
 
SOLVENCY RATIO  
1. Debt equity ratio = debt / borrowed funds/ Non-current liabilities 
    Equity / owner funds / shareholders fund 
? Debt /non-current liabilities= long term borrowings (loans+ debentures+ public deposits)   
Long term provisions (all employees and workers related provisions like provident 
fund, Gratuity ) 
? Equity / shareholders fund =  share capital (equity+ preference) 
     Reserves and surplus (sssccpo- S security premium) 
S sinking fund/D.R.R. 
  S Surplus in the statement of p&l a/c 
                 C capital Reserve 
                  C capital redemption reserve 
                  P P&L a/c or P&L appropriation a/c {if its Dr. balance its minus and cr. Balance  
its plus} 
 O other reserves (general reserves)    
? Ideal ratio is 2:1. 
? A high ratio means that the enterprise is depending more on external debts as compared to shareholders' funds. It 
indicates that external equities are at higher risks. 
? On the other hand, a low Debt to Equity Ratio means that the enterprise is depending more on shareholders' funds 
than external debts. It indicates that external equities are at a lower risk and have higher safety. 
 
2. Total assets to debt ratio = Total assets  
     Debt  
? Total assets = Non-current assets + current assets 
? A high ratio means higher safety margin for lenders, whereas, low ratio indicates lower safety margin for the 
lenders. 
 
3. Proprietary ratio = equity  
                          Total Assets  
? A higher ratio is generally taken as an indicator of sound financial position from long – term point of view, because 
it means that a large proportion of total assets has been financed by the equity and firm is less dependent on 
external sources of finance. 
 
4. Interest coverage Ratio = net profit before interest and tax 
Fixed interest charges  
? net profit before interest and tax = net profit after interest and tax X 100     +   fixed interest charges  
               (100 – tax rate ) 
? fixed interest charges = coupon rate or the interest rate on debt  
? like 10 % debentures = 2,00,000 then interest will be Rs.20,000 
? A high ratio is considered better for the lenders as it means higher safety margin. 
 
    
 
              
Notes:  
1. Debt = Long-term Borrowings + Long-term Provisions  
2. Equity = Equity Share Capital + Preference Share Capital + Reserves & Surplus.  
3. Equity = Non-Current Assets + Working Capital - Non-Current Liabilities  
4. Equity = Share Capital + Reserves & Surplus.  
5. Equity = Shareholders' Funds + Preference Share Capital  
6. Equity = Capital Employed - Debt  
7. Equity = Non-Current Assets + Current Assets - Current Liabilities - Non-Current Liabilities  
8. Equity = Total Assets - Total Debt 
9. Total assets = total liabilities  
10. Total assets / total liabilities= shareholders fund+ non c.l. + c.l. 
11.  Total debt = long term debt + current debt  
12.  Total liabilities = long term liabilities + current liabilities 
SOLVENCY RATIOS 
Name of Ratio Formula Significance  
1. Debt to Equity 
Ratio 
Ideal Ratio = 2:1 
Debt /  Equity  = ....... 
 
This ratio is calculated to assess the long – term financial 
soundness of the enterprise. It indicates the extent to which 
the enterprise depends on external funds for its business. 
2. Total Assets to 
Debt Ratio 
Total Assets /  Debt  = ........ 
 
This ratio measures the extent to which debt is covered by the 
assets, i.e. it measures the safety margin available to the 
lenders of long – term debts. A high ratio means higher safety 
margin for lenders, whereas, low ratio indicates lower safety 
margin. 
3. Proprietary 
Ratio 
Proprietors' Funds (Equity)  / Total 
Assets = ...... 
 
This ratio aims to measure the proportion of total assets, which 
have been funded by the owners or shareholders. A high ratio 
is generally taken as an indicator of sound financial position as 
it means that a large proportion of total assets has been 
financed by equity. 
4. Interest 
Coverage Ratio 
Profit before interest and Tax /  
Interest on Long – term Debt = 
...Times 
 
This ratio indicates how many times the interest charges are 
covered by the profits out of which interest will be paid. This 
ratio measures the margin of safety for long – term lenders. A 
high ratio is considered better for the lenders as it means 
higher safety margin. 
Important Points 
1. Debt = Long – term Borrowings (Debentures, Mortgage Loan, Term Loans from Banks and other financial institutions, 
Public Deposits, etc.) + Long – term Provisions (Provision for Employee Benefits, Provision for Provident fund, Provision 
for Warranty Claims, etc.) 
2. Equity = Share Capital (Equity Share Capital, Preference Share Capital) + Reserves and Surplus (Capital Reserve, 
Securities Premium Reserve, General Reserve, etc.) 
3. Total Assets = Non – Current Assets (Fixed Assets (Tangible and Intangible Assets), Non – Current Investments, Long 
– term Loans and Advances) + Current Assets (Inventories (including Loose Tools, Stores and Spares), Trade Receivables 
(Sundry Debtors and Bills Receivable less Provision for Doubtful Debts), Cash and Cash Equivalents, Short – term loans 
and advances, Other current assets (Prepaid expenses + Accrued Incomes + Advance tax)} 
4. Profit before Interest and Tax = Profit after Interest and after Tax + Tax + Interest on Long – term Debt*. 
5. *Interest on Long – term Debt: It includes interest on long – term debt such as interest on Debentures, Mortgage 
Loan, Term Loans, Public Deposits, etc. 
 
ACTIVITY OR TURNOVER RATIO   
1. Inventory turnover ratio=  Cost of revenue from operations  
             Average inventory   
? Cost of revenue from operations = Revenue from operations – gross profit    
Or   
  Cost of revenue from operations = op inventory – cl. Inventory + purchases – purchase return + direct 
expenses  
  op inventory – cl. Inventory= change in stock 
  purchases – purchase return = net purchases  
  direct expenses =  all expenses of trading a/c dr. side like wages , carriage , freight, octroi etc 
 
    
 
?  Average inventory  =   op inventory + cl. Inventory 
   2 
? A very high ratio is not desirable because it indicates that the inventory level is very low and it may lead to shortage 
of working capital. 
? On the other hand, a low ratio indicates that inventory does not sell quickly and there is over – investment in stock 
and inefficient use of funds. 
 
2. Average age of inventory (stock velocity)  =        12/365/52 
inventory turnover ratio 
? If not mentioned it is to be calculated in days (to be round off if necessary ) 
 
3. Trade receivables turnover ratio =  Net credit revenue from operations 
      Average Trade receivables  
? Net credit revenue from operations = total revenue from operations – cash revenue from operations 
? Revenue from operations less returns from revenue from operations should be recorded  
?       Average Trade receivables = op. Trade receivables + cl. Trade receivables 
             2 
Or   
?    Average Trade receivables = average debtors + average B/R  
 
4. Average collection period (debtors velocity) =  12/365/52 
Trade receivables turnover ratio 
• A high ratio indicates the shorter collection period, i.e. debts are collected promptly. 
• On the other hand, a low ratio indicates a longer collection period, i.e. delayed payments by Trade Receivables. 
 
5. Trade payables turnover ratio =  Net credit purchases 
                 Average Trade payables  
? Net credit purchases = total purchases – cash purchases 
? Purchases should be less returns      
?  Average Trade payables  =  op. Trade payables + cl. Trade payables 
             2 
Or   
?    Average Trade payables = average creditors  + average B/p  
 
6. Average Payment period (creditors velocity) =  12/365/52 
Trade payables turnover ratio 
• A high ratio indicates the shorter payment period, i.e. either availability of less credit or earlier payments. 
• A low ratio indicates a larger payment period, i.e. either availability of more credit or delayed payments. 
 
7. Working capital turnover ratio = revenue from operations 
Working capital 
? Working capital = Current Assets – Current Liabilities 
? Both 'Very High' and 'Very Low' Working Capital Turnover Ratios are not good for a firm 
? • 'Very High' Ratio indicates shortage of Working Capital: A very high ratio indicates overtrading, i.e. doing business 
with very less working capital. It shows shortage of working capital and may put the concern in financial difficulties. 
? • 'Very Low' Ratio indicates Excess Working Capital: A very low ratio indicates under – trading, i.e. doing business 
with working capital in excess of the requirements. 
 
ACTIVITY OR TURNOVER RATIO   
ACTIVITY RATIOS 
OR TURNOVER 
RATIOS 
Name of Ratio Formula Significance