NCERT Class 12 Accountancy Chapter 9 Accounting Ratios

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NCERT Class 12 Accountancy Chapter 9 Accounting Ratios

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Accounting Ratios

Chapter: 9

PART – II

Short Answer Questions:

1. What do you mean by Ratio Analysis? 

Ans: Ratio analysis is an indispensable part of interpretation of results revealed by the financial statements. It provides users with crucial financial information and points out the areas which require investigation. Ratio analysis is a technique which involves regrouping of data by application of arithmetical relationships, though its interpretation is a complex matter. It requires a fine understanding of the way and the rules used for preparing financial statements.

2. What are various types of ratios? 

Ans: The various types of ratios are:

(i) Statement of Profit and Loss Ratios: A ratio of two variables from the statement of profit and loss is known as statement of profit and loss ratio.

(ii) Balance Sheet Ratios: In case both variables are from the balance sheet, it is classified as balance sheet ratios.

(iii) Composite Ratios: If a ratio is computed with one variable from the statement of profit and loss and another variable from the balance sheet, it is called composite ratio.

3. What relationships will be established to study: 

(a) Inventory turnover. 

Ans: It determines the number of times inventory is converted into revenue from operations during the accounting period under consideration. It expresses the relationship between the cost of revenue from operations and average inventory. 

The formula for its calculation is as follows: 

Inventory Turnover Ratio = Cost of Revenue from Operations / Average Inventory. 

Where average inventory refers to arithmetic average of opening and closing inventory, and the cost of revenue from operations means revenue from operations less gross profit. 

(b) Trade receivables turnover. 

Ans: It expresses the relationship between credit revenue from operations and trade receivable. It is calculated as follows : 

Trade Receivable Turnover ratio	= Net Credit Revenue from Operations/Average Trade Receivable
Where Average Trade Receivable	= (Opening Debtors and Bills Receivable + Closing Debtors and Bills Receivable)/2

It needs to be noted that debtors should be taken before making any provision for doubtful debts. 

(c) Trade payables turnover. 

Ans: Trade payables turnover ratio indicates the pattern of payment of trade payable. As trade payable arise on account of credit purchases, it expresses relationship between credit purchases and trade payable. It is calculated as follows:

Trade Payables Turnover ratio	= Net Credit purchases/ Average trade payable
Where Average Trade Payable	= (Opening Creditors and Bills Payable + Closing Creditors and Bills Payable)/2
Average Payment Period	= No. of days/ month in a year / Trade payables turnover ratio.

(d) Working capital turnover. 

Ans: Capital employed turnover ratio which studies turnover of capital employed (or Net Assets) is analysed further by following two turnover ratios:

Working Capital Turnover Ratio: It is calculated as follows: 

Working Capital Turnover Ratio = Net Revenue from Operation/Working Capital. 

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? 

Ans: It is a ratio which deals with the servicing of interest on loan. It is a measure of security of interest payable on long-term debts. It expresses the relationship between profits available for payment of interest and the amount of interest payable. 

It is calculated as follows: 

Interest Coverage Ratio = Net Profit before Interest and Tax/ Interest on long-term debts It reveals the number of times interest on long-term debts is covered by the profits available for interest. A higher ratio ensures safety of interest on debts.

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.

Ans: The average age of inventory is the average number of days it takes for a firm to sell off inventory. It is a metric that analysts use to determine the efficiency of sales. It determines the number of times inventory is converted into revenue from operations during the accounting period under consideration. It expresses the relationship between the cost of revenue from operations and average inventory. 

The formula for its calculation is as follows: 

Inventory Turnover Ratio = Cost of Revenue from Operations / Average Inventory. 

Where average inventory refers to arithmetic average of opening and closing inventory, and the cost of revenue from operations means revenue from operations less gross profit.

Long Answer Questions

1. What are liquidity ratios? Discuss the importance of current and liquid ratio. 

Ans: Liquidity ratios are calculated to measure the short-term solvency of the business, i.e. the firm’s ability to meet its current obligations. These are analysed by looking at the amounts of current assets and current liabilities in the balance sheet. The two ratios included in this category are current ratio and liquidity ratio. 

Current ratio is the proportion of current assets to current liabilities. 

It is expressed as follows: 

Current Ratio = Current Assets: Current Liabilities or Current Assets/ Current Liabilities 

Current assets include current investments, inventories, trade receivables (debtors and bills receivables), cash and cash equivalents, short-term loans and advances and other current assets such as prepaid expenses, advance tax and accrued income, etc. Current liabilities include short-term borrowings, trade payables (creditors and bills payables), other current liabilities and short-term provisions.

It 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. The ratio should be reasonable. It should neither be very high or very low. Both the situations have their inherent disadvantages. A very high current ratio implies heavy investment in current assets which is not a good sign as it reflects under utilisation or improper utilisation of resources. A low ratio endangers the business and puts it at risk of facing a situation where it will not be able to pay its short-term debt on time. If this problem persists, it may affect firm’s credit worthiness adversely. Normally, it is safe to have this ratio within the range of 2:1.

2. How would you study the Solvency position of the firm? 

Ans: The persons who have advanced money to the business on long-term basis are interested in safety of their periodic payment of interest as well as the repayment of principal amount at the end of the loan period. Solvency ratios are calculated to determine the ability of the business to service its debt in the long run. The following ratios are normally computed for evaluating solvency of the business.

(i) Debt-Equity Ratio: Debt-Equity Ratio measures the relationship between long-term debt and equity. If debt component of the total long-term funds employed is small, outsiders feel more secure. From security point of view, capital structure with less debt and more equity is considered favourable as it reduces the chances of bankruptcy. 

(ii) Debt to Capital Employed Ratio: Like debt-equity ratio, it shows proportion of long-term debts in capital employed. Low ratio provides security to lenders and high ratio helps management in trading on equity. In the above case, the debt to Capital Employed ratio is less than half which indicates reasonable funding by debt and adequate security of debt.

(iii)  Proprietary Ratio: Higher proportion of shareholders funds in financing the assets is a positive feature as it provides security to creditors. This ratio can also be computed in relation to total assets instead of net assets (capital employed). It may be noted that the total of debt to capital employed ratio and proprietary ratio is equal to 1. 

(iv) Total Assets to Debt Ratio: This ratio primarily indicates the rate of external funds in financing the assets and the extent of coverage of their debts are covered by assets. It is better to take the net assets (capital employed) instead of total assets for computing this ratio also. It is observed that in that case, the ratio is the reciprocal of the debt to capital employed ratio.

(v) Interest Coverage Ratio: It is a ratio which deals with the servicing of interest on loan. It is a measure of security of interest payable on long-term debts. It expresses the relationship between profits available for payment of interest and the amount of interest payable. It reveals the number of times interest on long-term debts is covered by the profits available for interest. A higher ratio ensures safety of interest on debts.

3. What are various profitability ratios? How are these worked out? 

Ans: The profitability or financial performance is mainly summarised in the statement of profit and loss. Profitability ratios are calculated to analyse the earning capacity of the business which is the outcome of utilisation of resources employed in the business. There is a close relationship between the profit and the efficiency with which the resources employed in the business are utilised. 

The various ratios which are commonly used to analyse the profitability of the business are:

(i) Gross profit ratio: Gross profit ratio as a percentage of revenue from operations is computed to have an idea about gross margin. 

It is computed as follows: 

Gross Profit Ratio = Gross Profit/Net Revenue of Operations × 100 

It indicates gross margin on products sold. It also indicates the margin available to cover operating expenses, non-operating expenses, etc.

(ii) Operating ratio: It is computed to analyse cost of operation in relation to revenue from operations. 

It is calculated as follows: 

Operating Ratio = (Cost of Revenue from Operations + Operating Expenses)/ Net Revenue from Operations ×100 

Operating expenses include office expenses, administrative expenses, selling expenses, distribution expenses, depreciation and employee benefit expenses etc.

(iii) Operating profit ratio: It is calculated to reveal operating margin. It may be computed directly or as a residual of operating ratio. 

Operating Profit Ratio = 100 – Operating Ratio

Alternatively, it is calculated as under: 

Operating Profit Ratio = Operating Profit/ Revenue from Operations × 100 

Where Operating Profit = Revenue from Operations – Operating Cost

It helps to analyse the performance of business and throws light on the operational efficiency of the business. It is very useful for inter-firm as well as intra-firm comparisons.

(iv) Net profit ratio: Net profit ratio is based on all inclusive concept of profit. It relates revenue from operations to net profit after operational as well as non-operational expenses and incomes. 

It is calculated as under: 

Net Profit Ratio = Net profit/Revenue from Operations × 100 

Generally, net profit refers to profit after tax (PAT). It is a measure of net profit margin in relation to revenue from operations. Besides revealing profitability, it is the main variable in computation of Return on Investment.

(v) Return on Investment (ROI) or Return on Capital Employed (ROCE): It explains the overall utilisation of funds by a business enterprise. Capital employed means the long-term funds employed in the business and includes shareholders’ funds, debentures and long-term loans. Alternatively, capital employed may be taken as the total of non-current assets and working capital. Profit refers to the Profit Before Interest and Tax (PBIT) for computation of this ratio. 

Thus, it is computed as follows: 

Return on Investment (or Capital Employed) = Profit before Interest and Tax/ Capital Employed × 100

(vi) Return on Net Worth (RONW): This ratio is very important from shareholders’ point of view in assessing whether their investment in the firm generates a reasonable return or not. It should be higher than the return on investment otherwise it would imply that company’s funds have not been employed profitably. 

(vii) Earnings per share: The ratio is computed as: 

EPS = Profit available for equity shareholders/Number of Equity Shares 

In this context, earnings refer to profit available for equity shareholders which is worked out as:

Profit after Tax – Dividend on Preference Shares. 

This ratio is very important from equity shareholders point of view and also for the share price in the stock market. This also helps comparison with other to ascertain its reasonableness and capacity to pay dividend.

(viii) Book value per share: This ratio is calculated as: Book Value per share = Equity shareholders’ funds/Number of Equity Shares Equity shareholder fund refers to Shareholders’ Funds – Preference Share Capital. This ratio is again very important from equity shareholders point of view as it gives an idea about the value of their holding and affects market price of the shares. 

(ix) Dividend payout ratio: This refers to the proportion of earning that are distributed to the shareholders. It is calculated as – 

Dividend Payout Ratio = Dividend per share/ Earnings per share 

This reflects company’s dividend policy and growth in owner’s equity. 

(x) Price earning ratio: The ratio is computed as – 

P/E Ratio = Market Price of a share/earnings per share 

For example, if the EPS of X Ltd. is Rs. 10 and market price is Rs. 100, the price earning ratio will be 10 (100/10). It reflects investors expectation about the growth in the firm’s earnings and reasonableness of the market price of its shares. P/E Ratio vary from industry to industry and company to company in the same industry depending upon investors perception of their future. 

4. 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.

Ans: A very high current ratio implies heavy investment in current assets which is not a good sign as it reflects under utilisation or improper utilisation of resources. A low ratio endangers the business and puts it at risk of facing a situation where it will not be able to pay its short-term debt on time. If this problem persists, it may affect firm’s credit worthiness adversely. Normally, it is safe to have this ratio within the range of 2:1.

It is the ratio of quick (or liquid) asset to current liabilities. It is expressed as Quick ratio = Quick Assets: Current Liabilities or Quick Assets/ Current Liabilities The quick assets are defined as those assets which are quickly convertible into cash. While calculating quick assets we exclude the inventories at the end and other current assets such as prepaid expenses, advance tax, etc., from the current assets. Because of exclusion of non-liquid current assets it is considered better than current ratio as a measure of liquidity position of the business. It is calculated to serve as a supplementary check on liquidity position of the business and is therefore, also known as ‘Acid-Test Ratio’.