Accountancy NCERT Notes, Solutions and Extra Q & A (Class 11th & 12th)
11th										12th

Class 12th Chapters
Accountancy - Not-for-Profit Organisation
1. Accounting For Not-For-Profit Organisation	2. Accounting For Partnership : Basic Concepts	3. Reconstitution Of A Partnership Firm – Admission Of A Partner
4. Reconstitution Of A Partnership Firm – Retirement/Death Of A Partner	5. Dissolution Of Partnership Firm
Accountancy - Company Accounts and Analysis of Financial Statements
1. Accounting For Share Capital	2. Issue And Redemption Of Debentures	3. Financial Statements Of A Company
4. Analysis Of Financial Statements	5. Accounting Ratios	6. Cash Flow Statement

Content On This Page
Notes
Meaning of Accounting Ratios	Objectives of Ratio Analysis	Advantages of Ratio Analysis
Limitations of Ratio Analysis	Types of Ratios	Liquidity Ratios
Solvency Ratios	Activity (or Turnover) Ratios	Profitability Ratios
NCERT Questions Solution
Test your Understanding – I	Do it yourself (Page No. 203)	Test your Understanding – II
Do it yourself (Page No. 216)	Test your Understanding – III	Short Answers
Long Answers	Numerical Questions

Chapter 5 Accounting Ratios Concepts, Solutions and Extra Q & A

This chapter introduces Accounting Ratios as a fundamental tool of financial statement analysis, used to evaluate a company's performance and financial position. A ratio is a mathematical expression showing the relationship between two accounting figures. The primary objective of ratio analysis is to simplify complex data to assess four key areas: Liquidity (the ability to meet short-term obligations), Solvency (long-term financial stability), Activity or Turnover (operational efficiency in using assets), and Profitability (the earning capacity of the business). By calculating and interpreting various ratios, users can identify a firm's strengths and weaknesses.

The significance of ratio analysis lies in its ability to facilitate comparisons, both over time for the same company (intra-firm) and against competitors or industry benchmarks (inter-firm). Ratios are crucial for decision-making by various stakeholders like investors, creditors, and management. However, the chapter also highlights their inherent limitations. Since ratios are derived from historical financial statements, they ignore inflation, overlook vital qualitative factors like management quality, and can be skewed by differing accounting practices. Thus, ratios should be viewed as indicative tools that point to areas needing further investigation, not as definitive conclusions in themselves.

Meaning of Accounting Ratios

Financial statements provide a wealth of raw financial data. However, in their absolute form, these figures can be difficult to interpret and may not reveal the full story of a company's performance. To make this data useful for decision-making, it needs to be analyzed. Accounting Ratios are a key and widely used tool for this purpose. An accounting ratio is a mathematical expression that establishes a quantitative relationship between two or more related accounting numbers derived from a company's financial statements (the Balance Sheet and the Statement of Profit and Loss).

The calculation of a ratio simplifies complex accounting figures and highlights a specific aspect of a company's financial health. It is a tool that helps to summarize data and make it more understandable. Ratios are typically expressed in one of the following ways:

Expression of Ratios

As a Pure Ratio or Proportion: This expresses the relationship as a proportion, for example, '2 is to 1' or 2:1. This format is commonly used for Balance Sheet ratios. For instance, a Current Ratio of 2:1 means that for every one rupee of current liabilities, the company has two rupees of current assets.
As a Percentage: This expresses the relationship in terms of a hundred. For example, a Gross Profit Ratio of 10% means that for every ₹ 100 of revenue from operations, the company earns a gross profit of ₹ 10. This format is most commonly used for profitability ratios.
As a Rate or Number of Times: This expresses how many times a particular figure is contained in another. For example, an Inventory Turnover Ratio of 6 times implies that, on average, the company's inventory is sold and replaced six times during the year. This format is typically used for activity or turnover ratios.

Fundamental Principles of Ratio Analysis

The effectiveness and reliability of ratio analysis depend entirely on two critical principles. An analyst must always consider these before drawing any conclusions.

1. Reliability of Source Data

Ratios are derived directly from the numbers present in the financial statements. Therefore, their accuracy and efficacy are completely dependent on the reliability of the source data. This is often referred to as the "garbage in, garbage out" principle. If the underlying financial statements contain errors, are biased due to personal judgments, or have been deliberately manipulated (a practice known as "window dressing"), the ratios calculated from them will also be erroneous and will present a misleading picture of the company's performance and financial position. Therefore, a prerequisite for meaningful ratio analysis is the existence of accurate and reliable financial statements.

2. Meaningful Correlation

A ratio must be calculated using numbers that have a logical and meaningful relationship with each other. A ratio should be able to reveal a cause-and-effect relationship or a specific aspect of a company's operations or financial health. Calculating a ratio between two unrelated numbers serves no purpose and provides no insight. For example, if a company has furniture worth ₹ 1,00,000 and it made purchases of ₹ 3,00,000, calculating a ratio of purchases to furniture (3:1) is meaningless because there is no logical operational or financial relationship between these two items. In contrast, comparing credit revenue from operations with trade receivables is meaningful because receivables are a direct result of credit sales, and the ratio helps to assess the efficiency of credit collection.

Objectives of Ratio Analysis

Ratio analysis is an indispensable part of interpreting the results revealed by financial statements. It is not merely a mathematical exercise; its primary purpose is to transform raw financial data into meaningful, actionable information. This helps users to understand the company's financial situation more deeply and to identify areas of strength and weakness. While the calculations are arithmetical, their interpretation requires a fine understanding of accounting principles and the business context.

The specific objectives of conducting ratio analysis are as follows:

To know the areas of the business which need more attention: Ratios act as powerful diagnostic tools or "whistle-blowers." An unusually high or low ratio compared to past periods or industry norms can highlight a potential problem or an area of inefficiency. For example, a declining current ratio may signal a developing liquidity crisis, while a low inventory turnover ratio might indicate the presence of obsolete stock. These signals prompt management to investigate further and take corrective action.
To know about the potential areas which can be improved: Conversely, by identifying areas of strength (e.g., a consistently high gross profit margin), ratio analysis can help management understand what is working well. This allows them to focus on reinforcing these strengths and leveraging them to further improve performance.
To provide a deeper analysis of performance: Ratios provide a structured way to analyze the four key dimensions of a business: its profitability, liquidity, solvency, and efficiency. They offer insights that are not apparent from looking at the absolute figures alone. For instance, a profit of ₹10 lakh is hard to judge in isolation. But when expressed as a percentage of sales (Net Profit Ratio) or capital (Return on Investment), it becomes a powerful measure of performance.
To provide information for comparative analysis: Ratios are standardized metrics that facilitate meaningful comparisons. This can be:
- A cross-sectional analysis (inter-firm comparison), where a company's ratios are compared with those of its competitors or with industry averages to gauge its relative performance.
- A time-series analysis (intra-firm comparison), where a company's own ratios are compared over several years to identify trends and assess whether its performance is improving, deteriorating, or remaining stable.
To provide information for future projections: By analyzing historical trends through ratios, analysts can make more informed projections and estimates about the company's future performance. While not a perfect predictor, understanding past trends is crucial for effective financial planning, forecasting, and budgeting.

Advantages of Ratio Analysis

When properly conducted and interpreted, ratio analysis significantly enhances a user's understanding of a company's financial health and the efficiency of its operations. The numerical relationships revealed by ratios can illuminate latent aspects of the business, highlighting both problem areas that need attention and bright spots that can be built upon. It must be remembered that ratios are a means to an end, not an end in themselves; their role is indicative and serves as a starting point for further inquiry.

The main advantages of using ratio analysis are:

Helps to Understand Efficacy of Decisions: Ratios help in evaluating the effectiveness of the key business decisions—operating, investing, and financing—taken by the management. For example, an improved Fixed Asset Turnover Ratio after a major investment in machinery would indicate an effective investing decision. Similarly, an analysis of the Return on Equity can show whether a financing decision to take on more debt was beneficial for the shareholders.
Simplify Complex Figures and Establish Relationships: Financial statements contain a vast amount of complex data. Ratios simplify these figures into more understandable and digestible numbers. They effectively summarize the financial information and highlight crucial relationships, which helps in quickly assessing key indicators like managerial efficiency, creditworthiness, and earning capacity.
Helpful in Comparative Analysis: Ratios are powerful and standardized tools for comparison, which is essential for placing a company's performance in context.
- Intra-firm Comparison (Time Series Analysis): Comparing a company's ratios over several years helps in identifying financial trends and is crucial for strategic review and internal control.
- Inter-firm Comparison (Cross-sectional Analysis): Comparing a company's ratios with those of its direct competitors or with industry averages provides a benchmark to evaluate its performance relative to the market and identify its competitive position.
Identification of Problem Areas: By flagging unusual trends or deviations from norms, ratios help management identify specific problem areas. A declining Quick Ratio might signal an impending cash crunch, while a lengthening Average Collection Period could point to weaknesses in the credit and collection policy. This "whistle-blowing" function allows for timely corrective action.
Enables SWOT Analysis: The insights gained from ratio analysis provide a solid quantitative foundation for a company's SWOT (Strengths, Weaknesses, Opportunities, Threats) analysis. For instance, high profitability ratios represent a Strength, while a high debt-equity ratio might be a Weakness. This analysis is a cornerstone of effective strategic planning.

Limitations of Ratio Analysis

While ratio analysis is a powerful tool, it is not without its limitations. Since ratios are derived from financial statements, they inherit all the weaknesses and limitations of the accounting data they are based on. An analyst must be aware of these limitations to avoid making incorrect or overly simplistic judgments.

Limitations arising from Accounting Data

Limitations of Accounting Data itself: Accounting data is not always a precise and final figure. It is a combination of recorded facts, accounting conventions, and personal judgments (e.g., estimating the useful life of an asset, deciding the provision for doubtful debts). This inherent lack of absolute precision in the source data will naturally be reflected in the ratios calculated from it.
Ignores Price-level Changes: Financial statements are prepared based on the historical cost concept, which ignores the effect of inflation. This means that assets and profits recorded in different years are not truly comparable in terms of purchasing power, which can significantly distort the analysis, especially in a time-series comparison over a long period of high inflation.
Ignores Qualitative or Non-monetary Aspects: Ratios are purely quantitative. They completely ignore crucial non-monetary factors like the quality and integrity of management, employee morale, brand reputation, customer loyalty, and the overall economic climate. These qualitative factors can have a far greater impact on a company's long-term success than what the numbers alone might suggest.
Variations in Accounting Practices: Different companies may use different, though equally acceptable, accounting policies (e.g., for depreciation, inventory valuation). This lack of uniformity makes a valid inter-firm comparison difficult and potentially misleading. For example, comparing the inventory turnover ratio of a company using the FIFO method with one using the LIFO method can lead to incorrect conclusions.
Forecasting limitations: Ratios are based on historical data. While they can help identify trends, forecasting the future based solely on past performance can be unreliable, as business conditions, technology, and competition can change unexpectedly.

Limitations Inherent in Ratios

Means and Not the End: Ratios are merely a tool for analysis; they are not an end in themselves. They act as symptoms, not the diagnosis. They provide indicative information and can highlight areas for investigation, but they do not provide ready-made solutions to the problems they flag.
Lack of Standardised Definitions: There is often a lack of universally standardized definitions for the components of a ratio. For example, 'liquid liabilities' or 'long-term debt' might be defined differently by different analysts. This can lead to inconsistency in calculations and comparisons.
Lack of Universally Accepted Standard Levels: There is no single universal benchmark or "ideal" level for most ratios that is applicable to all industries and companies. The widely cited "rule of thumb" of 2:1 for the current ratio is not a magic number. What is considered a good ratio for a manufacturing firm might be poor for a software services company. The ideal ratio varies by industry, company size, and business strategy.
Ratios Based on Unrelated Figures: As a fundamental principle, calculating a ratio between two financially unrelated figures is a meaningless exercise. A ratio is only useful if it establishes a logical, cause-and-effect relationship between its components.

Types of Ratios

Accounting ratios can be classified in several ways to organize them for analysis. The two main classification systems are the traditional classification (based on the source of data) and the functional classification (based on the purpose of the analysis).

Traditional Classification

This is a structural classification based on the financial statement from which the components (numerator and denominator) of the ratio are taken. It is a less common approach in modern practice.

Statement of Profit and Loss Ratios (or Income Statement Ratios): In this case, both variables for the ratio are taken from the Statement of Profit and Loss. An example is the Gross Profit Ratio, which is calculated as (Gross Profit / Revenue from Operations). Both figures are from the income statement.
Balance Sheet Ratios (or Position Statement Ratios): Here, both variables are taken from the Balance Sheet. An example is the Current Ratio, calculated as (Current Assets / Current Liabilities). Both figures are from the balance sheet.
Composite Ratios (or Inter-statement Ratios): For these ratios, one variable is taken from the Statement of Profit and Loss and the other from the Balance Sheet, linking the two statements. An example is the Trade Receivables Turnover Ratio, calculated as (Credit Revenue from Operations / Average Trade Receivables).

While this classification is structurally logical, it is rarely used for interpretation because it does not group the ratios according to the financial aspect they measure.

Functional Classification

This is the most common and useful method of classifying ratios, as it groups them based on the specific financial attribute or purpose for which they are being calculated. This classification helps users to systematically analyze different facets of a company's performance and financial position. The main functional categories are:

Ratio Category	Purpose of the Ratio	Examples
1. Liquidity Ratios	To measure the firm's ability to meet its short-term obligations (current liabilities) as they become due. They focus on the firm's short-term solvency.	Current Ratio, Quick Ratio (or Liquid Ratio / Acid-Test Ratio)
2. Solvency Ratios	To measure the firm's ability to meet its long-term obligations and its overall long-term financial stability. They focus on the firm's capital structure and ability to service its long-term debt.	Debt-Equity Ratio, Total Assets to Debt Ratio, Proprietary Ratio, Interest Coverage Ratio
3. Activity (or Turnover) Ratios	To measure the efficiency and speed with which the firm is utilizing its assets to generate revenue. They are also known as Efficiency Ratios.	Inventory Turnover Ratio, Trade Receivables Turnover Ratio, Trade Payables Turnover Ratio, Working Capital Turnover Ratio
4. Profitability Ratios	To measure the earning capacity and profitability of the business in relation to its revenue or the capital it employs. They are a measure of the overall performance and success of the business.	Gross Profit Ratio, Operating Ratio, Net Profit Ratio, Return on Investment (ROI)

Liquidity Ratios

Liquidity ratios are a crucial category of financial metrics calculated to measure the short-term solvency of a business. In simple terms, they assess a company's ability to meet its current obligations (liabilities due within one year) as they become due, using its current assets. Maintaining adequate liquidity is vital for a business's survival, as a failure to pay short-term debts on time can lead to a loss of creditworthiness, legal action, and even bankruptcy. These ratios are of primary interest to short-term creditors, such as suppliers and banks providing overdraft facilities.

The two main ratios used to measure a company's liquidity are:

Current Ratio
Quick Ratio (also known as Liquid Ratio or Acid-Test Ratio)

1. Current Ratio

The current ratio is the most commonly used measure of short-term solvency. It establishes a direct relationship between a company's total current assets and its total current liabilities.

Formula and Derivation

The formula for the current ratio is derived by dividing the total current assets by the total current liabilities:

$ \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} $

The components are defined as follows:

Current Assets: These are assets that are expected to be converted into cash, sold, or consumed within one year from the date of the Balance Sheet or within the business's normal operating cycle. As per Schedule III, they include: Current Investments, Inventories, Trade Receivables (Debtors and Bills Receivable), Cash and Cash Equivalents, Short-term Loans and Advances, and Other Current Assets (like Prepaid Expenses, Accrued Income).
Current Liabilities: These are obligations that are due for payment within one year from the date of the Balance Sheet. They include: Short-term Borrowings (like Bank Overdraft), Trade Payables (Creditors and Bills Payable), Other Current Liabilities (like Outstanding Expenses, Unclaimed Dividend), and Short-term Provisions (like Provision for Tax).

Significance and Interpretation

The current ratio indicates how many rupees of current assets are available for every rupee of current liabilities. A higher ratio generally indicates a greater margin of safety for short-term creditors. A widely used, though not universal, benchmark for a safe current ratio is 2:1. This implies that current assets are twice the current liabilities, providing a comfortable buffer.

A very high ratio (e.g., 4:1) is not necessarily a good sign. It might indicate inefficient use of resources, such as excessive idle cash, over-investment in inventory (which could become obsolete), or poor collection from debtors, all of which can negatively impact profitability.
A low ratio (especially below 1:1) is a significant danger signal. It indicates that the company may struggle to meet its short-term debts on time, which could severely harm its creditworthiness and operational continuity.

Illustration 1. From the following Balance Sheet of ABC Ltd., calculate the Current Ratio.

Liabilities	Amount ($\text{₹} \ $)	Assets	Amount ($\text{₹} \ $)
Short-term Borrowings	50,000	Current Investments	20,000
Trade Payables	1,20,000	Inventories	1,50,000
Short-term Provisions	30,000	Trade Receivables	1,00,000
		Cash & Cash Equivalents	70,000
		Prepaid Expenses	10,000

Answer:

Step 1: Calculate Total Current Assets

Current Assets = Current Investments + Inventories + Trade Receivables + Cash & Cash Equivalents + Prepaid Expenses

$ = \text{₹} \ 20,000 + \text{₹} \ 1,50,000 + \text{₹} \ 1,00,000 + \text{₹} \ 70,000 + \text{₹} \ 10,000 = \text{₹} \ 3,50,000 $

Step 2: Calculate Total Current Liabilities

Current Liabilities = Short-term Borrowings + Trade Payables + Short-term Provisions

$ = \text{₹} \ 50,000 + \text{₹} \ 1,20,000 + \text{₹} \ 30,000 = \text{₹} \ 2,00,000 $

Step 3: Calculate the Current Ratio

$ \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} = \frac{\text{₹} \ 3,50,000}{\text{₹} \ 2,00,000} = 1.75 $

Current Ratio = 1.75 : 1. This indicates a satisfactory liquidity position, though slightly below the ideal 2:1 benchmark.

2. Quick Ratio (or Liquid Ratio)

The quick ratio is a more rigorous and conservative test of a company's liquidity. It refines the current ratio by excluding the least liquid of the current assets, providing a measure of the company's ability to meet its immediate liabilities without relying on the sale of inventory.

Formula and Derivation

The formula for the quick ratio is:

$ \text{Quick Ratio} = \frac{\text{Quick Assets (or Liquid Assets)}}{\text{Current Liabilities}} $

The key component, Quick Assets, is derived from current assets:

Quick assets are those current assets that can be converted into cash very quickly, typically within a short period like 90 days. They are calculated by excluding those current assets that are not readily convertible into cash. The derivation is as follows:
$ \text{Quick Assets} = \text{Current Assets} - (\text{Inventories} + \text{Prepaid Expenses}) $
Inventories are excluded because there is no guarantee that they can be sold quickly and for their full value. Prepaid expenses are excluded because they represent future services to be received and cannot be converted into cash to pay off liabilities.

Significance and Interpretation

The quick ratio, often called the Acid-Test Ratio, provides a more realistic picture of a company's ability to cover its current liabilities without liquidating its stock. A generally accepted benchmark for the quick ratio is 1:1. This suggests that the company has one rupee of highly liquid assets for every one rupee of current liabilities, indicating a strong immediate solvency position. A ratio significantly below 1:1 may indicate that the company is too dependent on its inventory to meet its short-term obligations, which can be risky.

Illustration 2. Using the data from Illustration 1 for ABC Ltd., calculate the Quick Ratio.

Answer:

From Illustration 1, we have:

Current Assets = $\text{₹} \ 3,50,000$

Current Liabilities = $\text{₹} \ 2,00,000$

Inventories = $\text{₹} \ 1,50,000$

Prepaid Expenses = $\text{₹} \ 10,000$

Step 1: Calculate Quick Assets

Quick Assets = Current Assets - (Inventories + Prepaid Expenses)

$ = \text{₹} \ 3,50,000 - (\text{₹} \ 1,50,000 + \text{₹} \ 10,000) = \text{₹} \ 1,90,000 $

Step 2: Calculate the Quick Ratio

$ \text{Quick Ratio} = \frac{\text{Quick Assets}}{\text{Current Liabilities}} = \frac{\text{₹} \ 1,90,000}{\text{₹} \ 2,00,000} = 0.95 $

Quick Ratio = 0.95 : 1. This is very close to the ideal 1:1 benchmark, suggesting the company has a strong ability to meet its short-term obligations even without selling its inventory.

Illustration 3. X Ltd., has a current ratio of 3.5:1 and a quick ratio of 2:1. If the excess of current assets over quick assets, represented by inventories, is $\text{₹} \ 24,000$, calculate current assets and current liabilities.

Answer:

Let Current Liabilities (CL) be $x$.

Based on the given ratios, we can establish the following relationships:

1. Current Ratio = 3.5:1 $ \implies \frac{\text{Current Assets (CA)}}{\text{CL}} = 3.5 \implies \text{CA} = 3.5x $

2. Quick Ratio = 2:1 $ \implies \frac{\text{Quick Assets (QA)}}{\text{CL}} = 2 \implies \text{QA} = 2x $

We know that the difference between Current Assets and Quick Assets is primarily Inventories (assuming no prepaid expenses are mentioned).

Therefore, the derivation is:

$ \text{Inventories} = \text{Current Assets} - \text{Quick Assets} $

The problem states that this difference (inventories) is $\text{₹} \ 24,000$.

Now, we can substitute the expressions for CA and QA into the equation:

$ \text{₹} \ 24,000 = 3.5x - 2x $

$ \text{₹} \ 24,000 = 1.5x $

Solving for $x$ (Current Liabilities):

$ x = \frac{\text{₹} \ 24,000}{1.5} = \text{₹} \ 16,000 $

Now, we can find the value of Current Assets:

$ \text{CA} = 3.5x = 3.5 \times \text{₹} \ 16,000 = \text{₹} \ 56,000 $

Thus, the final answers are:

Current Liabilities = $\text{₹} \ 16,000$
Current Assets = $\text{₹} \ 56,000$

Solvency Ratios

Solvency ratios are calculated to measure the long-term financial stability of a business. While liquidity ratios focus on the ability to meet short-term obligations, solvency ratios assess a company's capacity to meet its long-term debt obligations, including both the periodic payment of interest and the repayment of the principal amount at maturity. These ratios are of particular interest to long-term lenders, debenture holders, and shareholders, as they provide critical insights into the company's capital structure, financial leverage, and its ability to survive over a long period.

The key ratios computed to evaluate a company's solvency are:

Debt-Equity Ratio
Debt to Capital Employed Ratio
Proprietary Ratio
Total Assets to Debt Ratio
Interest Coverage Ratio

1. Debt-Equity Ratio

The Debt-Equity Ratio is a primary solvency ratio that measures the relationship between long-term borrowed funds and owners' funds. It reveals the proportion of debt and equity used in financing the company's assets.

Formula and Derivation

$ \text{Debt-Equity Ratio} = \frac{\text{Debt (Long-term Debts)}}{\text{Equity (Shareholders' Funds)}} $

Debt (Long-term Debts): This includes all liabilities that are due for payment after one year. As per Schedule III, this comprises Long-term Borrowings (e.g., Debentures, Bonds, Long-term Loans from banks) and Other Long-term Liabilities.
Equity (Shareholders' Funds): This represents the total funds belonging to the owners. It is calculated as: Share Capital (both Equity and Preference) + Reserves and Surplus + Money received against share warrants.

Significance and Interpretation

This ratio indicates the degree of a company's financial leverage and the margin of safety for lenders. A low ratio is generally considered safe from a lender's perspective, as it implies a larger safety cushion provided by the owners' capital. A high ratio indicates a heavy reliance on borrowed funds, which is considered risky as it increases the company's fixed interest burden and the risk of bankruptcy. A commonly accepted, though not universal, benchmark is 2:1, meaning debt should not be more than twice the equity.

2. Debt to Capital Employed Ratio

This ratio measures the proportion of long-term debt in the total long-term capital pool of the business.

Formula and Derivation

$ \text{Debt to Capital Employed Ratio} = \frac{\text{Long-term Debt}}{\text{Capital Employed}} $

Capital Employed: Represents the total long-term funds invested in the business. It is the sum of all long-term sources of finance. It can be derived in two ways:
Liability-side approach: $ \text{Capital Employed} = \text{Shareholders' Funds} + \text{Long-term Debt} $
Asset-side approach: $ \text{Capital Employed} = \text{Total Assets} - \text{Current Liabilities} $ (also known as Net Assets)

Significance

This ratio provides another perspective on the company's leverage. A low ratio indicates greater long-term financial stability and security for lenders. A high ratio might indicate a higher degree of risk but also the potential for higher returns for shareholders through "trading on equity".

3. Proprietary Ratio

This ratio expresses the relationship between the proprietors' (shareholders') funds and the total capital invested in the business.

Formula and Derivation

$ \text{Proprietary Ratio} = \frac{\text{Shareholders' Funds}}{\text{Capital Employed (or Net Assets)}} $ OR $ \frac{\text{Shareholders' Funds}}{\text{Total Assets}} $

Significance

A higher proprietary ratio is a positive indicator of a strong capital base and provides a greater margin of safety for all types of creditors, as it shows that a larger portion of the company's assets is financed by the owners' own funds. It is the complement of the Debt to Capital Employed Ratio; the sum of the two ratios is always 1 (or 100%).

4. Total Assets to Debt Ratio

This ratio measures the extent to which a company's total assets cover its long-term debt, providing another measure of the safety margin available to the long-term lenders.

Formula and Derivation

$ \text{Total Assets to Debt Ratio} = \frac{\text{Total Assets}}{\text{Long-term Debt}} $

Significance

A higher ratio indicates that the company's assets have been mainly financed by owners' funds and short-term liabilities, and that the long-term debt is adequately covered by the total assets of the business. This provides a strong sense of security to the long-term lenders.

Illustration 1. From the following Balance Sheet, calculate (a) Debt-Equity Ratio, (b) Debt to Capital Employed Ratio, (c) Proprietary Ratio, and (d) Total Assets to Debt Ratio.

Liabilities	Amount ($\text{₹} \ $)	Assets	Amount ($\text{₹} \ $)
Equity Share Capital	5,00,000	Non-Current Assets	10,00,000
10% Preference Share Capital	3,00,000	Current Assets	6,00,000
General Reserve	1,00,000
Surplus	1,00,000
12% Debentures	4,00,000
Current Liabilities	2,00,000
Total	16,00,000	Total	16,00,000

Answer:

Step 1: Calculate Key Components

Debt (Long-term Debt) = 12% Debentures = $\text{₹} \ 4,00,000$

Equity (Shareholders' Funds) = Equity Share Capital + Preference Share Capital + General Reserve + Surplus

$ = \text{₹} \ 5,00,000 + \text{₹} \ 3,00,000 + \text{₹} \ 1,00,000 + \text{₹} \ 1,00,000 = \textbf{$\text{₹} \ 10,00,000$} $

Capital Employed = Equity + Debt = $\text{₹} \ 10,00,000 + \text{₹} \ 4,00,000 = \textbf{$\text{₹} \ 14,00,000$}$

Total Assets = Non-Current Assets + Current Assets = $\text{₹} \ 10,00,000 + \text{₹} \ 6,00,000 = \textbf{$\text{₹} \ 16,00,000$}$

Step 2: Calculate the Ratios

(a) Debt-Equity Ratio = $ \frac{\text{Debt}}{\text{Equity}} = \frac{\text{₹} \ 4,00,000}{\text{₹} \ 10,00,000} = \textbf{0.4 : 1} $

(b) Debt to Capital Employed Ratio = $ \frac{\text{Long-term Debt}}{\text{Capital Employed}} = \frac{\text{₹} \ 4,00,000}{\text{₹} \ 14,00,000} = \textbf{0.286 : 1} $

(c) Proprietary Ratio = $ \frac{\text{Shareholders' Funds}}{\text{Total Assets}} = \frac{\text{₹} \ 10,00,000}{\text{₹} \ 16,00,000} = \textbf{0.625 : 1} $

(d) Total Assets to Debt Ratio = $ \frac{\text{Total Assets}}{\text{Long-term Debt}} = \frac{\text{₹} \ 16,00,000}{\text{₹} \ 4,00,000} = \textbf{4 : 1} $

5. Interest Coverage Ratio

This ratio is different from the others as it is calculated using figures from the Statement of Profit and Loss. It measures a company's ability to service its interest payments on its outstanding debt from its operating profits.

Formula and Derivation

$ \text{Interest Coverage Ratio} = \frac{\text{Profit Before Interest and Tax (PBIT)}}{\text{Interest on Long-term Debts}} $

Profit Before Interest and Tax (PBIT): This figure is used in the numerator because interest is a tax-deductible expense, so the profit available to pay interest is the profit before any tax has been deducted. It is derived as: $ \text{PBIT} = \text{Profit After Tax} + \text{Tax} + \text{Interest} $.

Significance

This ratio shows how many times the company's earnings can cover its fixed interest obligations. A higher ratio is considered better and safer, as it indicates a strong ability to meet interest payments without difficulty. A low ratio might be a warning sign that the company is struggling to generate enough profit to service its debt, increasing the risk of default.

Illustration 2. From the following details, calculate the interest coverage ratio: Net Profit after tax $\text{₹} \ 60,000$; 15% Long-term debt $\text{₹} \ 10,00,000$; and Tax rate 40%.

Answer:

Step 1: Calculate Net Profit Before Tax (PBT)

Net Profit After Tax (PAT) is the profit remaining after tax has been deducted. If the tax rate is 40%, then the PAT represents the remaining 60% (100% - 40%) of the Profit Before Tax.

$ \text{PBT} = \frac{\text{Net Profit After Tax}}{100\% - \text{Tax Rate}} = \frac{\text{₹} \ 60,000}{100\% - 40\%} = \frac{\text{₹} \ 60,000}{60\%} = \text{₹} \ 1,00,000 $

Step 2: Calculate Interest on Long-term Debt

$ \text{Interest} = 15\% \text{ of } \text{₹} \ 10,00,000 = \text{₹} \ 1,50,000 $

Step 3: Calculate Profit Before Interest and Tax (PBIT)

The profit available to cover interest is the profit before both interest and tax are deducted. So, we add the interest back to the Profit Before Tax.

$ \text{PBIT} = \text{PBT} + \text{Interest} = \text{₹} \ 1,00,000 + \text{₹} \ 1,50,000 = \text{₹} \ 2,50,000 $

Step 4: Calculate Interest Coverage Ratio

Finally, we divide the PBIT by the interest expense to find out how many times the profit can cover the interest obligation.

$ \text{Interest Coverage Ratio} = \frac{\text{PBIT}}{\text{Interest on Long-term Debt}} = \frac{\text{₹} \ 2,50,000}{\text{₹} \ 1,50,000} = \textbf{1.67 times} $

Activity (or Turnover) Ratios

Activity ratios, also known as Turnover ratios or Efficiency ratios, are calculated to measure the efficiency and speed with which a company utilizes its assets to generate revenue. The term "turnover" signifies the cycle of converting assets into sales or cash. These ratios establish a relationship between the level of activity (usually sales or cost of sales) and the level of investment in various assets. A higher turnover ratio generally signifies better utilization of assets and improved operational efficiency, which in turn leads to enhanced liquidity and profitability.

The important activity ratios that measure a company's operational performance are:

Inventory Turnover Ratio
Trade Receivables Turnover Ratio
Trade Payables Turnover Ratio
Net Assets or Capital Employed Turnover Ratio (and its components)

1. Inventory Turnover Ratio

This ratio measures how many times, on average, a company's inventory is sold and replaced during a specific accounting period. It is a critical indicator of the efficiency of inventory management.

Formula and Derivation

The formula is derived by comparing the cost of goods sold during a period to the average level of inventory held during that period.

$ \text{Inventory Turnover Ratio} = \frac{\text{Cost of Revenue from Operations}}{\text{Average Inventory}} $

Cost of Revenue from Operations (COGS): This is used in the numerator instead of sales because it creates a like-for-like comparison: inventory is valued at cost, so it should be compared with the cost of the goods that were sold. The derivation is: $ \text{COGS} = \text{Opening Inventory} + \text{Net Purchases} + \text{Direct Expenses} - \text{Closing Inventory} $. Alternatively, it can be derived from sales: $ \text{COGS} = \text{Revenue from Operations} - \text{Gross Profit} $.
Average Inventory: Using an average of the opening and closing inventory provides a more representative figure for the inventory held throughout the period, smoothing out any significant fluctuations. The derivation is: $ \text{Average Inventory} = \frac{\text{Opening Inventory} + \text{Closing Inventory}}{2} $.

Significance and Interpretation

A high ratio is generally desirable, as it indicates that inventory is sold quickly, minimizing storage costs and the risk of obsolescence. However, an excessively high ratio might suggest under-stocking, which could lead to lost sales opportunities. A low ratio is a significant warning sign, suggesting slow-moving or obsolete inventory, poor sales performance, or over-stocking, all of which tie up the company's capital unnecessarily.

A related metric, the Average Age of Inventory, shows the average number of days inventory is held before being sold: $ \text{Average Age of Inventory} = \frac{365}{\text{Inventory Turnover Ratio}} $.

Illustration 1. From the following information, calculate the inventory turnover ratio: Inventory in the beginning = $\text{₹} \ 18,000$; Inventory at the end = $\text{₹} \ 22,000$; Net purchases = $\text{₹} \ 46,000$; Wages = $\text{₹} \ 14,000$; Carriage inwards = $\text{₹} \ 4,000$.

Answer:

Step 1: Calculate Cost of Revenue from Operations (COGS)

Wages and Carriage Inwards are direct expenses involved in bringing inventory to a saleable condition, so they are included in COGS.

$ \text{COGS} = \text{Opening Inventory} + \text{Net Purchases} + \text{Direct Expenses} - \text{Closing Inventory} $

$ \text{COGS} = \text{₹} \ 18,000 + \text{₹} \ 46,000 + (\text{₹} \ 14,000 + \text{₹} \ 4,000) - \text{₹} \ 22,000 $

$ \text{COGS} = \text{₹} \ 18,000 + \text{₹} \ 46,000 + \text{₹} \ 18,000 - \text{₹} \ 22,000 = \text{₹} \ 60,000 $

Step 2: Calculate Average Inventory

$ \text{Average Inventory} = \frac{\text{Opening Inventory} + \text{Closing Inventory}}{2} = \frac{\text{₹} \ 18,000 + \text{₹} \ 22,000}{2} = \text{₹} \ 20,000 $

Step 3: Calculate Inventory Turnover Ratio

$ \text{Inventory Turnover Ratio} = \frac{\text{COGS}}{\text{Average Inventory}} = \frac{\text{₹} \ 60,000}{\text{₹} \ 20,000} = \textbf{3 times} $

(Additional Analysis) Step 4: Calculate Average Age of Inventory

$ \text{Average Age of Inventory} = \frac{365}{\text{Inventory Turnover Ratio}} = \frac{365}{3} = \approx \textbf{122 days} $

This means, on average, the company holds its inventory for about 122 days before selling it.

2. Trade Receivables Turnover Ratio

This ratio measures a company's efficiency in collecting its receivables (money owed by customers on credit sales). It indicates how many times, on average, the trade receivables are converted into cash during a period.

Formula and Derivation

$ \text{Trade Receivables Turnover Ratio} = \frac{\text{Net Credit Revenue from Operations}}{\text{Average Trade Receivables}} $

Net Credit Revenue from Operations: It is crucial to use only credit sales in the numerator, as cash sales do not generate trade receivables. If credit sales are not given, total sales may be used with an assumption.
Average Trade Receivables: This includes both Debtors and Bills Receivable. The average is calculated as: $ \frac{(\text{Opening Trade Receivables}) + (\text{Closing Trade Receivables})}{2} $.

A more intuitive measure derived from this ratio is the Average Collection Period:

$ \text{Average Collection Period (in days)} = \frac{365}{\text{Trade Receivables Turnover Ratio}} $

Significance and Interpretation

A high ratio (and a low collection period) is favorable, indicating that customers are paying their dues promptly. This improves the company's liquidity and reduces the risk of bad debts. A low ratio (and a high collection period) suggests inefficient credit and collection policies, which can lead to a shortage of cash and an increased likelihood of bad debts.

Illustration 2. Calculate the Trade Receivables Turnover Ratio from the following: Total Revenue from Operations $\text{₹} \ 8,00,000$; Cash Revenue from Operations 25% of Total Revenue; Trade Receivables at the beginning of the year $\text{₹} \ 1,00,000$; Trade Receivables at the end of the year $\text{₹} \ 2,00,000$.

Answer:

Step 1: Calculate Net Credit Revenue from Operations

Cash Revenue = 25% of $\text{₹} \ 8,00,000 = \text{₹} \ 2,00,000$.

Net Credit Revenue = Total Revenue - Cash Revenue = $\text{₹} \ 8,00,000 - \text{₹} \ 2,00,000 = \text{₹} \ 6,00,000$.

Step 2: Calculate Average Trade Receivables

$ \text{Average Trade Receivables} = \frac{\text{Opening Receivables} + \text{Closing Receivables}}{2} = \frac{\text{₹} \ 1,00,000 + \text{₹} \ 2,00,000}{2} = \text{₹} \ 1,50,000 $

Step 3: Calculate the Ratio

$ \text{Ratio} = \frac{\text{Net Credit Revenue}}{\text{Average Trade Receivables}} = \frac{\text{₹} \ 6,00,000}{\text{₹} \ 1,50,000} = \textbf{4 times} $

Average Collection Period = $ \frac{365}{4} = \textbf{91.25 days} $.

3. Trade Payables Turnover Ratio

This ratio measures how quickly, on average, a company pays off its suppliers (trade payables). It reflects the company's payment policy.

Formula and Derivation

$ \text{Trade Payables Turnover Ratio} = \frac{\text{Net Credit Purchases}}{\text{Average Trade Payables}} $

Average Trade Payables: This includes both Creditors and Bills Payable. The average is calculated as: $ \frac{(\text{Opening Trade Payables}) + (\text{Closing Trade Payables})}{2} $.

From this, the Average Payment Period can be calculated:

$ \text{Average Payment Period (in days)} = \frac{365}{\text{Trade Payables Turnover Ratio}} $

Significance and Interpretation

A high ratio (and a short payment period) indicates that the company is paying its suppliers quickly, which may be necessary to avail cash discounts or to maintain a good credit reputation. A very low ratio (and a long payment period) could either mean the company enjoys favorable credit terms from its suppliers or it is struggling with cash flow and delaying payments, which could damage its relationships with suppliers.

4. Net Assets or Capital Employed Turnover Ratio

This ratio acts as an overall measure of a company's ability to generate revenue from its total long-term funds (capital employed). It is often broken down into two more specific components:

Fixed Assets Turnover Ratio: This measures the efficiency of utilizing fixed assets to generate sales. A low ratio might indicate that expensive fixed assets are being underutilized.
$ \text{Formula} = \frac{\text{Net Revenue from Operations}}{\text{Net Fixed Assets}} $
Working Capital Turnover Ratio: This measures the efficiency of utilizing net working capital to support sales. A high ratio indicates efficient management of working capital.
$ \text{Formula} = \frac{\text{Net Revenue from Operations}}{\text{Working Capital}} $ (where Working Capital = Current Assets - Current Liabilities)

Significance

A high turnover ratio for capital employed, fixed assets, and working capital is a positive sign, indicating efficient utilization of the company's resources to generate sales. A low ratio might suggest that the company's assets are not being used to their full potential, which can negatively impact profitability.

Illustration 3. Calculate the Working Capital Turnover Ratio from the following: Revenue from Operations $\text{₹} \ 12,00,000$; Current Assets $\text{₹} \ 5,00,000$; Current Liabilities $\text{₹} \ 2,00,000$.

Answer:

Step 1: Calculate Working Capital

Working Capital = Current Assets - Current Liabilities = $\text{₹} \ 5,00,000 - \text{₹} \ 2,00,000 = \text{₹} \ 3,00,000$.

Step 2: Calculate the Ratio

$ \text{Working Capital Turnover Ratio} = \frac{\text{Revenue from Operations}}{\text{Working Capital}} = \frac{\text{₹} \ 12,00,000}{\text{₹} \ 3,00,000} = \textbf{4 times} $

This indicates that for every one rupee invested in working capital, the company generates four rupees in revenue.

Profitability Ratios

Profitability ratios are a category of financial metrics calculated to measure the earning capacity and overall financial performance of a business. Profit is the primary driver and the ultimate goal of a business, and these ratios help to analyze how successfully the company is generating profits from its operations and the resources it employs. They establish a crucial relationship between the profits earned and either the revenue generated from operations or the capital invested in the business. A higher profitability ratio is generally a positive sign, indicating better performance and efficiency.

The main profitability ratios can be analyzed from two perspectives: those based on sales (margin ratios) and those based on investment (return ratios).

1. Gross Profit Ratio

This ratio measures the relationship between a company's gross profit and its revenue from operations. It indicates the basic profitability of a company's core trading activities, i.e., buying/manufacturing and selling goods, before considering any operating, administrative, or financial expenses.

Formula and Derivation

It is expressed as a percentage of net revenue from operations.

$ \text{Gross Profit Ratio} = \frac{\text{Gross Profit}}{\text{Net Revenue from Operations}} \times 100 $

Where, Gross Profit is derived as:

$ \text{Gross Profit} = \text{Net Revenue from Operations} - \text{Cost of Revenue from Operations} $

Significance and Interpretation

The Gross Profit Ratio indicates the average gross margin on products sold. It is the first line of defense for a company's profitability, showing the profit available to cover all other operating and non-operating expenses. A low ratio might suggest an unfavorable purchasing policy, low selling prices, high manufacturing costs, or inefficient production. A high and stable ratio is always a good sign of a healthy core business.

Illustration 1. Calculate Gross Profit Ratio from the following: Revenue from Operations $\text{₹} \ 6,00,000$; Cost of Revenue from Operations $\text{₹} \ 4,80,000$.

Answer:

Gross Profit = Revenue from Operations - Cost of Revenue from Operations

$ = \text{₹} \ 6,00,000 - \text{₹} \ 4,80,000 = \text{₹} \ 1,20,000 $

$ \text{Gross Profit Ratio} = \frac{\text{Gross Profit}}{\text{Net Revenue from Operations}} \times 100 = \frac{\text{₹} \ 1,20,000}{\text{₹} \ 6,00,000} \times 100 = \textbf{20%} $

2. Operating Ratio and Operating Profit Ratio

These two ratios are complementary and are used to measure the operational efficiency of the business. They focus on the profitability of the core, principal business activities, excluding the impact of financial decisions (interest) and taxes.

Operating Ratio

This ratio measures the proportion of costs related to the company's main operations to its revenue.

$ \text{Operating Ratio} = \frac{\text{Operating Cost}}{\text{Net Revenue from Operations}} \times 100 $

Where, Operating Cost is derived as:
$ \text{Operating Cost} = \text{Cost of Revenue from Operations} + \text{Operating Expenses} $
(Operating Expenses include office & administrative expenses, selling & distribution expenses, employee benefit expenses, depreciation, etc.)

Operating Profit Ratio

This ratio measures the operating margin, or the profit earned purely from the core business operations.

$ \text{Operating Profit Ratio} = \frac{\text{Operating Profit}}{\text{Net Revenue from Operations}} \times 100 $

Where, Operating Profit is derived as:
$ \text{Operating Profit} = \text{Net Revenue from Operations} - \text{Operating Cost} $. It can also be calculated as Gross Profit - Other Operating Expenses.

Since these two ratios are complementary, their sum is always 100%. Therefore:

$ \text{Operating Profit Ratio} = 100 - \text{Operating Ratio} $

Significance and Interpretation

A lower Operating Ratio (and consequently a higher Operating Profit Ratio) is considered better, as it indicates a greater portion of revenue is left over after covering the core operational costs. This remaining profit is then available to meet interest payments, taxes, and provide returns to shareholders. These ratios are excellent for assessing the operational efficiency of the management.

3. Net Profit Ratio

This ratio, often referred to as the "bottom-line" ratio, measures the overall profitability of the company after considering all operational and non-operational incomes and expenses, including interest and taxes.

Formula

$ \text{Net Profit Ratio} = \frac{\text{Net Profit After Tax (PAT)}}{\text{Net Revenue from Operations}} \times 100 $

Significance and Interpretation

This is a key indicator of the company's overall efficiency and profitability. It shows how much of each rupee of sales is ultimately left as net profit for the shareholders after all expenses, of every kind, have been paid. It reflects the combined effect of both operational and financial management.

Illustration 2. The gross profit ratio of a company was 25%. Its credit revenue from operations was $\text{₹} \ 20,00,000$ and its cash revenue from operations was 10% of the total revenue from operations. If the indirect expenses of the company were $\text{₹} \ 50,000$, calculate its net profit ratio.

Answer:

Step 1: Calculate Total Revenue from Operations

We are given that Credit Revenue is $\text{₹} \ 20,00,000$, and this represents 90% of the Total Revenue (since Cash Revenue is 10%).

$ \text{Total Revenue} = \frac{\text{Credit Revenue}}{90\%} = \frac{\text{₹} \ 20,00,000}{0.9} = \text{₹} \ 22,22,222 $

Step 2: Calculate Gross Profit

$ \text{Gross Profit} = 25\% \text{ of Total Revenue} = 0.25 \times \text{₹} \ 22,22,222 = \text{₹} \ 5,55,556 $

Step 3: Calculate Net Profit

$ \text{Net Profit} = \text{Gross Profit} - \text{Indirect Expenses} = \text{₹} \ 5,55,556 - \text{₹} \ 50,000 = \text{₹} \ 5,05,556 $

Step 4: Calculate Net Profit Ratio

$ \text{Net Profit Ratio} = \frac{\text{Net Profit}}{\text{Total Revenue}} \times 100 = \frac{\text{₹} \ 5,05,556}{\text{₹} \ 22,22,222} \times 100 = \textbf{22.75%} $

4. Return on Investment (ROI) or Return on Capital Employed (ROCE)

This is a primary profitability ratio that measures the overall performance of the company by relating the profit earned to the total long-term funds invested in the business.

Formula and Derivation

$ \text{Return on Investment} = \frac{\text{Profit Before Interest and Tax (PBIT)}}{\text{Capital Employed}} \times 100 $

PBIT: Profit before deducting interest and tax is used in the numerator because Capital Employed in the denominator includes both debt (on which interest is paid) and equity. Therefore, the profit figure used should be the one that is available to all long-term fund providers before their respective returns are paid.
Capital Employed: Represents the total long-term funds invested in the business. It is derived as: $ \text{Shareholders' Funds} + \text{Long-term Debt} $.

Significance and Interpretation

ROI is considered one of the best measures of a company's overall performance. It shows how efficiently the management has used the funds entrusted to it by both owners and lenders to generate profits. It is extremely useful for inter-firm comparisons as it is not affected by the financing methods used by different companies.

Illustration 3. Calculate Return on Investment from the following data: Net Profit after Interest and Tax $\text{₹} \ 6,00,000$; 10% Debentures $\text{₹} \ 10,00,000$; Tax @ 40%; Capital Employed $\text{₹} \ 80,00,000$.

Answer:

Step 1: Calculate Profit Before Tax (PBT)

$ \text{PBT} = \frac{\text{Profit After Tax}}{1 - \text{Tax Rate}} = \frac{\text{₹} \ 6,00,000}{1 - 0.40} = \frac{\text{₹} \ 6,00,000}{0.60} = \text{₹} \ 10,00,000 $

Step 2: Calculate Interest on Debentures

$ \text{Interest} = 10\% \text{ of } \text{₹} \ 10,00,000 = \text{₹} \ 1,00,000 $

Step 3: Calculate Profit Before Interest and Tax (PBIT)

$ \text{PBIT} = \text{PBT} + \text{Interest} = \text{₹} \ 10,00,000 + \text{₹} \ 1,00,000 = \text{₹} \ 11,00,000 $

Step 4: Calculate Return on Investment

$ \text{ROI} = \frac{\text{PBIT}}{\text{Capital Employed}} \times 100 = \frac{\text{₹} \ 11,00,000}{\text{₹} \ 80,00,000} \times 100 = \textbf{13.75%} $

5. Ratios from Shareholders' Viewpoint

These ratios are of particular interest to equity shareholders as they focus on the returns and value accruing specifically to them.

Earnings Per Share (EPS)

$ \text{EPS} = \frac{\text{Profit available for Equity Shareholders}}{\text{Number of Equity Shares}} $

Where, Profit available for Equity Shareholders is derived as: Profit after Tax - Preference Dividend. This is a widely tracked metric showing the profit earned on behalf of each outstanding equity share.

Book Value Per Share

$ \text{Book Value per Share} = \frac{\text{Equity Shareholders' Funds}}{\text{Number of Equity Shares}} $

Where, Equity Shareholders' Funds = Shareholders' Funds - Preference Share Capital. This represents the net asset value of the company from an accounting perspective for each equity share.

Dividend Payout Ratio

$ \text{Dividend Payout Ratio} = \frac{\text{Dividend per Equity Share}}{\text{Earnings Per Share}} \times 100 $

This ratio shows what proportion of the earnings attributable to equity shareholders is actually distributed as dividends.

Price/Earning (P/E) Ratio

$ \text{P/E Ratio} = \frac{\text{Market Price per Share}}{\text{Earnings Per Share}} $

This ratio is a key metric used in the stock market. It reflects investors' expectations about the company's future growth and earnings potential. A high P/E ratio suggests that investors are willing to pay a premium for the company's shares, usually because they expect high future growth.

NCERT Questions Solution

Test your Understanding – I

Question. State which of the following statements are True or False.

(a) The only purpose of financial reporting is to keep the managers informed about the progress of operations.

(b) Analysis of data provided in the financial statements is termed as financial analysis.

(c) Long-term borrowings are concerned about the ability of a firm to discharge its obligations to pay interest and repay the principal amount.

(d) A ratio is always expressed as a quotient of one number divided by another.

(e) Ratios help in comparisons of a firm’s results over a number of accounting periods as well as with other business enterprises.

(f) A ratio reflects quantitative and qualitative aspects of results.

Answer:

(a) False

Reason: Financial reporting serves a wide range of external users (like shareholders, investors, creditors, government) in addition to internal users (managers). Its purpose is to provide information for decision-making to all stakeholders, not just management.

(b) True

Reason: This is the definition of financial analysis. It is the process of evaluating the financial information contained in the financial statements to understand the performance and financial position of an enterprise.

(c) True

Reason: The statement, although slightly rephrased, correctly identifies the primary concern of long-term lenders. They are interested in the firm's long-term solvency, which is its ability to pay periodic interest and repay the principal amount on maturity.

(d) False

Reason: A ratio is an arithmetical relationship that can be expressed in various forms, not just as a quotient. It can be expressed as a pure ratio (e.g., 2:1), a percentage (e.g., 25%), or a rate (e.g., 4 times).

(e) True

Reason: This statement correctly describes the two main types of comparison facilitated by ratio analysis: intra-firm comparison (trend analysis over different periods) and inter-firm comparison (comparing with other firms).

(f) False

Reason: Ratio analysis is a purely quantitative tool as it is derived from numerical data in the financial statements. It does not reflect qualitative aspects like management efficiency, employee morale, or brand reputation.

Do it yourself (Page No. 203)

Question 1. Current liabilities of a company are Rs. 5,60,000, current ratio is 2.5:1 and quick ratio is 2:1. Find the value of the Inventories.

Answer:

The value of inventories is the difference between Current Assets and Quick Assets. We can find these values using the given ratios.

Given:

Current Liabilities (CL) = $\textsf{₹ } \ 5,60,000$
Current Ratio (CR) = 2.5 : 1
Quick Ratio (QR) = 2 : 1

Step 1: Calculate Current Assets (CA)

$\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}$

$2.5 = \frac{\text{Current Assets}}{\textsf{₹ } \ 5,60,000}$

Current Assets = $2.5 \ \times \ \textsf{₹ } \ 5,60,000 = \textsf{₹ } \ 14,00,000$

Step 2: Calculate Quick Assets (QA)

$\text{Quick Ratio} = \frac{\text{Quick Assets}}{\text{Current Liabilities}}$

$2 = \frac{\text{Quick Assets}}{\textsf{₹ } \ 5,60,000}$

Quick Assets = $2 \ \times \ \textsf{₹ } \ 5,60,000 = \textsf{₹ } \ 11,20,000$

Step 3: Calculate Inventories

$\text{Inventories} = \text{Current Assets} \ - \ \text{Quick Assets}$

Inventories = $\textsf{₹ } \ 14,00,000 \ - \ \textsf{₹ } \ 11,20,000 = \textsf{₹ } \ 2,80,000$

The value of the Inventories is $\textsf{₹ } \ 2,80,000$.

Question 2. Current ratio = 4.5:1, quick ratio = 3:1.Inventory is Rs. 36,000. Calculate the current assets and current liabilities.

Answer:

Given:

Current Ratio (CR) = 4.5
Quick Ratio (QR) = 3
Inventories = $\textsf{₹ } \ 36,000$

Step 1: Express relationships in equations

Current Assets (CA) = Inventories + Quick Assets (QA)

We know that $CR = \frac{CA}{CL}$ and $QR = \frac{QA}{CL}$.

So, $CA = 4.5 \ \times \ CL$

And $QA = 3 \ \times \ CL$

Step 2: Calculate Current Liabilities (CL)

Substitute the expressions for CA and QA into the first equation:

$4.5 \ \times \ CL = \textsf{₹ } \ 36,000 + (3 \ \times \ CL)$

$4.5 \ CL - 3 \ CL = \textsf{₹ } \ 36,000$

$1.5 \ CL = \textsf{₹ } \ 36,000$

$CL = \frac{\textsf{₹ } \ 36,000}{1.5}$

Current Liabilities = $\textsf{₹ } \ 24,000$

Step 3: Calculate Current Assets (CA)

Using the Current Ratio:

$CA = 4.5 \ \times \ CL$

$CA = 4.5 \ \times \ \textsf{₹ } \ 24,000$

Current Assets = $\textsf{₹ } \ 1,08,000$

Question 3. Current assets of a company are Rs. 5,00,000. Current ratio is 2.5:1 and Liquid ratio is 1:1. Calculate the value of current liabilities, liquid assets and inventories.

Answer:

Given:

Current Assets (CA) = $\textsf{₹ } \ 5,00,000$
Current Ratio (CR) = 2.5 : 1
Liquid Ratio (LR) = 1 : 1

Step 1: Calculate Current Liabilities (CL)

$\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}$

$2.5 = \frac{\textsf{₹ } \ 5,00,000}{\text{Current Liabilities}}$

Current Liabilities = $\frac{\textsf{₹ } \ 5,00,000}{2.5}$

Current Liabilities = $\textsf{₹ } \ 2,00,000$

Step 2: Calculate Liquid Assets (LA)

Liquid Assets are also known as Quick Assets.

$\text{Liquid Ratio} = \frac{\text{Liquid Assets}}{\text{Current Liabilities}}$

$1 = \frac{\text{Liquid Assets}}{\textsf{₹ } \ 2,00,000}$

Liquid Assets = $1 \ \times \ \textsf{₹ } \ 2,00,000$

Liquid Assets = $\textsf{₹ } \ 2,00,000$

Step 3: Calculate Inventories

$\text{Inventories} = \text{Current Assets} \ - \ \text{Liquid Assets}$

Inventories = $\textsf{₹ } \ 5,00,000 \ - \ \textsf{₹ } \ 2,00,000$

Inventories = $\textsf{₹ } \ 3,00,000$

Test your Understanding – II

Question (i). The following groups of ratios are primarily measure risk:

A. liquidity, activity, and profitability

B. liquidity, activity, and inventory

C. liquidity, activity, and debt

D. liquidity, debt and profitability

Answer:

The correct option is D. liquidity, debt and profitability.

Explanation:

Liquidity ratios measure the risk of being unable to meet short-term obligations.
Debt (Solvency) ratios measure the risk of being unable to meet long-term obligations.
Profitability ratios are also linked to risk; low profitability increases the overall risk of business failure.
Activity ratios primarily measure efficiency, not risk directly.

Question (ii). The _________ ratios are primarily measures of return:

A. liquidity

B. activity

C. debt

D. profitability

Answer:

The correct option is D. profitability.

Explanation: Profitability ratios, such as Gross Profit Ratio, Net Profit Ratio, and Return on Investment (ROI), are specifically designed to measure the financial return generated by the business on its sales and investments.

Question (iii). The _________ of business firm is measured by its ability to satisfy its shortterm obligations as they become due:

A. activity

B. liquidity

C. debt

D. profitability

Answer:

The correct option is B. liquidity.

Explanation: Liquidity is the term used to describe a firm's ability to meet its current liabilities (short-term obligations) using its current assets. Ratios like the Current Ratio and Quick Ratio are used to measure this.

Question (iv). _________ ratios are a measure of the speed with which various accounts are converted into revenue from operations or cash:

A. activity

B. liquidity

C. debt

D. profitability

Answer:

The correct option is A. activity.

Explanation: Activity ratios, also known as turnover or efficiency ratios (e.g., Inventory Turnover Ratio, Trade Receivables Turnover Ratio), measure how efficiently a firm is using its assets to generate sales (revenue from operations) and cash.

Question (v). The two basic measures of liquidity are:

A. inventory turnover and current ratio

B. current ratio and liquid ratio

C. gross profit margin and operating ratio

D. current ratio and average collection period

Answer:

The correct option is B. current ratio and liquid ratio.

Explanation: The Current Ratio and the Liquid Ratio (also known as Quick Ratio or Acid-Test Ratio) are the two primary and most widely used ratios to assess the short-term solvency or liquidity of a business.

Question (vi). The _________ is a measure of liquidity which excludes _______, generally the least liquid asset:

A. current ratio, trade receivable

B. liquid ratio, trade receivable

C. current ratio, inventory

D. liquid ratio, inventory

Answer:

The correct option is D. liquid ratio, inventory.

Explanation: The Liquid Ratio (or Quick Ratio) is a more stringent measure of liquidity than the Current Ratio. It is calculated by excluding inventory from current assets because inventory is often the most difficult current asset to convert into cash quickly without a potential loss of value.

Do it yourself (Page No. 216)

Question 1. Calculate the amount of gross profit:

Average inventory = Rs. 80,000

Inventory turnover ratio = 6 times

Selling price = 25% above cost

Answer:

To calculate the Gross Profit, we first need to determine the Cost of Revenue from Operations (also known as Cost of Goods Sold) using the Inventory Turnover Ratio.

Step 1: Calculate the Cost of Revenue from Operations

The formula for the Inventory Turnover Ratio is:

$\text{Inventory Turnover Ratio} = \frac{\text{Cost of Revenue from Operations}}{\text{Average Inventory}}$

We are given:

Inventory Turnover Ratio = 6 times

Average Inventory = $\textsf{₹ } \ 80,000$

Substituting the values into the formula:

$6 = \frac{\text{Cost of Revenue from Operations}}{\textsf{₹ } \ 80,000}$

Cost of Revenue from Operations = $6 \ \times \ \textsf{₹ } \ 80,000$

Cost of Revenue from Operations = $\textsf{₹ } \ 4,80,000$

Step 2: Calculate the Gross Profit

The problem states that the selling price is 25% above cost. This means the Gross Profit is 25% of the cost.

$\text{Gross Profit} = \text{Cost of Revenue from Operations} \ \times \ 25\%$

Gross Profit = $\textsf{₹ } \ 4,80,000 \ \times \ \frac{25}{100}$

Gross Profit = $\textsf{₹ } \ 1,20,000$

Question 2. Calculate Inventory Turnover Ratio:

Annual Revenue from operations = Rs. 2,00,000

Gross Profit = 20% on cost of Revenue from operations

Inventory in the beginning = Rs. 38,500

Inventory at the end = Rs. 41,500

Answer:

To calculate the Inventory Turnover Ratio, we need two components: the Cost of Revenue from Operations and the Average Inventory.

Step 1: Calculate the Cost of Revenue from Operations

We are given that Gross Profit is 20% on cost. Let the Cost of Revenue from Operations be 'x'.

Gross Profit = $0.20 \ \times \ x$

We know that:

$\text{Revenue from Operations} = \text{Cost of Revenue from Operations} \ + \ \text{Gross Profit}$

$\textsf{₹ } \ 2,00,000 = x \ + \ 0.20x$

$\textsf{₹ } \ 2,00,000 = 1.20x$

$x = \frac{\textsf{₹ } \ 2,00,000}{1.20}$

Cost of Revenue from Operations (x) = $\textsf{₹ } \ 1,66,667$ (approx.)

Step 2: Calculate the Average Inventory

The formula for Average Inventory is:

$\text{Average Inventory} = \frac{\text{Opening Inventory} \ + \ \text{Closing Inventory}}{2}$

Average Inventory = $\frac{\textsf{₹ } \ 38,500 \ + \ \textsf{₹ } \ 41,500}{2} = \frac{\textsf{₹ } \ 80,000}{2}$

Average Inventory = $\textsf{₹ } \ 40,000$

Step 3: Calculate the Inventory Turnover Ratio

$\text{Inventory Turnover Ratio} = \frac{\text{Cost of Revenue from Operations}}{\text{Average Inventory}}$

Inventory Turnover Ratio = $\frac{\textsf{₹ } \ 1,66,667}{\textsf{₹ } \ 40,000}$

Inventory Turnover Ratio = 4.17 times (approx.)

Test your Understanding – III

Question (i). The _________ is useful in evaluating credit and collection policies.

A. average payment period

B. current ratio

C. average collection period

D. current asset turnover

Answer:

The correct option is C. average collection period.

Explanation: The Average Collection Period (or Debtors' Velocity) indicates the average number of days it takes for a company to collect cash from its credit customers. A comparison of this period with the company's credit terms helps in evaluating the efficiency of its credit and collection policies.

Question (ii). The ___________ measures the activity of a firm’s inventory.

A. average collection period

B. inventory turnover

C. liquid ratio

D. current ratio

Answer:

The correct option is B. inventory turnover.

Explanation: The Inventory Turnover Ratio is an activity ratio that measures how many times a company's inventory is sold and replaced over a period. It indicates the efficiency with which a firm is managing and selling its inventory.

Question (iii). The ___________ may indicate that the firm is experiencing stockouts and lost sales.

A. average payment period

B. inventory turnover ratio

C. average collection period

D. quick ratio

Answer:

The correct option is B. inventory turnover ratio.

Explanation: An abnormally high Inventory Turnover Ratio, when compared to the industry average, may suggest that the firm is maintaining insufficient inventory levels. This can lead to frequent stockouts (running out of goods) and result in lost sales opportunities.

Question (iv). ABC Co. extends credit terms of 45 days to its customers. Its credit collection would be considered poor if its average collection period was.

A. 30 days

B. 36 days

C. 47 days

D. 37 days

Answer:

The correct option is C. 47 days.

Explanation: The credit term is 45 days, meaning customers are expected to pay within this period. If the average collection period is longer than the allowed credit period (i.e., 47 days), it indicates that customers are, on average, not paying on time, which signifies a poor or inefficient credit collection process.

Question (v). ___________ are especially interested in the average payment period, since it provides them with a sense of the bill-paying patterns of the firm.

A. Customers

B. Stockholders

C. Lenders and suppliers

D. Borrowers and buyers

Answer:

The correct option is C. Lenders and suppliers.

Explanation: The average payment period indicates how long a company takes to pay its own bills to its suppliers (creditors). Lenders and suppliers are keen on this ratio to assess the company's creditworthiness and the promptness of its payment patterns before extending further credit.

Question (vi). The __________ ratios provide the information critical to the long run operation of the firm

A. liquidity

B. activity

C. solvency

D. profitability

Answer:

The correct option is C. solvency.

Explanation: Solvency ratios (like the Debt-Equity Ratio) measure a firm's ability to meet its long-term obligations. They indicate the financial leverage and the long-term financial health of the business, which are critical for its survival and long-run operations.

Short Answers

Question 1. What do you mean by Ratio Analysis?

Answer:

Ratio Analysis is a quantitative technique of financial analysis that involves the computation of ratios to establish a significant relationship between two or more interrelated items of financial data. It is a powerful tool for interpreting the financial statements by simplifying complex accounting figures into more understandable forms.

By analyzing these ratios and comparing them with past data, industry averages, or predetermined standards, stakeholders can gain meaningful insights into a company's financial performance (profitability), financial position (liquidity and solvency), and operational efficiency.

Question 2. What are various types of ratios?

Answer:

Financial ratios are broadly classified into the following four categories based on the specific aspect of the business they measure:

Liquidity Ratios: These ratios measure a firm's ability to meet its short-term financial obligations. They indicate the short-term solvency of the business.
Examples: Current Ratio, Quick Ratio (or Liquid Ratio).
Solvency Ratios: These ratios assess a firm's ability to meet its long-term financial obligations. They indicate the long-term financial health and the proportion of debt in the capital structure.
Examples: Debt-Equity Ratio, Total Assets to Debt Ratio, Proprietary Ratio.
Activity Ratios (or Turnover Ratios): These ratios measure the efficiency with which a firm is utilising its assets to generate revenue. They indicate the speed at which assets are being converted into sales or cash.
Examples: Inventory Turnover Ratio, Trade Receivables Turnover Ratio, Working Capital Turnover Ratio.
Profitability Ratios: These ratios measure the overall performance and profit-earning capacity of the business. They show the relationship between profits and sales or investments.
Examples: Gross Profit Ratio, Net Profit Ratio, Return on Investment (ROI).

Question 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 establishes the relationship between the Cost of Revenue from Operations (Cost of Goods Sold) and the Average Inventory. It measures how many times the inventory is sold and replaced during a period.

b. Trade Receivables Turnover Ratio:

This ratio establishes the relationship between Net Credit Revenue from Operations (Net Credit Sales) and the Average Trade Receivables. It measures the efficiency of credit collections.

c. Trade Payables Turnover Ratio:

This ratio establishes the relationship between Net Credit Purchases and the Average Trade Payables. It measures how quickly a company pays its suppliers.

d. Working Capital Turnover Ratio:

This ratio establishes the relationship between Revenue from Operations and Working Capital (Current Assets - Current Liabilities). It measures the efficiency with which the working capital is being used to generate sales.

Question 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 statement in the question is incorrect. The ability to satisfy long-term obligations measures a firm's Solvency, not its Liquidity. Liquidity relates to short-term obligations.

The ratios used to measure a firm's ability to satisfy its long-term obligations (Solvency) are:

Debt-Equity Ratio: Measures the relationship between long-term debt and shareholders' equity.
Total Assets to Debt Ratio: Measures the proportion of total assets financed through debt.
Proprietary Ratio: Measures the proportion of total assets financed by shareholders' funds.
Interest Coverage Ratio: Measures the firm's ability to cover its interest payments from its profits.

Question 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:

The statement is correct.

The Average Age of Inventory (also known as Inventory Holding Period) is a financial metric that calculates the average number of days that a company holds its inventory before selling it. It is calculated by dividing the number of days in a year by the Inventory Turnover Ratio.

Formula:

$\text{Average Age of Inventory} = \frac{\text{Days in a Year (365)}}{\text{Inventory Turnover Ratio}}$

Reason: The Inventory Turnover Ratio measures how many times the entire stock is sold and replaced in a year. By dividing the total number of days in the year by this turnover frequency, we can determine the average duration of one cycle of holding and selling inventory. A lower average age is generally better as it indicates that inventory is being sold quickly, which reduces holding costs and the risk of obsolescence.

Long Answers

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

Answer:

Meaning of Liquidity Ratios

Liquidity ratios are financial metrics used to measure a company's ability to meet its short-term financial obligations (current liabilities) as they become due. These ratios are a crucial indicator of a firm's short-term solvency and its capacity to manage its working capital efficiently. They provide insight into whether a company has enough liquid assets to cover its debts that are payable within a year.

Importance of Current Ratio and Liquid Ratio

The two primary liquidity ratios are the Current Ratio and the Liquid Ratio (also known as Quick Ratio or Acid-Test Ratio). Their importance is as follows:

1. Current Ratio

The Current Ratio establishes the relationship between a firm's total current assets and its total current liabilities.

$\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}$

Importance:

Overall Liquidity Assessment: It provides a comprehensive measure of the firm's ability to pay off its current liabilities using all its current assets. A generally accepted ideal ratio is 2:1, which indicates that the firm has twice the current assets to cover its current liabilities, providing a comfortable margin of safety.
Indicator of Working Capital: It reflects the company's working capital position. A high ratio indicates a sound working capital position, while a very low ratio might signal a potential liquidity crisis.
Creditors' Perspective: Short-term creditors, like suppliers and banks, rely heavily on this ratio to assess the creditworthiness of the firm and the risk associated with extending short-term credit.

2. Liquid Ratio (Quick Ratio)

The Liquid Ratio is a more stringent test of liquidity. It relates the firm's quick assets (current assets excluding inventory and prepaid expenses) to its current liabilities.

$\text{Liquid Ratio} = \frac{\text{Liquid Assets (Current Assets - Inventories)}}{\text{Current Liabilities}}$

Importance:

Stringent Test of Solvency: It measures the firm's ability to meet its immediate liabilities without relying on the sale of inventory. This is important because inventory can be difficult to convert into cash quickly and without a potential loss of value.
Quality of Current Assets: A comparison between the Current Ratio and the Liquid Ratio reveals the extent to which the firm's current assets are composed of slow-moving inventory. A large difference between the two ratios indicates heavy reliance on inventory for liquidity.
Better for Immediate Obligations: It provides a more realistic picture of the firm's ability to handle sudden financial pressures or emergencies. A commonly accepted ideal ratio is 1:1, indicating that the firm has enough liquid assets to cover its current liabilities completely.

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

Answer:

The solvency position of a firm refers to its ability to meet its long-term financial obligations, including interest payments and repayment of principal, as they become due. A firm is considered solvent if its total assets exceed its total liabilities. Studying the solvency position is crucial for long-term lenders, investors, and management to assess the financial risk and long-term viability of the business.

The solvency position is studied using a set of ratios known as Solvency Ratios. The key ratios used for this purpose are:

Debt-Equity Ratio:

This is the primary solvency ratio. It measures the relationship between long-term debt (borrowed funds) and shareholders' equity (owned funds). A low ratio indicates a higher degree of financial security for lenders, as the business is less dependent on outside funds.

$\text{Debt-Equity Ratio} = \frac{\text{Long-term Debt}}{\text{Shareholders' Equity}}$
Total Assets to Debt Ratio:

This ratio measures the extent to which a firm's total assets are financed by long-term debt. A higher ratio indicates a greater margin of safety for creditors, as it shows that a larger portion of assets is financed by owner's funds.

$\text{Total Assets to Debt Ratio} = \frac{\text{Total Assets}}{\text{Long-term Debt}}$
Proprietary Ratio:

This ratio shows the proportion of total assets that is financed by the proprietors' (shareholders') funds. A high ratio is a positive sign, indicating a strong financial structure and greater security for creditors.

$\text{Proprietary Ratio} = \frac{\text{Shareholders' Funds}}{\text{Total Assets}}$
Interest Coverage Ratio:

This ratio assesses the firm's ability to service its debt obligations by measuring how many times the profit available for paying interest covers the interest expense. A higher ratio indicates a lower risk of default on interest payments.

$\text{Interest Coverage Ratio} = \frac{\text{Profit Before Interest and Tax (PBIT)}}{\text{Interest on Long-term Debt}}$

By analysing these ratios, often in conjunction with industry benchmarks and the firm's past trends, an analyst can form a comprehensive view of the company's long-term financial stability and risk profile.

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

Answer:

Profitability ratios are financial metrics used to measure and evaluate a company's ability to generate profits from its sales, assets, and equity. They are crucial for assessing the overall financial performance and efficiency of the business. The various profitability ratios are worked out as follows:

1. Gross Profit Ratio:

It measures the relationship between gross profit and revenue from operations. It indicates the company's efficiency in production and pricing.

$\text{Gross Profit Ratio} = \frac{\text{Gross Profit}}{\text{Revenue from Operations}} \times 100$

2. Operating Ratio:

It measures the proportion of revenue that is absorbed by the cost of operations (Cost of Revenue from Operations + Operating Expenses). A lower ratio indicates higher operational efficiency.

$\text{Operating Ratio} = \frac{\text{Cost of Revenue from Operations} + \text{Operating Expenses}}{\text{Revenue from Operations}} \times 100$

3. Operating Profit Ratio:

It measures the relationship between operating profit and revenue from operations. It shows the profit earned from the core business activities. It is the complement of the Operating Ratio (100% - Operating Ratio).

$\text{Operating Profit Ratio} = \frac{\text{Operating Profit}}{\text{Revenue from Operations}} \times 100$

4. Net Profit Ratio:

It establishes the relationship between net profit after tax and revenue from operations. It is a measure of the overall profitability of the firm after considering all operating and non-operating incomes and expenses, including taxes.

$\text{Net Profit Ratio} = \frac{\text{Net Profit After Tax}}{\text{Revenue from Operations}} \times 100$

5. Return on Investment (ROI) or Return on Capital Employed (ROCE):

This is a comprehensive ratio that measures the overall profitability of the firm in relation to the total capital invested in the business. It shows how efficiently the capital employed has been used to generate profits.

$\text{Return on Investment} = \frac{\text{Profit Before Interest and Tax (PBIT)}}{\text{Capital Employed}} \times 100$

(Where Capital Employed = Total Assets - Current Liabilities, or Shareholders' Funds + Long-term Debt)

Question 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.

Answer:

The statement presented in the question is incorrectly phrased. It seems to have reversed the roles of the current ratio and the quick ratio. The correct explanation is as follows:

The Current Ratio is a measure of overall liquidity, calculated as: $\frac{\text{Current Assets}}{\text{Current Liabilities}}$. It includes all current assets, including inventory. This ratio is a good general indicator, but its reliability depends on the liquidity of its components, especially inventory.

The Quick Ratio (or Liquid Ratio) is a more stringent measure, calculated as: $\frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}}$. It is specifically designed to address the potential non-liquidity of inventory.

The relationship between the two ratios and the liquidity of inventory is as follows:

When Inventory is NOT Easily Converted into Cash (i.e., not liquid): In this situation, inventory is the least liquid of all current assets. Including it in the liquidity calculation (as the Current Ratio does) can be misleading and can overstate the firm's true ability to meet its immediate obligations. In such cases, the Quick Ratio is the preferred and better measure of liquidity because it excludes inventory and provides a more conservative and realistic picture of the firm's short-term solvency.
When Inventory IS Liquid: If a firm's inventory is highly liquid (e.g., fast-moving consumer goods that sell quickly), then the difference between the Current Ratio and the Quick Ratio will be small. In this scenario, the Current Ratio provides a perfectly adequate and reliable measure of overall liquidity, as the inventory can be converted into cash with relative ease to pay off liabilities.

In summary, the statement in the question has it backward. The Quick Ratio is preferred when inventory is not liquid, and the Current Ratio is a reliable measure when inventory is liquid.

Numerical Questions

Question 1. Following is the Balance Sheet of Raj Oil Mills Limited as at March 31, 2017. Calculate current ratio.

Particulars	(Rs.)
I. Equity and Liabilities:
1. Shareholders’ funds
(a) Share capital	7,90,000
(b) Reserves and surplus	35,000
2. Current Liabilities
Trade Payables	72,000
Total	8,97,000
II. Assets
1. Non-current Assets
Fixed assets
- Tangible assets	7,53,000
2. Current Assets
a) Inventories	55,800
b) Trade Receivables	28,800
c) Cash and cash equivalents	59,400
Total	8,97,000

Answer:

The Current Ratio is a liquidity ratio that measures a company's ability to pay short-term obligations or those due within one year. It is calculated by dividing current assets by current liabilities.

The formula for the Current Ratio is:

$\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}$

Step 1: Identify Current Assets

From the Balance Sheet, the current assets are:

Inventories: $\textsf{₹ }$ 55,800
Trade Receivables: $\textsf{₹ }$ 28,800
Cash and cash equivalents: $\textsf{₹ }$ 59,400

Total Current Assets = $\textsf{₹ } 55,800 + \textsf{₹ } 28,800 + \textsf{₹ } 59,400 = \textsf{₹ } 1,44,000$

Step 2: Identify Current Liabilities

From the Balance Sheet, the only current liability is:

Trade Payables: $\textsf{₹ }$ 72,000

Total Current Liabilities = $\textsf{₹ }$ 72,000

Step 3: Calculate the Current Ratio

$\text{Current Ratio} = \frac{\textsf{₹ } 1,44,000}{\textsf{₹ } 72,000} = 2$

The Current Ratio is 2 : 1.

Question 2. Following is the Balance Sheet of Title Machine Ltd. as at March 31, 2017.

Particulars	Amount (Rs.)
I. Equity and Liabilities
1. Shareholders’ funds
(a) Share capital	24,00,000
(b) Reserves and surplus	6,00,000
2. Non-current liabilities
Long-term borrowings	9,00,000
3. Current liabilities
(a) Short-term borrowings	6,00,000
(b) Trade payables	23,40,000
(c) Short-term provisions	60,000
Total	69,00,000
II. Assets
1. Non-current assets
Fixed assets
- Tangible assets	45,00,000
2. Current Assets
a) Inventories	12,00,000
b) Trade receivables	9,00,000
c) Cash and cash equivalents	2,28,000
d) Short-term loans and advances	72,000
Total	69,00,000

Calculate Current Ratio and Liquid Ratio.

Answer:

1. Calculation of Current Ratio

$\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}$

Current Assets = Inventories + Trade Receivables + Cash and Cash Equivalents + Short-term Loans and Advances

$= \textsf{₹ } 12,00,000 + \textsf{₹ } 9,00,000 + \textsf{₹ } 2,28,000 + \textsf{₹ } 72,000 = \textsf{₹ } 24,00,000$

Current Liabilities = Short-term Borrowings + Trade Payables + Short-term Provisions

$= \textsf{₹ } 6,00,000 + \textsf{₹ } 23,40,000 + \textsf{₹ } 60,000 = \textsf{₹ } 30,00,000$

$\text{Current Ratio} = \frac{24,00,000}{30,00,000} = 0.8$

The Current Ratio is 0.8 : 1.

2. Calculation of Liquid Ratio (or Quick Ratio)

The Liquid Ratio is a more stringent liquidity test that excludes less liquid assets like inventory.

$\text{Liquid Ratio} = \frac{\text{Liquid Assets}}{\text{Current Liabilities}}$

Liquid Assets = Current Assets - Inventories

$= \textsf{₹ } 24,00,000 - \textsf{₹ } 12,00,000 = \textsf{₹ } 12,00,000$

$\text{Liquid Ratio} = \frac{12,00,000}{30,00,000} = 0.4$

The Liquid Ratio is 0.4 : 1.

Question 3. Current Ratio is 3.5 : 1. Working Capital is Rs. 90,000. Calculate the amount of Current Assets and Current Liabilities.

Answer:

We are given two pieces of information and two unknowns (Current Assets and Current Liabilities). We can form two equations to solve for the unknowns.

Given:

1. Current Ratio = 3.5 : 1 $\implies \frac{\text{Current Assets (CA)}}{\text{Current Liabilities (CL)}} = 3.5 \implies \text{CA} = 3.5 \times \text{CL}$

2. Working Capital = $\textsf{₹ }$ 90,000 $\implies \text{CA} - \text{CL} = 90,000$

Calculation:

Substitute the value of CA from the first equation into the second equation:

$(3.5 \times \text{CL}) - \text{CL} = 90,000$

$2.5 \times \text{CL} = 90,000$

$\text{CL} = \frac{90,000}{2.5}$

Current Liabilities (CL) = $\textsf{₹ }$ 36,000

Now, calculate Current Assets using the working capital formula:

$\text{CA} - 36,000 = 90,000$

$\text{CA} = 90,000 + 36,000$

Current Assets (CA) = $\textsf{₹ }$ 1,26,000

Question 4. Shine Limited has a current ratio 4.5 : 1 and quick ratio 3 : 1; if the inventory is 36,000, calculate Current Liabilities and Current Assets.

Answer:

We can use the relationship between Current Ratio, Quick Ratio, and Inventory to solve this problem.

Given:

1. $\frac{\text{Current Assets (CA)}}{\text{Current Liabilities (CL)}} = 4.5 \implies \text{CA} = 4.5 \times \text{CL}$

2. $\frac{\text{Quick Assets (QA)}}{\text{Current Liabilities (CL)}} = 3 \implies \text{QA} = 3 \times \text{CL}$

3. Inventory = $\textsf{₹ }$ 36,000

We also know the relationship: Current Assets = Quick Assets + Inventory

Calculation:

Substitute the equations from the ratios into the relationship formula:

$4.5 \times \text{CL} = (3 \times \text{CL}) + 36,000$

$4.5 \times \text{CL} - 3 \times \text{CL} = 36,000$

$1.5 \times \text{CL} = 36,000$

$\text{CL} = \frac{36,000}{1.5}$

Current Liabilities (CL) = $\textsf{₹ }$ 24,000

Now, use the current ratio to find Current Assets:

$\text{CA} = 4.5 \times \text{CL} = 4.5 \times 24,000$

Current Assets (CA) = $\textsf{₹ }$ 1,08,000

Question 5. Current Liabilities of a company are Rs. 75,000. If current ratio is 4:1 and Liquid Ratio is 1 : 1, calculate value of Current Assets, Liquid Assets and Inventory.

Answer:

We can directly apply the given ratios to the known value of Current Liabilities to find the other values.

Given:

Current Liabilities (CL) = $\textsf{₹ }$ 75,000

Current Ratio = 4 : 1

Liquid Ratio = 1 : 1

1. Calculation of Current Assets

$\frac{\text{Current Assets (CA)}}{\text{Current Liabilities (CL)}} = 4 \implies \frac{\text{CA}}{75,000} = 4$

$\text{CA} = 4 \times 75,000$

Current Assets = $\textsf{₹ }$ 3,00,000

2. Calculation of Liquid Assets

$\frac{\text{Liquid Assets (LA)}}{\text{Current Liabilities (CL)}} = 1 \implies \frac{\text{LA}}{75,000} = 1$

$\text{LA} = 1 \times 75,000$

Liquid Assets = $\textsf{₹ }$ 75,000

3. Calculation of Inventory

Inventory = Current Assets - Liquid Assets

$= \textsf{₹ } 3,00,000 - \textsf{₹ } 75,000$

Inventory = $\textsf{₹ }$ 2,25,000

Question 6. Handa Ltd. has inventory of Rs. 20,000. Total liquid assets are Rs. 1,00,000 and quick ratio is 2 : 1. Calculate current ratio.

Answer:

To find the current ratio, we need to calculate Current Assets and Current Liabilities using the given information.

Given:

Inventory = $\textsf{₹ }$ 20,000

Liquid Assets (LA) = $\textsf{₹ }$ 1,00,000

Quick Ratio = 2 : 1

Step 1: Calculate Current Liabilities

$\text{Quick Ratio} = \frac{\text{Liquid Assets}}{\text{Current Liabilities (CL)}} \implies 2 = \frac{1,00,000}{\text{CL}}$

$2 \times \text{CL} = 1,00,000$

$\text{CL} = \frac{1,00,000}{2} = \textsf{₹ } 50,000$

Step 2: Calculate Current Assets

Current Assets (CA) = Liquid Assets + Inventory

$= \textsf{₹ } 1,00,000 + \textsf{₹ } 20,000 = \textsf{₹ } 1,20,000$

Step 3: Calculate Current Ratio

$\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} = \frac{1,20,000}{50,000} = 2.4$

The Current Ratio is 2.4 : 1.

Question 7. Calculate debt-equity ratio from the following information:

Total Assets	₹ 15,00,000
Current Liabilities	₹ 6,00,000
Total Debts	₹ 12,00,000

Answer:

The Debt-Equity Ratio is a leverage ratio that measures the proportion of debt financing relative to equity financing. It is calculated by dividing total long-term debt by shareholders' equity.

$\text{Debt-Equity Ratio} = \frac{\text{Debt (Long-term Debt)}}{\text{Equity (Shareholders' Funds)}}$

Step 1: Calculate Debt (Long-term Debt)

Total Debts = Long-term Debt + Current Liabilities

$\textsf{₹ } 12,00,000 = \text{Long-term Debt} + \textsf{₹ } 6,00,000$

Long-term Debt = $\textsf{₹ } 12,00,000 - \textsf{₹ } 6,00,000 = \textsf{₹ } 6,00,000$

Step 2: Calculate Equity (Shareholders' Funds)

Equity = Total Assets - Total Debts

$= \textsf{₹ } 15,00,000 - \textsf{₹ } 12,00,000 = \textsf{₹ } 3,00,000$

Step 3: Calculate Debt-Equity Ratio

$\text{Debt-Equity Ratio} = \frac{\text{Debt}}{\text{Equity}} = \frac{6,00,000}{3,00,000} = 2$

The Debt-Equity Ratio is 2 : 1.

Question 8. Calculate Current Ratio if:

Inventory is Rs. 6,00,000; Liquid Assets Rs. 24,00,000; Quick Ratio 2 : 1.

Answer:

We will first find Current Liabilities using the Quick Ratio and Liquid Assets. Then we will calculate Current Assets and finally the Current Ratio.

Given:

Inventory = $\textsf{₹ }$ 6,00,000

Liquid Assets (LA) = $\textsf{₹ }$ 24,00,000

Quick Ratio = 2 : 1

Step 1: Calculate Current Liabilities (CL)

$\text{Quick Ratio} = \frac{\text{Liquid Assets}}{\text{Current Liabilities}} \implies 2 = \frac{24,00,000}{\text{CL}}$

$\text{CL} = \frac{24,00,000}{2} = \textsf{₹ } 12,00,000$

Step 2: Calculate Current Assets (CA)

Current Assets = Liquid Assets + Inventory

$= \textsf{₹ } 24,00,000 + \textsf{₹ } 6,00,000 = \textsf{₹ } 30,00,000$

Step 3: Calculate Current Ratio

$\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} = \frac{30,00,000}{12,00,000} = 2.5$

The Current Ratio is 2.5 : 1.

Question 9. Compute Inventory Turnover Ratio from the following information:

Revenue from Operations	₹ 2,00,000
Gross Profit	₹ 50,000
Inventory at the end	₹ 60,000
Excess of inventory at the end over inventory in the beginning	₹ 20,000

Answer:

The Inventory Turnover Ratio measures how many times a company has sold and replaced inventory during a given period. It helps in assessing the efficiency of inventory management.

The formula is:

$\text{Inventory Turnover Ratio} = \frac{\text{Cost of Revenue from Operations}}{\text{Average Inventory}}$

Step 1: Calculate Cost of Revenue from Operations (Cost of Goods Sold)

Cost of Revenue from Operations = Revenue from Operations - Gross Profit

$= \textsf{₹ } 2,00,000 - \textsf{₹ } 50,000 = \textsf{₹ } 1,50,000$

Step 2: Calculate Average Inventory

Inventory at the end (Closing Inventory) = $\textsf{₹ }$ 60,000

Inventory in the beginning (Opening Inventory) = Closing Inventory - Excess = $\textsf{₹ } 60,000 - \textsf{₹ } 20,000 = \textsf{₹ } 40,000$

Average Inventory = $\frac{\text{Opening Inventory} + \text{Closing Inventory}}{2} = \frac{40,000 + 60,000}{2} = \textsf{₹ } 50,000$

Step 3: Calculate Inventory Turnover Ratio

$\text{Inventory Turnover Ratio} = \frac{1,50,000}{50,000} = 3$

The Inventory Turnover Ratio is 3 times.

Question 10. Calculate following ratios from the following information:

(i) Current ratio (ii) Liquid ratio (iii) Operating Ratio (iv) Gross profit ratio

Current Assets	₹ 35,000
Current Liabilities	₹ 17,500
Inventory	₹ 15,000
Operating Expenses	₹ 20,000
Revenue from Operations	₹ 60,000
Cost of Revenue from operation	₹ 30,000

Answer:

(i) Current Ratio:

$ = \frac{\text{Current Assets}}{\text{Current Liabilities}} = \frac{35,000}{17,500} = \textbf{2 : 1}$

(ii) Liquid Ratio:

$ = \frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}} = \frac{35,000 - 15,000}{17,500} = \frac{20,000}{17,500} = \textbf{1.14 : 1}$

(iii) Operating Ratio:

$ = \frac{\text{Cost of Revenue from Operations} + \text{Operating Expenses}}{\text{Revenue from Operations}} \times 100 = \frac{30,000 + 20,000}{60,000} \times 100 = \textbf{83.33\%}$

(iv) Gross Profit Ratio:

Gross Profit = Revenue from Operations - Cost of Revenue from Operations = $\textsf{₹ } 60,000 - \textsf{₹ } 30,000 = \textsf{₹ } 30,000$

$ = \frac{\text{Gross Profit}}{\text{Revenue from Operations}} \times 100 = \frac{30,000}{60,000} \times 100 = \textbf{50\%}$

Question 11. From the following information calculate:

(i) Gross Profit Ratio (ii) Inventory Turnover Ratio (iii) Current Ratio (iv) Liquid Ratio (v) Net Profit Ratio (vi) Working Capital Turnover Ratio:

Revenue from Operations	₹ 25,20,000
Net Profit	₹ 3,60,000
Cost of Revenue from Operations	₹ 19,20,000
Long-term Debts	₹ 9,00,000
Trade Payables	₹ 2,00,000
Average Inventory	₹ 8,00,000
Current Assets	₹ 7,60,000
Fixed Assets	₹ 14,40,000
Current Liabilities	₹ 6,00,000
Net Profit before Interest and Tax	₹ 8,00,000

(Note: "Liquid Assets" in the question has been interpreted as "Current Assets" for a logical solution)

Answer:

(i) Gross Profit Ratio:

Gross Profit = $25,20,000 - 19,20,000 = \textsf{₹ } 6,00,000$

$ = \frac{6,00,000}{25,20,000} \times 100 = \textbf{23.81\%}$

(ii) Inventory Turnover Ratio:

$ = \frac{\text{Cost of Revenue from Operations}}{\text{Average Inventory}} = \frac{19,20,000}{8,00,000} = \textbf{2.4 times}$

(iii) Current Ratio:

$ = \frac{\text{Current Assets}}{\text{Current Liabilities}} = \frac{7,60,000}{6,00,000} = \textbf{1.27 : 1}$

(iv) Liquid Ratio:

Inventory = Current Assets - Liquid Assets. (Here, we need Inventory to find Liquid Assets, but we only have Average Inventory. Assuming Average Inventory = Closing Inventory for this calculation).

Liquid Assets = $7,60,000 - 8,00,000 = -\textsf{₹ } 40,000$. (This result is not practical and highlights an inconsistency in the question's data).

(v) Net Profit Ratio:

$ = \frac{\text{Net Profit}}{\text{Revenue from Operations}} \times 100 = \frac{3,60,000}{25,20,000} \times 100 = \textbf{14.29\%}$

(vi) Working Capital Turnover Ratio:

Working Capital = Current Assets - Current Liabilities = $7,60,000 - 6,00,000 = \textsf{₹ } 1,60,000$

$ = \frac{\text{Revenue from Operations}}{\text{Working Capital}} = \frac{25,20,000}{1,60,000} = \textbf{15.75 times}$

Question 12. Compute Working Capital Turnover Ratio, Debt Equity Ratio and Proprietary Ratio from the following information:

Paid-up Share Capital	₹ 5,00,000
Current Assets	₹ 4,00,000
Revenue from Operations	₹ 10,00,000
13% Debentures	₹ 2,00,000
Current Liabilities	₹ 2,80,000

Answer:

(i) Working Capital Turnover Ratio:

Working Capital = Current Assets - Current Liabilities = $\textsf{₹ } 4,00,000 - \textsf{₹ } 2,80,000 = \textsf{₹ } 1,20,000$

$ \text{Ratio} = \frac{\text{Revenue from Operations}}{\text{Working Capital}} = \frac{10,00,000}{1,20,000} = \textbf{8.33 times}$

(ii) Debt Equity Ratio:

Debt = 13% Debentures = $\textsf{₹ } 2,00,000$

Equity = Paid-up Share Capital = $\textsf{₹ } 5,00,000$

$ \text{Ratio} = \frac{\text{Debt}}{\text{Equity}} = \frac{2,00,000}{5,00,000} = \textbf{0.4 : 1}$

(iii) Proprietary Ratio:

Equity (Shareholders' Funds) = $\textsf{₹ } 5,00,000$

Total Assets = Equity + Total Liabilities = $\textsf{₹ } 5,00,000 + (\textsf{₹ } 2,00,000 + \textsf{₹ } 2,80,000) = \textsf{₹ } 9,80,000$

$ \text{Ratio} = \frac{\text{Shareholders' Funds}}{\text{Total Assets}} = \frac{5,00,000}{9,80,000} = \textbf{0.51 : 1}$

Question 13. Calculate Inventory Turnover Ratio if:

Inventory in the beginning is Rs. 76,250, Inventory at the end is Rs. 98,500, Sales is Rs. 5,20,000, Sales Return is Rs. 20,000, Purchases is Rs. 3,22,250.

Answer:

The question provides components to calculate Cost of Revenue from Operations (COGS) without mentioning Gross Profit. We will use the COGS formula related to inventory and purchases.

Step 1: Calculate Cost of Revenue from Operations

Net Revenue = Sales - Sales Return = $\textsf{₹ } 5,20,000 - \textsf{₹ } 20,000 = \textsf{₹ } 5,00,000$. (This is not needed for COGS calculation with purchases data).

COGS = Opening Inventory + Purchases - Closing Inventory

$= \textsf{₹ } 76,250 + \textsf{₹ } 3,22,250 - \textsf{₹ } 98,500 = \textsf{₹ } 3,00,000$

Step 2: Calculate Average Inventory

Average Inventory = $\frac{76,250 + 98,500}{2} = \textsf{₹ } 87,375$

Step 3: Calculate Inventory Turnover Ratio

$\text{Ratio} = \frac{\text{COGS}}{\text{Average Inventory}} = \frac{3,00,000}{87,375} = \textbf{3.43 times}$

Question 14. Calculate Inventory Turnover Ratio from the data given below:

Inventory in the beginning of the year	₹ 10,000
Inventory at the end of the year	₹ 5,000
Carriage	₹ 2,500
Revenue from Operations	₹ 50,000
Purchases	₹ 25,000

Answer:

Step 1: Calculate Cost of Revenue from Operations (COGS)

COGS = Opening Inventory + Purchases + Direct Expenses (Carriage) - Closing Inventory

$= \textsf{₹ } 10,000 + \textsf{₹ } 25,000 + \textsf{₹ } 2,500 - \textsf{₹ } 5,000 = \textsf{₹ } 32,500$

Step 2: Calculate Average Inventory

Average Inventory = $\frac{10,000 + 5,000}{2} = \textsf{₹ } 7,500$

Step 3: Calculate Inventory Turnover Ratio

$\text{Ratio} = \frac{\text{COGS}}{\text{Average Inventory}} = \frac{32,500}{7,500} = \textbf{4.33 times}$

Question 15. A trading firm’s average inventory is Rs. 20,000 (cost). If the inventory turnover ratio is 8 times and the firm sells goods at a gross profit of 20% on sales, ascertain the gross profit of the firm.

Answer:

Step 1: Calculate Cost of Goods Sold (COGS)

Inventory Turnover Ratio = $\frac{\text{COGS}}{\text{Average Inventory}}$

$8 = \frac{\text{COGS}}{20,000} \implies \text{COGS} = 8 \times 20,000 = \textsf{₹ } 1,60,000$

Step 2: Ascertain the Gross Profit

Let Sales be 'S'.

Gross Profit = $20\%$ of Sales = $0.20 \times S$

We know, COGS = Sales - Gross Profit

$\textsf{₹ } 1,60,000 = S - (0.20 \times S)$

$\textsf{₹ } 1,60,000 = 0.80 \times S$

$S = \frac{1,60,000}{0.80} = \textsf{₹ } 2,00,000$

Gross Profit = $20\%$ of Sales = $0.20 \times 2,00,000 = \textsf{₹ } 40,000$

The Gross Profit of the firm is $\textsf{₹ }$ 40,000.

Question 16. You are able to collect the following information about a company for two years:

	2015-16	2016-17
Trade receivables on Apr. 01	Rs. 4,00,000	Rs. 5,60,000
Trade receivables on Mar. 31	Rs. 5,60,000	Rs. 4,40,000
Stock in trade on Apr. 01	Rs. 6,00,000	Rs. 9,00,000
Revenue from operations (assuming all credit)	Rs. 30,00,000	Rs. 24,00,000

Gross profit is 25% on cost of Revenue from operations.

Calculate Inventory Turnover Ratio and Trade Receivables Turnover Ratio

(Note: Some data points have been rationalized for calculation.)

Answer:

For the year 2015-16

1. Inventory Turnover Ratio:

Let Cost be 'C'. Sales = C + 0.25C = 1.25C.
COGS = $30,00,000 / 1.25 = \textsf{₹ } 24,00,000$.
Stock on Mar 31, 2016 is not given, so ratio cannot be calculated for 2015-16.

2. Trade Receivables Turnover Ratio:

Average Receivables = $(4,00,000 + 5,60,000) / 2 = \textsf{₹ } 4,80,000$.

Ratio = $\frac{30,00,000}{4,80,000} = \textbf{6.25 times}$.

For the year 2016-17

1. Inventory Turnover Ratio:

COGS = $24,00,000 / 1.25 = \textsf{₹ } 19,20,000$.
Average Inventory = $(6,00,000 + 9,00,000) / 2 = \textsf{₹ } 7,50,000$.

Ratio = $\frac{19,20,000}{7,50,000} = \textbf{2.56 times}$.

2. Trade Receivables Turnover Ratio:

Average Receivables = $(5,60,000 + 4,40,000) / 2 = \textsf{₹ } 5,00,000$.

Ratio = $\frac{24,00,000}{5,00,000} = \textbf{4.8 times}$.

Question 17. From the following Balance Sheet and other information, calculate following ratios:

(i) Debt-Equity Ratio (ii) Working Capital Turnover Ratio (iii) Trade Receivables Turnover Ratio

Balance Sheet as at March 31, 2017

Particulars	Note No.	(Rs.)
I. Equity and Liabilities:
1. Shareholders’ funds
a) Share capital		10,00,000
b) Reserves and surplus		7,00,000
c) Money received against share warrants		2,00,000
2. Non-current Liabilities
Long-term borrowings		12,00,000
3. Current Liabilities
Trade payables		5,00,000
Total		36,00,000
II. Assets
1. Non-current Assets
Fixed assets
– Tangible assets		18,00,000
2. Current Assets
a) Inventories		4,00,000
b) Trade Receivables		9,00,000
c) Cash and cash equivalents		5,00,000
Total		36,00,000

Additional Information: Revenue from Operations Rs. 18,00,000

Answer:

(i) Debt-Equity Ratio:

Debt (Long-term Borrowings) = $\textsf{₹ }$ 12,00,000

Equity (Shareholders' Funds) = Share Capital + Reserves & Surplus + Money received against share warrants

$= \textsf{₹ } 10,00,000 + \textsf{₹ } 7,00,000 + \textsf{₹ } 2,00,000 = \textsf{₹ } 19,00,000$

Ratio = $\frac{\text{Debt}}{\text{Equity}} = \frac{12,00,000}{19,00,000} = \textbf{0.63 : 1}$

(ii) Working Capital Turnover Ratio:

Current Assets = Inventories + Trade Receivables + Cash = $\textsf{₹ } 4,00,000 + \textsf{₹ } 9,00,000 + \textsf{₹ } 5,00,000 = \textsf{₹ } 18,00,000$

Working Capital = Current Assets - Current Liabilities = $\textsf{₹ } 18,00,000 - \textsf{₹ } 5,00,000 = \textsf{₹ } 13,00,000$

Ratio = $\frac{\text{Revenue from Operations}}{\text{Working Capital}} = \frac{18,00,000}{13,00,000} = \textbf{1.38 times}$

(iii) Trade Receivables Turnover Ratio:

(Assuming all revenue is from credit sales)

Ratio = $\frac{\text{Net Credit Revenue from Operations}}{\text{Average Trade Receivables}}$

(Assuming closing receivables are average receivables)

$= \frac{18,00,000}{9,00,000} = \textbf{2 times}$

Question 18. From the following information, calculate the following ratios:

i) Liquid Ratio

ii) Inventory turnover ratio

iii) Return on investment

Inventory in the beginning	₹ 50,000
Inventory at the end	₹ 60,000
Net Profit	₹ 50,000
10% Debentures	₹ 1,30,000
Revenue from operations	₹ 4,00,000
Gross Profit	₹ 1,00,000
Cash and Cash Equivalents	₹ 40,000
Trade Receivables	₹ 1,00,000
Trade Payables	₹ 90,000
Other Current Liabilities	₹ 70,000
Share Capital	₹ 2,00,000
Reserves and Surplus	₹ 70,000

(Note: Figures have been adjusted for consistency)

Answer:

i) Liquid Ratio:

Liquid Assets = Cash + Trade Receivables = $\textsf{₹ } 40,000 + \textsf{₹ } 1,00,000 = \textsf{₹ } 1,40,000$

Current Liabilities = Trade Payables + Other Current Liabilities = $\textsf{₹ } 90,000 + \textsf{₹ } 70,000 = \textsf{₹ } 1,60,000$

Ratio = $\frac{1,40,000}{1,60,000} = \textbf{0.875 : 1}$

ii) Inventory Turnover Ratio:

Cost of Revenue from Operations = Revenue - Gross Profit = $\textsf{₹ } 4,00,000 - \textsf{₹ } 1,00,000 = \textsf{₹ } 3,00,000$

Average Inventory = $\frac{50,000 + 60,000}{2} = \textsf{₹ } 55,000$

Ratio = $\frac{3,00,000}{55,000} = \textbf{5.45 times}$

iii) Return on Investment (ROI):

Net Profit before Interest & Tax (PBIT) = Net Profit + Interest = $\textsf{₹ } 50,000 + (\textsf{₹ } 1,30,000 \times 10\%) = \textsf{₹ } 63,000$

Capital Employed = Share Capital + Reserves & Surplus + Debentures = $\textsf{₹ } 2,00,000 + \textsf{₹ } 70,000 + \textsf{₹ } 1,30,000 = \textsf{₹ } 4,00,000$

ROI = $\frac{\text{PBIT}}{\text{Capital Employed}} \times 100 = \frac{63,000}{4,00,000} \times 100 = \textbf{15.75\%}$

Question 19. From the following, calculate (a) Debt-Equity Ratio (b) Total Assets to Debt Ratio (c) Proprietary Ratio.

Equity Share Capital	₹ 75,000
Share application money pending allotment	₹ 25,000
General Reserve	₹ 45,000
Balance in the Statement of Profit & Loss	₹ 30,000
Debentures	₹ 75,000
Trade Payables	₹ 40,000
Outstanding Expenses	₹ 10,000

Answer:

(a) Debt-Equity Ratio:

Debt (Long-term) = Debentures = $\textsf{₹ } 75,000$

Equity = Equity Capital + General Reserve + P&L Balance = $\textsf{₹ } 75,000 + \textsf{₹ } 45,000 + \textsf{₹ } 30,000 = \textsf{₹ } 1,50,000$

Ratio = $\frac{75,000}{1,50,000} = \textbf{0.5 : 1}$

(b) Total Assets to Debt Ratio:

Total Assets = Total Liabilities = Equity + Debentures + Current Liabilities + Share App Money = $\textsf{₹ } 1,50,000 + \textsf{₹ } 75,000 + (\textsf{₹ } 40,000 + \textsf{₹ } 10,000) + \textsf{₹ } 25,000 = \textsf{₹ } 3,00,000$

Ratio = $\frac{\text{Total Assets}}{\text{Debt}} = \frac{3,00,000}{75,000} = \textbf{4 : 1}$

(c) Proprietary Ratio:

Ratio = $\frac{\text{Shareholders' Funds}}{\text{Total Assets}} = \frac{1,50,000}{3,00,000} = \textbf{0.5 : 1}$ or 50%

Question 20. Cost of Revenue from Operations is Rs. 1,50,000. Operating expenses are Rs. 60,000. Revenue from Operations is Rs. 2,50,000. Calculate Operating Ratio.

Answer:

The Operating Ratio measures the cost of operations per rupee of sales. It indicates the operational efficiency of the business.

$\text{Operating Ratio} = \frac{\text{Cost of Revenue from Operations} + \text{Operating Expenses}}{\text{Revenue from Operations}} \times 100$

Calculation:

Operating Cost = Cost of Revenue from Operations + Operating Expenses

$= \textsf{₹ } 1,50,000 + \textsf{₹ } 60,000 = \textsf{₹ } 2,10,000$

$\text{Operating Ratio} = \frac{2,10,000}{2,50,000} \times 100 = \textbf{84\%}$

Question 21. Calculate the following ratio on the basis of following information:

(i) Gross Profit Ratio (ii) Current Ratio (iii) Acid Test Ratio (iv) Inventory Turnover Ratio (v) Fixed Assets Turnover Ratio

Gross Profit	₹ 50,000
Revenue from Operations	₹ 1,00,000
Inventory	₹ 15,000
Trade Receivables	₹ 27,500
Cash and Cash Equivalents	₹ 17,500
Current Liabilities	₹ 40,000
Land & Building	₹ 50,000
Plant & Machinery	₹ 30,000
Furniture	₹ 20,000

Answer:

(i) Gross Profit Ratio: $= \frac{50,000}{1,00,000} \times 100 = \textbf{50\%}$

(ii) Current Ratio:

Current Assets = $15,000 + 27,500 + 17,500 = \textsf{₹ } 60,000$

Ratio = $\frac{60,000}{40,000} = \textbf{1.5 : 1}$

(iii) Acid Test Ratio (Liquid Ratio):

Liquid Assets = $27,500 + 17,500 = \textsf{₹ } 45,000$

Ratio = $\frac{45,000}{40,000} = \textbf{1.125 : 1}$

(iv) Inventory Turnover Ratio:

COGS = $1,00,000 - 50,000 = \textsf{₹ } 50,000$

Ratio = $\frac{50,000}{15,000} = \textbf{3.33 times}$

(v) Fixed Assets Turnover Ratio:

Fixed Assets = $50,000 + 30,000 + 20,000 = \textsf{₹ } 1,00,000$

Ratio = $\frac{1,00,000}{1,00,000} = \textbf{1 time}$

Question 22. From the following information calculate Gross Profit Ratio, Inventory Turnover Ratio and Trade Receivable Turnover Ratio.

Revenue from Operations	₹ 3,00,000
Cost of Revenue from Operations	₹ 2,40,000
Inventory at the end	₹ 62,000
Gross Profit	₹ 60,000
Inventory in the beginning	₹ 58,000
Trade Receivables	₹ 32,000

Answer:

(i) Gross Profit Ratio:

$= \frac{\text{Gross Profit}}{\text{Revenue from Operations}} \times 100 = \frac{60,000}{3,00,000} \times 100 = \textbf{20\%}$

(ii) Inventory Turnover Ratio:

Average Inventory = $\frac{58,000 + 62,000}{2} = \textsf{₹ } 60,000$

Ratio = $\frac{\text{Cost of Revenue from Operations}}{\text{Average Inventory}} = \frac{2,40,000}{60,000} = \textbf{4 times}$

(iii) Trade Receivables Turnover Ratio:

(Assuming closing receivables are average receivables)

Ratio = $\frac{\text{Net Credit Revenue from Operations}}{\text{Average Trade Receivables}} = \frac{3,00,000}{32,000} = \textbf{9.375 times}$