Accounting Ratios

Written and reviewed by Devendra Dubey, Mathematics & Commerce faculty at UniDrill (M.Sc. Mathematics, Osmania University · 10 years teaching). Based on NCERT Accountancy Class XII (Accountancy Part II), Chapter 5.

Same profit, very different shops

Two shopkeepers each earn ₹10 lakh in a year. Shop A sold goods worth ₹1 crore using ₹50 lakh of capital. Shop B sold goods worth ₹40 lakh using only ₹10 lakh of capital. The profit is the same, yet they are not equally good businesses. Shop A keeps 10 paise of every rupee of sales and earns 20% on its capital. Shop B keeps 25 paise per rupee and earns 100% on its capital. A raw number such as "₹10 lakh" says very little until it is placed next to another number. That is what an accounting ratio does.

What an accounting ratio is

An accounting ratio is a mathematical relationship between two accounting numbers taken from the financial statements. It can be shown as a fraction, a proportion (2 : 1), a percentage or "number of times". The two numbers must be meaningfully related. Dividing purchases by furniture gives an answer, but the answer means nothing.

Ratios help in six ways: they point to problem areas and bright areas, allow deeper analysis of profitability, liquidity, solvency and efficiency, let you compare with industry standards, support projections, simplify complex figures and make intra-firm and inter-firm comparison possible.

Four families of ratios

Ratios can be grouped by statement (traditional: Statement of Profit and Loss ratios, balance sheet ratios, composite ratios) or by purpose (functional). The functional classification is the one CUET uses.

Liquidity ratios: can the bills be paid this year?

Liquidity is the ability to pay short term obligations when they fall due. Creditors, banks and suppliers look at it first.

The current ratio compares everything that will turn into cash within a year with everything that must be paid within a year.

$$\text{Current ratio} = \dfrac{\text{Current assets}}{\text{Current liabilities}}$$

Current assets include inventories, trade receivables, current investments, cash and cash equivalents, short-term loans and advances, prepaid expenses, advance tax and accrued income. Current liabilities include short-term borrowings, trade payables, other current liabilities and short-term provisions. The ideal value is 2 : 1. The reason: stock may sell at a discount and some debtors may not pay, so a firm wants twice the assets it needs to meet its dues.

The quick ratio (acid test ratio) is stricter. It removes the assets that cannot be turned into cash quickly.

$$\text{Quick ratio} = \dfrac{\text{Quick assets}}{\text{Current liabilities}}, \qquad \text{Quick assets} = \text{Current assets} - \text{Inventories} - \text{Prepaid expenses} - \text{Advance tax}$$

Inventory has to be sold first, and prepaid expenses and advance tax can never be paid out as cash. The ideal value is 1 : 1.

Worked example: current ratio, quick ratio and working capital. Tara Ltd. has this balance sheet as at 31 March 2025. We will use it for the next few examples too.

Both ratios are above the ideal, so the firm's short term position is comfortable. Common wrong step. Subtracting only inventories to get quick assets of ₹5,00,000 and a quick ratio of 1.25 : 1. Prepaid expenses and advance tax must come out as well.

Worked example: working back to the figures. A firm has a current ratio of 3.5 : 1 and a quick ratio of 2 : 1. The excess of current assets over quick assets (here, inventories) is ₹90,000. Find the current liabilities, current assets and quick assets.

Common wrong step. Treating ₹90,000 as the current liabilities because the ratios differ by "1". The ratios differ by 1.5, so the gap is 1.5 times the liabilities, not one times.

How transactions move the ratios. CUET often asks the effect of one transaction. Assume the current ratio is above 1 and the quick ratio is above 1 to start with.

The key idea: when current assets and current liabilities both rise by the same amount, the ratio moves toward 1. When both fall by the same amount, the ratio moves away from 1.

Pause and predict: a firm has current assets of ₹80,000 and current liabilities of ₹1,00,000 (ratio 0.8 : 1). It pays ₹20,000 to creditors in cash. Does the ratio rise or fall?

Check your answer: it falls. New ratio = 60,000 ÷ 80,000 = 0.75 : 1. When the ratio is below 1, paying off liabilities moves it further from 1 (downward). When the ratio is above 1, the same payment raises it.

Beyond the textbook. For the exam: a firm that pays creditors in cash improves a current ratio that is above 1. In reality: some firms time such payments just before the balance sheet date. In Tara Ltd., paying ₹1,00,000 to trade payables would lift the current ratio from 2.25 to 2.67 and the quick ratio from 1.15 to 1.20, without any change in the business. This is a form of window dressing. Why it matters: a single year's ratio can be dressed up, so analysts read ratios over several years and alongside other figures.

Solvency ratios: can the firm survive in the long run?

Solvency is the ability to meet long term obligations: interest, and repayment of debt when it falls due. Lenders and debenture holders watch these ratios. Three terms must be clear first.

Worked example: solvency ratios of Tara Ltd. Use the balance sheet above. In addition, Tara earned a net profit after tax of ₹1,68,000 and the tax rate is 30%. Find the five solvency ratios.

Steps 5 and 6 add to 1, which is a quick check. The debt equity ratio of 0.43 : 1 is far below 2 : 1, so Tara is lightly geared, and it covers its interest more than four times. Common wrong steps. Counting the preference capital as debt (it belongs to shareholders' funds), and adding the interest to the profit after tax (1,68,000 + 72,000 = 2,40,000, which gives 3.33 times). The numerator is profit before interest and tax, so tax has to be added back first.

Pause and predict: a firm's interest coverage ratio is 0.8 times. What does that tell you?

Check your answer: its profit before interest and tax is smaller than the interest it owes. It cannot pay the interest out of its earnings and must use reserves or borrow more. A ratio below 1 is a danger signal.

Activity ratios: how hard are the assets working?

Activity (turnover) ratios show how many times an asset or balance is used up or renewed in a year. A higher figure generally means better use of that asset.

Cost of revenue from operations is what the goods sold actually cost.

$$\text{Cost of revenue from operations} = \text{Opening inventory} + \text{Net purchases} + \text{Direct expenses} - \text{Closing inventory}$$

Direct expenses include wages and carriage inwards. Average inventory is (opening + closing) ÷ 2, and the same averaging is used for trade receivables and payables.

Worked example: turnover ratios. A firm has revenue from operations of ₹15,00,000, of which 20% is cash sales. Opening inventory ₹1,80,000; net purchases ₹8,40,000 (all on credit); wages ₹90,000; carriage inwards ₹30,000; closing inventory ₹2,20,000. Trade receivables: opening ₹1,30,000, closing ₹1,70,000. Trade payables: opening ₹1,20,000, closing ₹1,60,000. Find the inventory turnover, trade receivables turnover with collection period, and trade payables turnover with payment period.

The firm collects in about 46 days but pays suppliers in about 61 days, which is a healthy gap. Common wrong steps. Using revenue of ₹15,00,000 for inventory turnover (7.5 times, when stock is carried at cost and sales include profit), and using the total revenue instead of the credit revenue for receivables (10 times instead of 8).

Profitability ratios: what does the firm earn?

Operating expenses are the running costs of the business (selling, administration, employee benefits, depreciation). Finance costs, other income and tax are not operating items.

Worked example: margin ratios. A firm has revenue from operations of ₹20,00,000; cost of revenue from operations ₹13,00,000; selling expenses ₹1,20,000; administrative expenses ₹1,30,000; depreciation ₹50,000; other income ₹40,000; finance costs ₹60,000; tax at 30%. Find the gross profit, operating and net profit ratios.

The margin narrows from 35% to 20% to 13.3% as more costs are brought in. Common wrong step. Writing the operating profit ratio as 100 − gross profit ratio (65%). That is the cost of revenue from operations as a percentage, not the operating ratio. The operating ratio includes the operating expenses too.

Worked example: returns and per share ratios. For Tara Ltd. (profit after tax ₹1,68,000; interest ₹72,000; 80,000 equity shares of ₹10 each; 10% preference capital ₹2,00,000; market price ₹18.50), find ROI, return on net worth, EPS, book value per share and the P/E ratio.

Common wrong step. Dividing the whole profit after tax (₹1,68,000) by the shares to get ₹2.10. Preference shareholders have the first claim, so their dividend comes out before the equity shareholders' EPS is found.

Beyond the textbook. For the exam: learn the ideal values (current 2 : 1, quick 1 : 1, debt equity 2 : 1). In reality: ideal values depend on the industry. A supermarket collects cash at the counter and pays suppliers on credit, so it can run a current ratio below 1 and still be healthy. Banks and finance companies, whose business is borrowing, run debt to equity far above 2 : 1. Why it matters: the textbook values are a starting point for judgement, and a ratio should be compared with firms in the same line of business.

Exam traps

Formula sheet

60-second revision

Where this chapter connects

• Previous: Analysis of Financial Statements introduced ratio analysis as the fourth tool; this chapter develops it.
• Next: Cash Flow Statement turns from profit and ratios to the actual movement of cash.
• Also: Financial Statements of a Company fixes the heads (current assets, long-term borrowings, shareholders' funds) that these ratios use.
• Business Studies link: Financial Management uses the debt equity ratio when it discusses capital structure and trading on equity.