Accounting Ratios

2.1 Core concepts

Accounting ratios are the bridge between raw financial statement figures and decision-useful information. Absolute numbers in a balance sheet or P&L tell us little until they are placed in relation to one another — a net profit of ₹10 lakh sounds large but is uninformative without knowing the sales, the capital employed, or last year's figure. Ratios convert these absolute numbers into fractions, percentages, proportions or "number of times" relationships, making them comparable across periods (intra-firm) and across firms or industries (inter-firm). The functional classification — Liquidity, Solvency, Activity (Turnover) and Profitability — gives, for each ratio, a definition, a formula, an interpretation, and where relevant an ideal benchmark. This is a high-yield CUET area: almost any line item on the balance sheet or P&L can become a numerator or denominator, and the variety of formulae creates a rich pool of distractors.

• Meaning of Accounting Ratio: A mathematical relationship between two accounting numbers derived from financial statements, expressed as fraction, proportion, percentage or number of times. The two numbers must be meaningfully correlated — e.g. purchases-to-furniture is arithmetic but meaningless (NCERT §5.1, p. 194-195).
• Objectives of Ratio Analysis: Identify problem and bright areas; deeper analysis of profitability, liquidity, solvency, efficiency; enable cross-sectional comparison with industry standards; support projections (NCERT §5.2, p. 195).
• Advantages: Tests efficacy of past decisions; simplifies complex figures; aids comparative (time-series & cross-sectional) analysis; identifies problem areas; enables SWOT analysis; permits intra-firm, inter-firm and standard comparisons (NCERT §5.3, p. 195-196).
• Limitations: Limitations of accounting data; ignores price-level (inflation) changes; ignores qualitative/non-monetary aspects; variation in accounting policies makes inter-firm comparison weak; historical-only forecasting. Ratio-specific limits: means not end; cannot resolve problems; lack of standardised definitions; no universal ideal standard; ratios on unrelated figures meaningless (NCERT §5.4, p. 197-198).
• Two-way classification: Traditional — P&L ratios, Balance Sheet ratios, Composite ratios. Functional (commonly used) — Liquidity, Solvency, Activity (Turnover), Profitability (NCERT §5.5, p. 198-199).
• Liquidity Ratios — short-term solvency. Current Ratio = Current Assets / Current Liabilities; ideal ≈ 2:1; CA includes inventories, trade receivables, current investments, cash & cash equivalents, short-term loans & advances, prepaid expenses, advance tax, accrued income; CL includes short-term borrowings, trade payables, other current liabilities, short-term provisions. Quick/Acid-test Ratio = Quick Assets / Current Liabilities where Quick Assets = Current Assets – (Inventories + Prepaid expenses + Advance tax); ideal ≈ 1:1 (NCERT §5.6, p. 200-202).
• Solvency Ratios — long-term solvency. Five sub-ratios. Debt-Equity = Long-term Debts / Shareholders' Funds; safe ≈ 2:1. Shareholders' Funds = Share Capital (Equity + Preference) + Reserves & Surplus + Money received against share warrants + Share application money pending allotment. Debt to Capital Employed = Long-term Debt / Capital Employed (Capital Employed = Long-term Debt + Shareholders' Funds, or Total Assets – Current Liabilities). Proprietary Ratio = Shareholders' Funds / Capital Employed (or Total Assets); Debt-to-Capital-Employed + Proprietary = 1. Total Assets to Debt = Total Assets / Long-term Debts; higher is better. Interest Coverage = Net Profit before Interest & Tax / Interest on long-term debts (NCERT §5.7, p. 204-212).
• Activity/Turnover Ratios — efficiency. Inventory Turnover = Cost of Revenue from Operations / Average Inventory; Avg Inv = (Opening + Closing)/2. Trade Receivables Turnover = Net Credit Revenue from Operations / Average Trade Receivables; Average Collection Period = 365 days / TR Turnover. Trade Payables Turnover = Net Credit Purchases / Average Trade Payables; Average Payment Period = 365 / TP Turnover. Net Assets / Capital Employed Turnover = Revenue from Operations / Capital Employed. Fixed Assets Turnover = Net Revenue from Operations / Net Fixed Assets. Working Capital Turnover = Net Revenue from Operations / Working Capital (NCERT §5.8, p. 213-222).
• Profitability Ratios — earning capacity. Gross Profit Ratio = (Gross Profit / Net Revenue from Operations) × 100. Operating Ratio = ((Cost of Revenue from Operations + Operating Expenses) / Net Revenue from Operations) × 100. Operating Profit Ratio = 100 – Operating Ratio. Net Profit Ratio = (Net Profit / Revenue from Operations) × 100. Return on Investment / ROCE = (Profit before Interest & Tax / Capital Employed) × 100. Return on Shareholders' Funds (RONW) = (Profit after Tax / Shareholders' Funds) × 100. EPS = Profit available for Equity Shareholders / Number of Equity Shares (Profit available = PAT – Preference Dividend). Book Value per Share = Equity Shareholders' Funds / Number of Equity Shares. Dividend Payout = Dividend per Share / Earnings per Share. P/E Ratio = Market Price per Share / EPS (NCERT §5.9, p. 223-229). The Profitability ratio family deserves particular attention because each ratio uses a different numerator and denominator drawn from the P&L and Balance Sheet. Gross Profit Ratio is the broadest measure — it strips out only direct expenses (purchases, wages, carriage inwards) and tells the analyst what proportion of every rupee of sales is available after covering Cost of Revenue from Operations. Operating Ratio narrows further by adding selling, administrative and depreciation expenses to COGS; it answers the question "what proportion of sales is consumed by all operating costs". Net Profit Ratio is the bottom-line measure — net profit (after non-operating items, interest and tax) as a percentage of revenue. Return on Investment (ROI / ROCE) scales profit before interest and tax against capital employed, allowing comparison across firms with different capital structures. Return on Shareholders' Funds (RONW) restricts the denominator to equity (PAT ÷ Shareholders' Funds), reflecting the return earned for owners after meeting interest obligations. Earnings per Share (EPS) divides residual profit by the number of equity shares — preference dividend is deducted first because it has a prior claim. Book Value per Share is the per-share net worth from the balance sheet; Dividend Payout is the share of EPS distributed as dividend; P/E Ratio is the market price expressed as a multiple of EPS — the most-watched profitability indicator on the stock market.

2.2 Definitions to memorise

2.3 Diagrams / processes to remember

• Classification chart: Traditional (P&L / Balance Sheet / Composite) and Functional (Liquidity / Solvency / Activity / Profitability) classification of ratios (NCERT §5.5, p. 198-199).
• Standard formula sheet for the five Solvency ratios — Debt-Equity, Debt-to-Capital-Employed, Proprietary, Total Assets-to-Debt, Interest Coverage (NCERT §5.7, p. 204-212).
• Six Turnover ratios formula box — Inventory, Trade Receivables, Trade Payables, Capital Employed/Net Assets, Fixed Assets, Working Capital (NCERT §5.8, p. 213, 220-221).
• Profitability ratio family — Gross Profit, Operating, Operating Profit, Net Profit, ROI/ROCE, RONW, EPS, Book Value per Share, Dividend Payout, P/E (NCERT §5.9, p. 223).

2.4 Common confusions / NTA trap points

• Quick Assets vs Current Assets: Quick Assets exclude Inventories AND Prepaid Expenses AND Advance Tax — not just inventories. Many students subtract only inventory and get a wrong quick ratio (p. 201-202).
• Debt-Equity vs Debt-to-Capital-Employed vs Proprietary: Different denominators. Remember Debt-to-Capital-Employed + Proprietary = 1 (p. 208-209).
• Cash sale vs credit sale and Trade Receivables Turnover: TR Turnover uses Net Credit Revenue from Operations only, NOT total revenue. Subtract cash revenue first (p. 217-218).
• Inventory Turnover denominator: Numerator is Cost of Revenue from Operations — not Revenue from Operations. A common trap option uses Revenue and inflates the ratio (p. 215).
• Operating Profit Ratio = 100 – Operating Ratio, not 100 – Gross Profit Ratio. Operating Ratio includes operating expenses (selling, admin, depreciation, employee benefit) on top of Cost of Revenue from Operations (p. 224-225).
• EPS numerator: Profit available for equity shareholders = PAT – Preference Dividend. Forgetting to deduct preference dividend is a textbook NTA trap (p. 227-229).
• Ideal ratios: Current 2:1, Quick 1:1, Debt-Equity 2:1. NTA loves to swap these (NCERT p. 201, 202, 205).
• Average period calculation. Average Collection Period = 365 ÷ TR Turnover; Average Payment Period = 365 ÷ TP Turnover (NCERT §5.8.2, p. 220).
• Capital Employed two definitions. (i) Long-term Debt + Shareholders' Funds OR (ii) Total Assets − Current Liabilities — both give the same answer (NCERT §5.7.2, p. 208).
• Working Capital. Current Assets − Current Liabilities. Used as denominator in Working Capital Turnover Ratio (NCERT §5.8.6, p. 221).
• Profit available to equity shareholders. PAT − Preference Dividend, used in EPS (NCERT §5.9.7, p. 227).

2.5 Journal entry templates

Accounting Ratios is a computational chapter — no fresh journal entries arise from it. However, the entries below show how individual transactions move particular ratios, which is the basis of "effect-of-transaction" MCQs.

(a) Cash purchase of inventory — improves current ratio only if CR < 1; degrades if CR > 1 (NCERT §5.6.1)

(b) Issue of fresh equity shares — improves debt-equity ratio (NCERT §5.7.1)

(c) Repayment of long-term loan — improves debt-equity ratio (NCERT §5.7.1)

(d) Sale of inventory at cost — no impact on current ratio, improves quick ratio (NCERT §5.6.2)

(e) Sale of inventory above cost — both CR and QR improve (NCERT §5.6.1)

(f) Bills receivable discounted with bank — does not affect debt-equity (off-balance sheet contingent)

(g) Provision for tax (effect on Net Profit Ratio) (NCERT §5.9.4)

(h) Declaration of dividend (effect on EPS / Dividend Payout) (NCERT §5.9.9)