# NCERT Solutions for Class 12 Accountancy Chapter 10 Accounting Ratios

Detailed, Step-by-Step NCERT Solutions for 12 Accountancy Chapter 10 Accounting Ratios Questions and Answers were solved by Expert Teachers as per NCERT (CBSE) Book guidelines covering each topic in chapter to ensure complete preparation.

## Accounting Ratios NCERT Solutions for Class 12 Accountancy Chapter 10

### Accounting Ratios Questions and Answers Class 12 Accountancy Chapter 10

Test Your Understanding-I (Page No. 241)

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) Analyses of data provided in the financial statements as is termed as financial analysis.
(c) Long-term creditors are concerned about the ability of a firm to discharge its obligations to pay interest and repay the principal amount of term.
(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) One ratio reflect both quantitative and qualitative aspects.
(a) False
(b) True
(c) True
(d) False
(e) True
(f) False.

On Test Your Understanding-II (Page No. 255)

Question 1.
The following groups of ratios primarily measure risk—
(a) liquidity, activity, and profitability
(b) liquidity, activity and common stock
(c) liquidity, activity and debt
(d) activity, debt and profitability
(d) activity, debt and profitability

Question 2.
The ratios are primarily measures of return.
(a) liquidity
(b) activity
(c) debt
(d) profitability
(b) activity

Question 3.
The of a business firm is measured by its ability to satisfy its short-term obligations as they come due.
(a) activity
(b) liquidity
(c) debt
(d) profitability
(b) liquidity

Question 4
ratios are a measure of the speed with which various accounts are converted into sales or cash.
(a) Activity
(b) Liquidity
(c) Debt
(d) Profitability
(a) Activity

Question 5.
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
(b) current ratio and liquid ratio.

Question 6.
The is a measure of liquidity which excludes generally the least liquid asset.
(a) current ratio, accounts debtors
(b) liquid ratio, accounts debtors
(c) current ratio, inventory
(d) liquid ratio, inventory
(d) liquid ratio, inventory.

Test Your Understanding-III (Page No. 262)

Question 1.
The ……….. is useful in evaluating credit and collection policies.
(a) average payment period
(b) current ratio
(c) average collection period
(d) current asset turnover
(c) average collection period

Question 2.
The measures the activity of a firm’s inventory.
(a) average collection period
(b) inventory turnover
(c) liquid ratio
(d) current ratio
(b) inventory turnover

Question 3.
The ratio may indicate the firm is experiencing stock outs and last sales.
(a) average payment period
(b) inventory turnover
(c) average collection period
(d) quick
(a) average payment period

Question 4.
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) 57 days
(c) 47 days

Question 5.
………… 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
(c) Lenders and suppliers

Question 6.
The ………… ratios provide the information critical to the long-run operation of the firm.
(a) liquidity
(b) activity
(c) solvency
(d) profitability
(c) solvency

Do it Yourself (Page No. 247)

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

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

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

Do it Yourself (Page No. 257)

Question 1.
Calculate the amount of gross profit:
Average stock = Rs. 80,000
Stock turnover ratio = 6 times
Selling price = 25% above cost

Question 2.
Calculate Stock Turnover Ratio :
Annual sales = Rs. 2,00,000
Gross Profit = 20% on cost of Goods Sold
Opening stock = Rs. 38,500
Closing Stock = Rs. 41,500

Question 1.
What do you mean by Ratio Analysis?
Ratio Analysis: The English word ratio comes directly from Latin. The Latin word has many derivates in the English language, among them are reason/ratio, rational and relational. Ratio is defined formally as “the indicated quotient of two mathematical expressions”— and indeed, a ratio does result from the division of one number into another—and as “the relationship between two or more things”.

An operational definition of a financial ratio is the relationship between two financial values. The word “relationship” implies that a financial ratio is the result of comparing mathematically two values.

And this numerical comparison is important, for these ratios are used as indexes, and as indexes, they are used to make qualitative judgements about the financial health of the firm.

Analysis of the firm by financial ratios enables the financial manager as well as interested external parties, to evaluate the firm’s financial performance and condition rapidly by making comparisons of ratios obtained from the firm with ratios obtained from comparable firms. Financial ratio also presents ready comparison of firm’s financial performance and condition over time as a way of identifying and evaluating performance trends.

Ratio analysis requires considerable judgement and direction by the analyst if it is to serve as a basis for future financial and operating decisions. Rule of thumb and other mechanical interpretations may produce disastrous decisions by those who are ill-informed about the ambiguity of information that may be contained in ratios.

Financial and operating relationships expressed in terms of ratios or otherwise have little significance except as they are judged on the basis of appropriate standards of comparison. Therefore, in interpreting the ratios of a particular business, the analyst cannot determine whether the ratios of a particular business indicates favourable or unfavourable conditions unless there are available measuring devices standards of comparison may consist of

• Mental standard of the analyst i.e., general conception of what is adequate or normal which has been gained by his personal experience and observation.
• Ratios and percentages based on the records of the past financial and operating performance of the individual business.
• Ratios and percentages of selected competing companies, especially the most progressive and successful ones.
• Ratios and percentages developed by using the data included in the current budgets.
Such ratios would be based on the individual company’s past experience modified by anticipated changes during the accounting period. These ratios would properly be called “good ratios”.
• Ratio and percentages of the industry of which the individual company is a member.

Question 2.
What are various types of ratios?
Ratios can be classified from various points of view. In reality, the classification depends on the objectives and available data. Thus, accounting ratio may be classified as under :
(ii) Functional Classification
(i) Traditional Classification : Traditional classification of accounting ratios is based on the statement from which the ratios are calculated. Ratios may be based on figures in the balance sheet, in the profit and loss account or in both. On this basis the various types of accounting ratios are as follows :

(a) Balance Sheet Ratios: In case both variables are from balance sheet, it is classified as Balance Sheet Ratios. For example ratio of current assets to current liabilities known as current ratio is calculated using both figures from Balance Sheet. Some other ratios are following which comes under this category :

• Current Ratio
• Quick Ratio
• Debt Equity Ratio
• Proprietary Ratio

(b) Income Statement Ratios : A ratio of two variables from the Income Statement (Profit and Loss A/c) is known as Income Statement Ratio. For example ratio of Gross Profit to Sales known as Gross Profit Ratio is calculated using both figures from the income statement. Some other ratios are :

• Gross Profit Ratio
• Net Profit Ratio
• Operating Ratio
• Stock Turnover Ratio

(c) Composite or Inter-Statement Ratios : If a ratio is computed with one variable from Income Statement and another variables from Balance Sheet, it is called composite ratio. For example, ratio of credit sales to debtors and bills receivable known as debtors turnover ratio is calculated using one figure from income statement (credit sale) and another figure from balance sheet (Debtors and Bills receivable). Some other ratios are :

• Return on Investment
• Return on Equity
• Fixed Assets Turnover Ratio
• Debtors Turnover Ratio
• Creditors Turnover Ratio

(ii) Functional Classification : The most popular and useful classification of ratios is the functional classification. Functional classification is the classification of ratios according to functions. Accounting ratios are classified as under :

(a) Liquidity Ratios: It measures the short term solvency i.e. the firm ability to pay its current dues. The term liquidity means the conversion of the assets into cash without much loss. The objective is to find the ability of the business enterprise to meet short term liabilities. The ratios included in this category are :

• Current Ratio
• Liquid Ratio

(b) Solvency Ratios : These ratios are computed to judge the ability of a firm to pay off its long-term liabilities. It shows the proportion of the fund which is provided by outside creditors in comparison to owners. These ratios shown the long term financial solvency and measures the enterprise’s, ability to pay the interest regularly and of repay the principal on maturity or in pre-determined installments at due dates. The following ratios are normally computed for solvency analysis:

• Debt Equity Ratio
• Total Assets to Debt Ratio
• Proprietary Ratio
• Interest Coverage Ratio

(c) Activity (or Turnover) Ratios : Activity ratios are used to indicate the efficiency with which assets such as stock, debtors, fixed assets etc. of the firm are being utilised. These ratios are also known as Turnover Ratios because they indicate the speed with which assets are being converted or turned over into sales. These ratios, thus express the relationship between cost of goods sold or sales various assets and arte expressed in number of times. The following are the important ratios of this category:

• Stock Turnover Ratio
• Debtors Turnover Ratio
• Creditors Turnover Ratio
• Working Capital Turnover Ratio
• Fixed Assets Turnover Ratio
• Current Assets Turnover Ratio

(d) Profitability Ratios : Efficiency of a business is measured in term of profits. Thus profitability ratio are computed to measures the efficiency of a business. Profit earning capacity may be expressed in the form of sales. Some important profitability ratios are :

• Gross Profit Ratio
• Operating Ratio
• Net Profit Ratio
• Return on Investment Ratio
• Earning Per Share Ratio
• Dividend Per Share Ratio

Question 3.
What relationship will be established to study:
(a) Inventory Turnover
(b) Debtors Turnover
(c) Payable Turnover
(d) Working Capital Turnover
These all four ratios are Turnover or Activity Ratios. These ratios measures the effectiveness with which a firm uses its available resources. These ratios are called ‘Turnover Ratios’ since they indicate the speed with which the resources are being turned into sales. These ratios, thus express the relationship between cost of goods sold or sales and various assets and are expressed in number of times.

(a) Inventory Turnover: This is also called Stock Turnover Ratio. This ratio establishes a relationship between cost of goods sold and average inventory. The objective of computing this ratio is to determine the efficiency with which the inventory is utilised.

This ratio shows the rate at which stocks are converted into sales. The higher the ratio, the better it is for the business, since it means that stock is being quickly converted into sales. Industries which has very high stock turnover ratio may be operating with low margin of profits and vice-versa.

(b) Debtors Turnover Ratio: This ratio is computed to establishes the relationship between net credit sales and average debtors (or receivable) of the year. It shows the rate at which cash is generated by the turnover ratio of debtors.

This ratio indicates the number of times the receivable are turned over in a year in relations to sales. It shows how quickly debtors are converted into cash. The higher the ratio, the better it is, since it means speedier collection and lesser amount being blocked up in debtors and vice versa.

(c) Payable Turnover Ratio : It is also called Creditors Turnover Ratio. It indicates the pattern of payment of accounts payable. An accounts payable arise on account of credit purchase, it expresses relationship between credit purchases and accounts payable.

It shows average payment period. By comparing it with the credit period allowed by the suppliers,-conclusion may be drawn. Lower ratio means credit allowed by the supplier is not enjoyed by the business. Higher ratio means delayed payment to supplier which is not a very good policy as it may affect the reputation of the business.

(d) Working Capital Turnover: This ratio indicates whether the working capital has been effectively utilized or not in making sales. In fact, in the short run, it is the current assets and current liabilities which plays a major role. A careful handling of current assets and current liabilities will mean a reduction in the amount of capital employed thereby improving turnover.

Working Capital Turnover Ratio $$=\frac{\text { Net Sales }}{\text { Working Capital }}$$
A high working capital turnover ratio show the efficient utilisation of working capital in generating sales. A low ratio, on the other hand, may indicate excess of working capital or has not been utilized efficiently.

Question 4.
Why would the Inventory Turnover Ratio be more important wrhen analysing a grocery store than an insurance company?
Inventory turnover is more important for a grocery store being a trading concern rather than insurance company, contracting for indemnity. Inventory is an element of current assets.

Inventory is needed for smooth flow of production and sales inventory is of three types i.e. raw material, work-in-progress and finished goods. Raw- material and work-in-progress inventory is maintained for the uninterrupted flow of production. Finished goods inventory is kept for meeting the demands of customers.

Inventory turnover ratio measures the efficiency with which inventory has been converted into sales. Inventory is generally valued at cost.

This ratio indicates the speed with which the goods have been sold. Low ratio means low speed of sales and high ratio indicates that goods have not been retained in the godown for a longer period. Higher ratio is considered good from the view point of liquidity.

Question 5.
The liquidity of a business firm is measured by its ability to satisfy its long term obligations as they come due. Comment.
The term solvency means the ability of the enterprise to meet its obligations on the due date. Some payments have short-term maturity and some have long term maturity. Long-term liquidity means ability to meet long term commitments or obligations, long term lenders are primarily interested in this type of analysis.

Leverage or Capital Structure Ratio : Solvency of business is related to its debt paying capacity. Normally, the ordinary shareholders, debenture holders, financial institutions and other long term creditors are interested in these ratios. With the help of these ratios, long term creditors can analysis the capacity of business to pay interest and the principal. Therefore, long term solvency of business means its ability to pay the long term debts and interest thereon regularly.

Therefore, the long term solvency or financial position has two aspects—
(i) The ability to repay principal on due date.
(ii) The ability to pay interest regularly.

(i) Debt-Equity Ratio – In any business, there should be equitable balance between owned capital and debt capital because it affects long term solvency of business. If a business procures more funds from the owners of business, it will secure the interest of creditors.

(ii) Proprietary Ratio – This ratio is another form of debt equity ratio. It is also known as Net Worth to Total Assets Ratio. This ratio establishes relationship between shareholders’ funds and total assets of business.

The higher ratio, the more profitable it is for the creditors. If the ratio is low, the creditors can be suspicious about the repayment of their debt on liquidation of company.

Coverage Ratio – To evaluate the long term solvency, coverage ratios are calculated. In the ordinary course of business, the claims of creditors are’ not met by selling the fixed assets. Rather, these claims are paid out of income of the firm. If the firm is able to pay these claims in time, the finanacial position of the firm will be considered sound. The coverage ratio includes

(i) Interest Coverage Ratio—With the help of this ratio, it can be ascertained whether the interest on long term debts of business can be paid out of profits or not. The higher the ratio, the safer will be the interests of creditors.
Interest Coverage Ratio =$$\frac{\text { EBIT }}{\text { Interest }}$$
EBIT = Earning before Interest and Taxes.

(ii) Dividend Coverage Ratio—This ratio measures the dividend paying capacity of the firm.
Dividend Coverage Ratio = $$\frac{\text { Earnings after Taxes }}{\text { Preference Dividend }}$$

(iii) Fixed Charges Coverage Ratio—This ratio considers both interest on long term loans and dividend on preference share capital.
Fixed Charge Coverage Ratio = $$\frac{\text { EBIT }}{\text { Interest + Preference Dividend }}$$

Question 6.
The average age of inventory is viewed as the average length of time inventory held by the firm or as the average number of days sales in inventory. Explain.
Inventory is an element of current assets. Inventory is needed for smooth flow of production and sales. Inventory is of three types i.e., raw-material, work-in-progess and finished goods. Raw-material and work-in-progress inventory is maintained for the uninterupted flow of production.

Finished goods inventory is kept for meeting the demands of customers. The firms usually maintain finished goods inventory. Inventory is generally valued at cost. Firstly, to calculate inventory turnover ratio and then convert it into number of days for the calculation of average age of inventory.

If the Inventory Turnover ratio goes up, the average age of inventory will go down and vice versa.

Aging Schedule of Inventory—According to the time, Inventory can be calculated and classified to find out those items which are used in the production process at a slow rate or which are sold at slow rate. By preparing aging schedule of Inventory, the dates of their purchase or manufacture are taken note of. A specimen of aging schedule of inventory is as under :

From the above table, it is clear that 50% of total inventory is in stocks for more than 80 days.

Question 1.
Who are the users of financial ratio analysis? Explain the significance of ratio analysis to them?
The following are the main users of financial ratio analysis.
1. Investors and Owners
2. Management
3. Short Term Creditors
4. Long Term Creditors
Tire significance of ratio analysis for the various groups may be discussed as under:
1. Investors and Owners : Investors and Owners are primarily interested in the Profitability and safety of their investments. Hence they calculate profitability ratios such as earning per share, dividend per share, return on investment, return on equity, dividend yielded etc. On the basis of these ratios, investors.decide whether to buy or retain the shares of the company.

2. Management: Management makes the use of ratio analysis as a means of self-evaluation. Management assesses its managerial skill and performance on the basis of profitability ratios and turnover ratios. Management uses different ratios for forecasting to events. Management can assess its performance by making inter-firm comparison and intra-firm comparison.

3. Short Term Creditors : Short term creditors like suppliers of goods and lenders supplying short term loans, uses liquidity ratio such as current ratio and acid test ratio to assess the liquidity position of the company. Liquidity ratios give them an idea of company’s ability to repay their claims at the time of maturity of the claims.

4. Long Term Creditors : Long term creditors are the creditors who provide funds to the company for a period over one year. Long term creditors are interested in the solvency of the company and the company’s ability of pay its interest obligations. Solvency ratios such as debt equity ratio, proprietary ratio and interest coverage ratio are calculated by long term creditors.

Question 2.
What are liquidity ratios? Discuss the importance of current and liquid ratio.
Liquidity Ratios : It measures the short term solvency i.e. the firm’s ability to pay its current dues. The term liquidity means the conversion of the assets into cash without much loss. The objective is to find out the ability of the business enterprise to meet short term liabilities. The ratios included in this category are :
(i) Current Ratio
(ii) Liquid Ratio

(i) Current Ratio: Current ratio is the proportion of current assets to current liabilities.
$$\text { Current Ratio }=\frac{\text { Current Assets }}{\text { Current Liabilities }}$$
Current assets which means the assets which are held for their conversion into cash with in a year. The following are the examples of current assets:

Cash Balances – Accurred Income
Bank Balances – Marketable Securities
Debtors – Bills Receivable
Stock – Prepaid Expenses etc.
Short term loans

Current Liabilities which mean the liabilities which are expected to be matured within a year. The following are the example of current liabilities:

Creditors – Provision for Tax
Bank Overdraft – Unclaimed dividend
Short Term Loans

Importance : An ideal ratio is 2 :1. A higher ratio indicates poor investment policies of the management and poor inventory control while a low ratio indicates lack of liquidity and shortage of working capital. The current ratio, thus, throws a good light on the short term financial position and policy of a firm.

(ii) Liquid Ratio or Quick Ratio: It is the ratio of quick (or liquid) assets to current liabilities.
$$\text { Quick Ratio }=\frac{\text { Quick Assets }}{\text { Current Liabilities }}$$
Quick Assets (or liquid Assets) = Current Assets – Stock – Prepaid expenses.

The objectives of computing this ratio is to measures the ability of the firm to meet its short term obligation as and when due without relying upon the realization of stock.

Importance : A quick (or liquid) ratio of 1 : 1 is supposed to be good for the reason that it indicates availability of funds to meet the liabilities 100%. If this ratio is more than 1 : 1 it can be said that the financial position of the business enterprise is sound and good.

On the other hand. If the ratio is less than 1 :1 i.e. liquid assets are less than current liabilities the financial position of the concern shall be deemed to be unsound and additional cash will have to be provided for the payment of current liabilities.

Question 3.
How would you study the solvency position of a firm?
Solvency position of a firm may be studied with the help of solvency ratios. These solvency or leverage ratios are important to creditors, since they reflect the capacity of firm’s revenue to support interest and other fixed charges, and whether there are sufficient assets to pay-off the debt in the event of liquidation.

Shareholders, are concerned with leverage, since interest payments increases with greater debt. If borrowing and interest are excessive, the company can even experience bankruptcy.

(i) Total Debt to Total Assets Ratio—The ratio of total debt to total assets, generally, called the debt ratio, measures the percentage total funds provided by creditors. Debts includes current liabilities and all creditors, moderate debt ratio, since the lower the ratio, the greater the cushion against creditors losses in the event of liquidation. In contrast to the creditors preference of low debt ratios the owners may seek high leverage either.
(i) to magnify earnings or
(ii) because raising new equity means giving up some degree of control. If the debt ratio is too high, there is a degree of encouraging irresponsibility on the part of the owners.

The stake of the owners can become so small that speculative activity, if it is successful, will yield a substantial return to the owners. If the venture is unsuccessful, however, only a concrete loss is incurred by the Owners because there investment is small.

(ii) Capitalisation Ratio : Another widely used measure of financial or solvency position is the capitalisation ratio, which is derived by dividing long-term debt by the total of long-term debt plus owner’s equity. Since the sum of debt and owner’s equity represents the permanent capital of the firm, this ratio indicates the portion of the permanent capital that is financed with debt.

(iii) Earning Coverage Ratio—This in many ways a superior measure of financial risk to the leverage ratio as it attempts to measure the company’s ability to avoid future financial difficulties which can arise because of its use of debt finance. The larger this ratio, the greater the reduction of the company’s earnings which can occur before the company will default on its interest payments.

EBIT = Earnings before Interest & Taxes.

(iv) Ratio of Owner’s-Equity to Total Assets—The ratio of owner’s equity to total assets shows the percentage of the total investment. This ratio often called the “Proprietary ratio” or Shareholder Equity Ratio.

The larger amount of owner’s equity indicates an improvement in the long term financial position, since there is relatively greater margin of safely for outside creditors and less long-term pressure from the point of view of the owners. The most conservative, although not always the most profitable, basis of financing when broad or other long term obligations are used in place of capital stock is to provide for the gradual retirement of the debt.

From the point of view of creditors, the larger the percentage of assets that is supplied by shareholders, the more satisfactory the fianancial structure of the business. Since owner’s equity is a “Cushion” that first absorbs losses.

However, an upward trend in this ratio is usually considered by creditors to be favourable, and the larger the percentage of funds, supplied by outside creditors, the less ‘conservative’ the financial structure is likely to be especially in periods of poor business, because of the fixed interest and necessity of paying or refunding maturing debts.

Question 4.
What are important profitability ratios? How are they worked cut?
Efficiency of a business is measured in terms of profits. Thus profitability ratio are computed to measure the efficiency of a business. Profit earning capacity may be expressed in the form of sales. Some important profitability ratios are :
(i) Gross Profit Ratio
(ii) Operating Ratio
(iii) Operating Profit Ratio
(iv) Net Profit Ratio
(v) Overall Profitability Ratio
(vi) Return of Shareholder fund
(vii) Return on Capital Employed etc.

(i) Gross Profit Ratio: The main objective of computing tl us ratio is to be determine the efficiency with which production and/or purchase operations are carried on. It establishes relationship of gross profit on sales of a firm, which is calculated

Gross Profit = Net Sales – Cost of Goods Sold
Cost of Goods Sold = Opening Stock + Purchases + Direct Expenses – Closing Stock
Net Sales = Total Sales – Sales Return

(ii) Operating Ratio : This ratio establishes the relationship between the cost of goods sold plus other operating expenses to net sales. The lower the percentage of operating ratio, the higher the net profit ratio.

Operating Expenses = Office and Financial Expenses + Administrative Expenses + Selling and Distribution Expenses + Discount + Bad Debts + Interest on Short Term Loans Cost of Goods Sold = Sales – Gross Profit

(iii) Operating Profit Ratio : It is calculated to reveal operating margin. It may be computed directly or as a residual of operating ratio.
Operating Profit Ratio = 100 – Operating Ratio Alternatively,

(iv) Net Profit Ratio : Net profit ratio is based on all inclusive concept of profit JH: relates sales to net profit after operational as well as non-operational expenses and income
$$\text { Net Profit Ratio }=\frac{\text { Net Profit }}{\text { Sales }} \times 100$$
Net Profit is taken after income tax.

(v) Overall Profitability Ratio : The Overall Profitability Ratio establishes the relationship of profit to the amount of funds employed.
$$\text { Overall Profitability Ratio }=\frac{\text { Profit }}{\text { Investment of Funds }} \times 100$$

(vi) Return of Shareholder’s fund: This ratio reflects the return on shareholder’s fund that the business enterprise was able to earn. Return on Shareholder’s Fund =

(vii) Return on Equity Shareholders’ fund : It is computed to draw an idea about the return available to equity shareholders.

Profit after appropriation less Preference dividend

(viii) Return on Capital Employed or Investment (ROCE or ROI): This ratio, also known as return on investment, is a basic ratio of profitability. It is calculated by establishing a relationship between the profit earned and the capital employed to earn the profit. It is therefore an indicator of the earning capacity of the capital invested in the business.

Return on Capital Employed
Capital Employed = Fixed Assets + Working Capital = Long Term Funds + Share Capital + Reserves and Surplus – Ficitious Assets (Miscellaneous Expenditure)

Question 5.
Financial ratio analysis are conducted by four groups of analysis : Managers, equity investors, long term creditors and short term creditors. What is the primary emphasis of each of these groups in evaluating ratios?
Financial ratio analysis are conduced by four groups of analysis : Managers, equity investors, long term creditors and short term creditors. The primary emphasis of each these groups in evaluating ratios are following

(i) Managers : Manager’s makes the use of ratio analysis as a means of self evaluations. Managers assesses their managerial skill and performance on the basis of profitability ratios and turnover ratio. They uses different ratios for forecasting of events. They can assess their performance by making inter-firm comparison and intra-firm comparison.

(ii) Equity Investors : They are primarily interested in the profitability and safety of their investments. Hence they calculate profitability ratios such as earning per share, dividend per share, return on investment, return on equity, divided yield etc. On the basis of these ratios, investors decide whether to buy or retain the share of the company.

(iii) Long Term Creditors: Long term creditors are the creditors who provide funds to the company for a period over one year. Long term creditors are interested in the solvency of the company and the company’s ability to pay its interest obligations. Solvency ratios such as debt equity ratio, proprietary ratio and interest coverage ratio are calculated by long term creditors.

(iv) Short Term Creditors: Short Term creditors like suppliers of goods and lenders supplying short term loans, uses liquidity ratios such as current ratio and acid test ratio to assess the liquidity position of the company. Liquidity ratios give them an idea of company’s ability to repay their claims at the time of maturity of the claims.

Question 6.
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 (liquid) ratio is a preferred measure of overall liquidity. Explain.
(i) Current Ratio : This ratio establishes the relationship between current assets and current liabilities. With its help, the ability of the business to pay-off its short-term liabilities is determined. It helps to find out how many times current assets are there in business as compared to current liabilities. This ratio is calculated by dividing current assets by current liabilities. Current ratio of 2 :1 is considered ideal i.e. The current assets should be twice the current liabilities.
$$\text { Current Ratio }=\frac{\text { Current Assets }}{\text { Current Liabilities }}$$
Current assets are those assets which are converted into cash within one year or an operating cycle. They include cash in hand, bank balance, stock, debtors, prepaid expenses, bills receivable, short-term investments etc. Current Liabilities are those liabilities which have to be paid during one year.

These include, creditors, bills payable, outstanding expenses, dividend payable, short-term loans, bank overdrafts etc. This ratio is also called Working Capital Ratio. Because working capital is the difference between current assets and current liabilities.

This ratio gives us the information as to whether the business has adequate current assets to pay-off its current liabilities. Current assets should be more than current liabilities so that despite fall in their prices, current liabilities could be paid easily. If current ratio is 2 :1, it means that the current liabilities would be paid even if there is 50% fall in the prices of current assets.

The greater this ratio, better will be the short term solvency of the firm and more safe will be the interests of the short term creditors.

This ratio should neither be too high nor too low. High ratio is an indicator of weak investment policy of the firm and low ratio increases the risk in payment of short term debts. High ratio also means that funds of the firm are lying surplus and unutilised.

Although, the current ratio should be 2 :1 but it is not a fixed or certain rule because it depends on the nature of business, its working conditions and availableHinancial resources.

For public utility companies, a current ratio of less than 2 : 1 may also be satisfactory because in such business, the amount of current assets is normally low. Contrarily, for a wholesaler who purchases goods on cash or on credit of small period and sells on credit to the retailers, the current ratio should be high.

Current Ratio’s main limitation is that is a quantitative measure, not a qualitative one. To ascertain this ratio, all current assets are given equal importance. In other words, the liquidity of individual current asset is given no attention. But there is difference in the liquidity of various current assets.

Cash is the most liquid asset. On the other hand, stock is the least liquid of all current assets. Debtors, B/Rs etc. are more liquid as compared to stock but less liquid than cash. The current ratio of two firms can be similar. But if the current assets of a firm consist of stock as a major proportion, it will be less liquid as compared to other firm.

This ratio can be easily altered for window dressing. Window dressing means manipulation in current assets and current liabilities to show favourable position as compared to the actual one.

This manipulation is done by higher valuation the stock, lesser provision for bad and doubtful debts, lesser amount of provisions and transferring a current liability to a long term liability. All this will raise the Current Ratio. Therefore, the current ratio can’t be an absolute measure of short term solvency of the firm.

(ii) Liquidity Ratio or Acid Test Ratio or Quick Ratio—With the help of this ratio, the capacity of the firm to pay off its current liabilities immediately is measured. This ratio is calculated by dividing liquid assets by current liabilities.
Liquid assets are those assets which can immediately or in a short period be converted into cash without much loss Liquid assets do not include stock and prepaid expenses because stock is less liquid and its price fluctuates. Prepaid expenses can’t be realised

A liquid ratio of 1 :1 is considered as standard ratio. The higher this ratio, more will be the short term solvency of the business. This ratio is calculated to remove the shortcomings of the current ratio. Tins ratio is considered better than current ratio. Sometimes, the current ratio is high because of large proportion of stock but due to low liquidity ratio, the short term financial position of business is weak.

If liquid assets are less than current liabilities, the management should manage cash. According to some authors to calculate this ratio, liquid liabilities should be used in place of current liabilities. Liquid liabilities are those liabilities which are to be paid in near future. Bank overdraft and cash credit are not included in them because they are not immediately payable.
$$\text { Liquidity Ratio }=\frac{\text { Liquid Assets }}{\text { Liquid Liabilities }}$$

Although liquid ratio is considered better than current ratio, but to analysis short term financial position of the business both ratios should be used simultaneously.

Numerical Questions

Question 1.
Following is the Balance Sheet of Rohit and Co. as on March 31, 2006.

Calcuate Current Ratio
(Ans. Current Ratio 2:1)

Question 2.
Following is the Balance Sheet of Title Machine Ltd. as on March 31, 2006.

Calculate Current Ratio and Liquid Ratio.
(Ans. Currcnt Ratio 0.8, Liquid Ratio 0.37: 1)

Question 3.
Current Ratio is 3 : 5. Working Capital is Rs. 90,000. Calculate the amount of Current Assets and Current Liabilities.
(Ans. Current Assets Rs. 1,26, 000 and Current Liabilities Rs. 36,000)

Question 4.
Shine Limited has a current ratio 4.5 :1 and quick ratio 3 : 1; If the stock is 36,000, calculate current liabilities and current assets. (Ans. Current Assets Rs. 1,08,000, current liabilities Rs. 24,000)

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 stock. (Ans : Current Assets Rs. 3,00,000. Liquid Assets Rs. 75,000 and stock Rs. 2,25,000

Question 6.
Handa Ltd. has stock of Rs. 20,000. Total liquid assets are Rs. 1,00,000 and quick ratio is 2 :1. Calculate current ratio. (Ans : Current Ration 2.4 :1)

Question 7.
Calculate debt equity ratio from the following information:
Total Assets – Rs. 15,00,000
Current Liabilities – Rs. 6,00,000
Total Debts – Rs. 1200,000
(Ans : Debt Equity Ratio 2 : 1)

Question 8.
Calculate Current Ratio if: Stock is Rs. 6,00,000; Liquid Assets Rs. 24,00,000; Quick Ratio (Ans. Current Ratio 2.5 :1)

Question 9.
Compute Stock Turnover Ratio from the following information:
Net Sales – Rs. 2,00,000
Gross Profit – Rs. 50,000
Closing Stock – Rs, 60,000
Excess of Closiiig Stock – Rs. 20,000
over Opening Stuck
(Ans : Stock Turnover Rho 3 times)

Question 10.
Calculate following ratios from the following information:
(i) Current ratio
(ii) Acid test ratio
(iii) Operating Ratio
(iv) Gross Profit Ratio
Current Assets – Rs. 35,000
Current Liabilities – Rs. 17,500
Stock – Rs. 15,000
Ope rating Expences – Rs. 20,000
Sales – Rs. 60,000
Cost of Goods Sold – Rs. 30,000
(Ans: Current Ratio 2:1; Liquid Ratio 1.14: 1; Operating Ratio
83.3%: Gross Profit Ratio 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 Ratio :

(Ans: Gross Profit Ratio 23.81; Inventory Turnover Ratio 2.4 times; Current Ratio 2.6 : 1; Liquid Ratio 1.27 : 1; Net Profit Ratio 14.21%; forking Capital Ratio 2.625 times)

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

(Ans : Gross Profit Ratio 40%; Working Capital Ratio 8.33 times; Debt Equity Ratio 2:5; Proprietary Ratio 25:49)

Question 13.
Calculate Stock Turnover Ratio if :
Opening Stock is Rs. 76,250, Closing Stock is 98,500, Sales is Rs. 5,20,000, Sales Return is Rs. 20,000, Purchases is Rs. 3,22,250. (Ans : Stock Turnover Ratio 3.43 times)

Question 14.
Calculate Stock Turnover Ratio from the data given 1 below:

Question 15.
A trading firm’s average stock is Rs. 20,000 (cost). If the stock turnover ratio is 8 times and the firm sells goods at a profit of 20% on sale, ascertain the profit of the firm. (Ans : Profit Rs. 40,000)

Profit = Sales – Cost of Goods Sold
= Rs. 2,00,000 – Rs. 1,60,000
= Rs. 4,000

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

Calculate Stock Turnover Ratio and Debtor Turnover Ratio if in the year 2004 stock in trade increased by Rs. 2,00,000
(Ans. Stock Turnover Ratio 2.4 times, Debtors Turnover Ratio 4.52 times)

Question 17.
The following Balance Sheet and other information, calculate following ratios:
(i) Debt Equity Ratio
(ii) Working Capital Turnover Ratio
(iii) Debtors Turnover Ratio.

(Ans : Debt Equity 12 :19; Working Capital Turnover 1.4 times; Debtors Turnover 2 times)

Question 18.
The following is the summerised Profit and Loss account and the Balance Sheet of Nigam Limited for the year ended March 31, 2007:

Calculate (i) Quick Ratio
(ii) Stock Turnover Ratio
(iii) Return on Investment
(Ans: Quick Ratio 7:13; Stock Turnover Ratio 3.74 times; Return on Investment 41.17%) .

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

Question 20.
Cost of Goods Sold is Rs. 1,50,000. Operating expenses are Rs. 60,000, Sales is Rs. 2,60,000 and Sales Return is Rs. 10,000. Calculate Operating Ratio.
(Ans. Operating Ratio 84%)
Operating Ratio

Question 21.
The following is the summerised transactions and Profit and Loss Account for the year ending March 31,2007 and the Balance Sheet as on that date.

Calculate (i) Gross Profit Ratio, (ii) Current Ratio, (iii) Acid Test Ratio, (iv) Stock Turnover Ratio, (v) Fixed Assets Turnover Ratio.
(Ans : Gross Profit Ratio 50%; (ii) Current Ratio 3 : 2; (iii) Acid Test Ratio 1.125 :1; (iv) Stock Turnover Ratio 4 times; (v) Fixed Assets