AHSEC - 12: Ratio Analysis Important Notes for MAY' 2021 Exam | Revised and Reduced Syllabus

Class 12 Accountancy Notes

Unit – 9: Ratio Analysis

Unit – 9: Ratio Analysis FOR 2021 EXAM

Q.N.1. what do you mean by ratio analysis? What are the objectives and advantages of such analysis? Also point out the limitations of ratio analysis.                       2012, 2012, 2018, 2020

Answer: A Ratio is an arithmetical expression of relationship between two related or interdependent items. If such ratios are calculated on the basis of accounting information, then they are called accounting ratios. Simply, accounting ratio is an expression of relationship between two accounting terms or variables or two set of accounting heads or group of items stated in financial statement. It is one of the techniques of financial analysis which is used to evaluate the operating efficiency and financial position of a business concern.

According to J. Betty,” The term accounting ratio is used to describe significant relationships which exist between figures shown in a balance sheet and in a profit and loss account.”

Objectives of Ratio analysis                        2018

1. To know the weak areas of the business which need more attention.

2. To know about the potential areas which can be improved with the effort in the desired direction.

3. To provide a deeper analysis of the profitability, liquidity, solvency and efficiency levels in the business.

4. To provide information for decision making.

5. To provide information for inter-firm and intra-firm comparison.

Advantages and Uses of Ratio Analysis

1. Helpful in analysis of financial situation: It helps the management to know about the financial strength and weakness of the business concern. Bankers, Investors, Creditors etc. analyse financial statements with the help of ratios.

2. Useful in judging the operating efficiency of business: Accounting ratios are useful in evaluating the operating results financial health of an enterprise. This is done by evaluating liquidity, solvency, profitability etc.

3. Helpful in inter-firm and intra-firm comparison: Ratio analysis helps in comparing the performance of business with that of other firms and of industry in general. This comparison is called inter-firm comparison. Ratio analysis also helps in comparing results of different units belonging to the same firm. This comparison is called intra-firm comparison.

4. Simplifies the accounting information: It simplifies and summarises the accounting figures to make them understandable to the users. It gives a brief idea about the whole story of changes in the financial condition of a business.

5. Useful for forecasting: Ratios are helpful in business planning and forecasting. What should be the course of action in the future can be decided with the help of trend percentage.

Limitations of Ratio Analysis

1.       False Result: Ratios are calculated from the financial statements, so the reliability of ratio is dependent upon the correctness of the financial statements. If financial statements are misleading, then the accounting ratios also gives a false pictures.

2.       Ignores Price Level Changes: Change is price level affects the comparability of ratios. A change in the price level makes the ratio analysis of different accounting years invalid because accounting records ignores change in value of money.

3.       Qualitative aspect Ignored: Since the financial statements are based on quantitative aspects only, the quality aspect such as quality of management, quality of labour force etc., are ignored while calculating accounting ratios. Under such circumstances, the conclusions derived from ratio analysis would be misleading.

4.       Lack of standard ratio: The financial and economic scenario is dynamic; therefore, it is very difficult to evolve a standard ratio acceptable for all time. There is almost no single standard ratio which is acceptable in every scenario.

5.       Not free from Bias: Financial statements are largely affected by the personal judgment of the accountant in selecting accounting policies, therefore accounting ratios are also not free from this limitations. If the personal judgement of the analyst is biased, then the conclusion drawn will be misleading.










Q.N.2. What are the types of Ratios according to traditional classification?                         2016, 2017


The ratios are used for different purposes, for different users and for different analysis. The ratios can be classified as under:

a)      Traditional classification

b)      Functional classification

c)       Classification from user‘s point of view

1) Traditional classification: As per this classification, the ratios readily suggest through their names, their respective resources. From this point of view, the ratios are classified as follows.

a) Balance Sheet Ratio. b) Revenue Statement Ratio. c) Combined Ratio.

2) Functional Classification of Ratios: The accounting ratios can also be classified according their functions as follows:

a) Liquidity Ratios. b) Leverage Ratios. c) Efficiency/Activity Ratio. d) Profitability Ratio. e) Coverage Ratios.

3) Classification from the view point of user: Ratio from the users' point of view is classified as follows:

a) Shareholders' point of view: Example: Return on proprietor's funds, Return on capital, Earning per share.

b) Long term creditors: Example: Debt equity ratio, return on capital employed, proprietary ratio.

c) Short term creditors: Example: a) Liquidity Ratios - Current Ratio, Liquid Ratio. b) Debtors Turnover Ratio. c) Stock working capital Ratio.

d) Management: Example: Return on capital employed, Turnover Ratio, Operating Ratio, Expenses Ratio.

Q.N.3. Explain the meaning and method of calculation of some specific ratios.

Ans: a) Current Ratio: Current ratio is calculated in order to work out firm’s ability to pay off its short-term liabilities. This ratio is also called working capital ratio. This ratio explains the relationship between current assets and current liabilities of a business. It is calculated by applying the following formula:

Current Ratio = Current Assets/Current Liabilities

Current Assets includes Cash in hand, Cash at Bank, Sundry Debtors, Bills Receivable, Stock of Goods, Short-term Investments, Prepaid Expenses, Accrued Incomes etc.

Current Liabilities includes Sundry Creditors, Bills Payable, Bank Overdraft, Outstanding Expenses etc.

Objective and Significance: Current ratio shows the short-term financial position of the business. This ratio measures the ability of the business to pay its current liabilities. The ideal current ratio is supposed to be 2:1. In case, if this ratio is less than 2:1, the short-term financial position is not supposed to be very sound and in case, if it is more than 2:1, it indicates idleness of working capital.

b) Liquid Ratio: Liquid ratio shows short-term solvency of a business. It is also called acid-test ratio and quick ratio. It is calculated in order to know whether or not current liabilities can be paid with the help of quick assets quickly. Quick assets mean those assets, which are quickly convertible into cash.

Liquid Ratio = Liquid Assets/Current Liabilities

Liquid assets includes Cash in hand, Cash at Bank, Sundry Debtors, Bills Receivable, Short-term investments etc. In other words, all current assets are liquid assets except stock and prepaid expenses.

Current liabilities includes Sundry Creditors, Bills Payable, Bank Overdraft, Outstanding Expenses etc.

Objective and Significance: Liquid ratio is calculated to work out the liquidity of a business. This ratio measures the ability of the business to pay its current liabilities in a real way. The ideal liquid ratio is supposed to be 1:1. In case, this ratio is less than 1:1, it shows a very weak short-term financial position and in case, it is more than 1:1, it shows a better short-term financial position.

c) Stock Turnover Ratio: Stock turnover ratio is a ratio between cost of goods sold and average stock. This ratio is also known as stock velocity or inventory turnover ratio.

Stock Turnover Ratio = Cost of Goods Sold/Average Stock

Where Average Stock = [Opening Stock + Closing Stock]/2

Cost of Goods Sold = Opening Stock + Net Purchases + Direct Expenses – Closing Stock

Objective and Significance: Stock is a most important component of working capital. This ratio provides guidelines to the management while framing stock policy. It measures how fast the stock is moving through the firm and generating sales. It helps to maintain a proper amount of stock to fulfill the requirements of the concern. A proper inventory turnover makes the business to earn a reasonable margin of profit.