ACCOUNTING RATIOS

Financial Statements aims at providing financial information about a

business enterprise to users of financial statements. These
statements provide financial data which require analysis, comparison
and interpretation for taking decision by the external as well as
internal users of accounting information. This act is termed as
financial statement analysis. It is regarded as an integral and
important part of accounting.
This chapter covers the technique of accounting ratios for analyzing
the information contained in financial statements for assessing the
solvency, efficiency and profitability of the enterprises.
RATIO ANALYSIS is the process of determining and interpreting
numerical relationship based on financial statements. It is the
technique of interpretation of financial statements with the help of
accounting ratios derived from the balance sheet and profit and loss
account.
● Ratio is an arithmetical expression of relationship between two
interdependent or related items. Ratios, when calculated on the basis
of accounting information, are called Accounting Ratios. Thus, it is
expressed as arithmetical relationship between two accounting
variables.
● A ratio is a mathematical number calculated as a reference to
relationship of two or more numbers and can be expressed as a
fraction, proportion, percentage and a number of times.
● Meaning of Ratio Analysis :
● An analysis of financial statement with the help of 'accounting ratios'
is termed as 'Ratio Analysis'. It is a process of determining and
interpreting relationships between items of FS to provide a
meaningful understanding of the performance & financial position of
the enterprise. Thus, it is technique of analyzing the FS by computing
accounting ratios.
● Objectives of Ratio Analysis :
• It provides users with crucial financial information and points out the
areas which require investigation. It simplifies, summarizes and
systematizes the figures in the FS. The objectives include :
1. To know the 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 making cross-sectional analysis by
comparing the performance with the best industry standards; and
5. To provide information derived from financial statements useful for
making projections and estimates for the future.
● Advantages of Ratio Analysis :
1.Useful tool for Analysis of FS : They are useful tools for understanding the
financial position of the company. Bankers, Investors, Lenders, creditors etc
analyze Balance Sheet and Statement of Profit & Loss using ratios.
2.Simplifies Accounting Data : Ratios help in simplifying the complex accounting
figures to make it understandable and bring out their relationships. They help
summarize the financial information effectively and assess the managerial
efficiency, firm’s credit worthiness, earning capacity, etc.
3.Identification of problem areas : Ratios help business in identifying the problem
areas as well as the bright areas of the business. Problem areas would need more
attention and bright areas will need polishing to have still better results.
4.Useful for forecasting : These are helpful in business planning and forecasting.
The trends of Ratios are analyzed which can be used as a guide for future
planning.
● Limitations of Ratio Analysis :
1. False Results : Reliability of ratios is dependent upon the correctness of FS. If the FS
are not true and fair, the analysis will give false picture of affairs.
2. Qualitative Factor Ignored : Ratio analysis is a technique of quantitative analysis. It
ignores qualitative factors such as efficiency of labour force / management etc.
3. Lack of Standard Ratios : There is no single standard ratio against which accounting
ratios can be compared.
4. Variations in Accounting Practices : There are differing accounting policies for
valuation of inventory, calculation of depreciation, treatment of intangibles Assets
definition of certain financial variables etc., available for various aspects of business
transactions. These variations leave a big question mark on the cross-sectional
analysis. As there are variations in accounting practices followed by different business
enterprises, a valid comparison of their financial statements is not possible.

Contd....
● Limitations of Ratio Analysis (contd):
5. Ignores Price-level Changes : The financial accounting is based on
stable money measurement principle. It implicitly assumes that
price level changes are either non-existent or minimal. But the truth
is otherwise. We are normally living in inflationary economies
where the power of money declines constantly. A change in the
price-level makes analysis of financial statement of different
accounting years meaningless because accounting records ignore
changes in value of money.
6. Personal Bias : FS are prepared based on personal judgments of the
makers of FS. Thus, accounting ratios are also not free from this
limitation. Also the same ratio may be interpreted by different
people in different ways.
7. Forecasting : Forecasting of future trends based only on historical
analysis is not feasible. Proper forecasting requires consideration
of non-financial factors as well.
CLASSIFICATION OF ACCOUNTING RATIOS
 LIQUIDITY RATIO (SHORT – TERM SOLVENCY)
❖ 'Liquidity of Business' refers to the firm's ability to meet its current
liabilities, ie, short term liabilities. The liquidity ratios are used to
test the short term solvency or liquidity position of the business.
❖ It enables to know whether short term liabilities can be paid out of
short term assets. It is a valuable aid to management in checking
the efficiency with which working capital is being employed.
❖ Commonly used Liquidity Ratios are :
(1) Current Ratio ; and
(2) Quick / Liquid Ratio / Acid Test Ratio
 LIQUIDITY RATIO (SHORT – TERM SOLVENCY)
(1) Current Ratio : It is the most widely used of all analytical devices based on
the balance sheet. It establishes relationship between total current assets and
current liabilities.
Current Assets
Current Ratio / WC Ratio =
Current Liabilities

It is a measure of financial health of the enterprise in a short – term.

Items Included in Current Assets :
• (a) Current investments (including short- term investments and marketable securities)
• (b) Inventories (Excluding loose tools, stores and spares)
• (c) Trade receivables (bills receivable and sundry debtors less provision for doubtful debts)
• (d) Cash and cash equivalents (cash in hand, cash at bank, cheques/drafts in hand)
• (e) Short-term loans and advances
• (f) Other current assets (prepaid expenses, interest receivable, etc.)
 LIQUIDITY RATIO (SHORT – TERM SOLVENCY)
(1) Current Ratio (Contd) :
An asset shall be classified as current when it satisfies any of the following
criteria:
• (a) it is expected to be realized in, or is intended for sale or consumption in, the
company’s normal operating cycle:
• (b) it is held primarily for the purpose of being traded:
• (c) it is expected to be realized within twelve months after the reporting date; or
• (d) it is cash or cash equivalent unless it is restricted from being exchanged or
used to settle a liability for at least twelve months after the reporting date.
 LIQUIDITY RATIO (SHORT – TERM SOLVENCY)
(1) Current Ratio (Contd) :
Items Included in Current Liabilities
• (a) Short-term borrowings
• (b) Trade payables (bills payable and sundry creditors)
• (c) Other current liabilities (current maturities of long-term debts, interest, accrued but
not due on borrowings, interest accrued and due on borrowings, outstanding expenses,
unclaimed dividend, calls-in-advance, etc)
• (d) Short-term provisions
A liability shall be classified as current when it satisfies any of the following criteria:
• (a) It is expected to be settled in the company’s normal operating cycle;
• (b) It is held primarily for the purpose of being traded:
• (c) It is due to be settled within twelve months after the reporting date; or
• (d) The company does not have an unconditional right to defer settlement of the liability
for at least twelve months after the reporting date.
 LIQUIDITY RATIO (SHORT – TERM SOLVENCY)
(1) Current Ratio (Contd) :
Ideal ratio: 2:1
High ratio indicates better liquidity position. But a very high ratio indicates poor
operational efficiency - under trading and over capitalization [high investment in
trade receivables, poor collections, idle cash/bank balance, overstocking /
increased stock due to less sales etc]. Low ratio indicates over trading and under
capitalization.
Analysis & comments are not in syllabus. These are explained for better
Understanding of the ratios

ILLUSTRATION : ACCOUNTING RATIOS

Practice Sums : Let’s Do It……

 LIQUIDITY RATIO (SHORT – TERM SOLVENCY)
(2) Liquid Ratio / Quick Ratio / Acid Test Ratio :
It is a liquidity ratio which measures the ability of the enterprise to meet it
short – term financial obligations ,ie., Current Liabilities.
Liquid / Quick Ratio = Liquid / Quick Assets
Current Liabilities

Quick Assets = Current Assets – Inventory – Prepaid Expenses

Inventory cannot be converted to cash immediately ( it takes time) and prepaid expenses
are expenses paid in cash and thus cannot be converted to cash. It is thus that these two
items are removed from CA to arrive at quick assets.
Ideal Ratio : 1:1 is considered as best.
Liquid ratio is better indicator of liquidity of an entity when compared to current ratio. A
high liquid ratio when compared to current ratio may indicate understocking while a low
liquid ratio indicates overstocking.
 LIQUIDITY RATIO (SHORT – TERM SOLVENCY)
(2) Liquid Ratio / Quick Ratio / Acid Test
Ratio(Contd) :
Uses of Liquidity Ratios :
• The liquidity ratios are used to test the short term solvency or liquidity position of
the business. It enables to know whether short term liabilities can be paid out of
short term assets.
• It is a valuable aid to management in checking the efficiency with which working
capital is being employed.
• It is also of importance to shareholders and long term creditors in determining to
some extent the prospects of dividend and interest payment
 LIQUIDITY RATIO (SHORT – TERM SOLVENCY)
(2) Liquid Ratio / Quick Ratio / Acid Test
Ratio(Contd) :

ILLUSTRATION : ACCOUNTING RATIOS

Practice Sums : Let’s Do It……