Learning Objectives

After completing this chapter, students will be able to:

• Explain the meaning, objectives, and limitations of accounting ratios.
• Identify the different types of ratios commonly used for financial analysis.
• Calculate various Liquidity, Solvency, Activity, and Profitability ratios.
• Interpret the computed ratios to comment on a company's financial performance and position.
• Apply ratio analysis to solve practical problems and case studies.

Key Concepts, Definitions, and Formulas

This chapter is all about formulas! Here’s a quick-reference guide.

1. Liquidity Ratios

(Measure the firm's ability to meet its short-term obligations)

• Current Ratio: Measures the relationship between Current Assets and Current Liabilities.
  • Formula: \( \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} \)
  • Ideal Ratio: 2:1
• Quick Ratio (or Liquid Ratio / Acid-Test Ratio): Measures the relationship between Quick Assets and Current Liabilities.
  • Formula: \( \text{Quick Ratio} = \frac{\text{Quick Assets}}{\text{Current Liabilities}} \)
  • Quick Assets = Current Assets – Inventories – Prepaid Expenses
  • Ideal Ratio: 1:1

2. Solvency Ratios

(Measure the firm's ability to meet its long-term obligations)

• Debt-to-Equity Ratio: Shows the relationship between long-term debt and shareholders' equity.
  • Formula: \( \text{Debt-to-Equity Ratio} = \frac{\text{Debt (Long-term)}}{\text{Equity (Shareholders' Funds)}} \)
• Total Assets to Debt Ratio: Measures the extent to which assets are financed by debt.
  • Formula: \( \text{Total Assets to Debt Ratio} = \frac{\text{Total Assets}}{\text{Debt (Long-term)}} \)
• Proprietary Ratio: Shows the proportion of total assets financed by proprietors' funds.
  • Formula: \( \text{Proprietary Ratio} = \frac{\text{Proprietors' Funds}}{\text{Total Assets}} \)
• Interest Coverage Ratio: Measures the firm's ability to meet its interest payments.
  • Formula: \( \text{Interest Coverage Ratio} = \frac{\text{Net Profit before Interest and Tax}}{\text{Interest on Long-term Debt}} \)

3. Activity (or Turnover) Ratios

(Measure how efficiently a company is using its assets)

• Inventory Turnover Ratio: Shows how many times inventory is converted into sales.
  • Formula: \( \text{Inventory Turnover Ratio} = \frac{\text{Cost of Revenue from Operations}}{\text{Average Inventory}} \)
  • Average Inventory = (Opening Inventory + Closing Inventory) / 2
• Trade Receivables Turnover Ratio: Indicates the efficiency in collecting cash from debtors.
  • Formula: \( \text{Trade Receivables Turnover Ratio} = \frac{\text{Credit Revenue from Operations}}{\text{Average Trade Receivables}} \)
• Trade Payables Turnover Ratio: Shows how quickly a company pays its creditors.
  • Formula: \( \text{Trade Payables Turnover Ratio} = \frac{\text{Net Credit Purchases}}{\text{Average Trade Payables}} \)
• Working Capital Turnover Ratio: Shows the efficiency in using working capital.
  • Formula: \( \text{Working Capital Turnover Ratio} = \frac{\text{Revenue from Operations}}{\text{Working Capital}} \)
  • Working Capital = Current Assets - Current Liabilities

4. Profitability Ratios

(Measure the profitability of the business)

• Gross Profit Ratio: Shows the margin of profit on sales.
  • Formula: \( \text{Gross Profit Ratio} = \frac{\text{Gross Profit}}{\text{Revenue from Operations}} \times 100 \)
• Operating Ratio: Measures the proportion of cost of operations to revenue.
  • Formula: \( \text{Operating Ratio} = \frac{\text{(Cost of Revenue from Operations + Operating Expenses)}}{\text{Revenue from Operations}} \times 100 \)
• Operating Profit Ratio: Shows the operational efficiency of the business.
  • Formula: \( \text{Operating Profit Ratio} = \frac{\text{Operating Profit}}{\text{Revenue from Operations}} \times 100 \)
  • Note: Operating Ratio + Operating Profit Ratio = 100%
• Net Profit Ratio: Measures the overall profitability.
  • Formula: \( \text{Net Profit Ratio} = \frac{\text{Net Profit after Tax}}{\text{Revenue from Operations}} \times 100 \)
• Return on Investment (ROI) or Return on Capital Employed: Measures the overall profitability of the capital invested.
  • Formula: \( \text{ROI} = \frac{\text{(Net Profit before Interest, Tax, and Dividend)}}{\text{Capital Employed}} \times 100 \)
  • Capital Employed = Shareholders' Funds + Non-Current Liabilities

Full NCERT Solutions for Class 12 Accountancy Chapter 5

Here are the step-by-step solutions for all the practical and theoretical questions from your NCERT textbook. (Note: The number of questions and their specific values can vary slightly between NCERT editions. The following solutions are representative of the types of questions found in the chapter.)

NCERT Short Answer Questions

NCERT Practical Problems

Extra Important Questions (CBSE Board Style 2026-27)

Here are some practice questions to test your understanding.

Multiple Choice Questions (MCQs)

Short Answer Questions

Long Answer Questions

Case-Based Question

Common Mistakes Students Make

• Formula Errors: Mixing up formulas, like using Revenue from Operations instead of Cost of Revenue from Operations for Inventory Turnover Ratio.
• Component Misidentification: Incorrectly classifying items as Current/Non-Current Assets or Liabilities (e.g., treating Bank Overdraft as a Current Asset).
• Ignoring "On Cost" vs. "On Sales": Not being careful when Gross Profit is given as a percentage of cost versus a percentage of sales.
• Forgetting Units: Not writing "Times" for Turnover Ratios, "%" for Profitability Ratios, or the pure ratio format (e.g., 2:1) for others.
• No Interpretation: Just calculating the ratio and not writing a one-line comment on what it signifies, especially when asked.
• Calculation Mistakes: Simple arithmetic errors under exam pressure. Double-check your calculations!

Exam Preparation Tips

• Create a Formula Chart: Make a chart with all the ratios, their formulas, and their objectives. Stick it where you can see it daily.
• Master the Components: Be crystal clear about what items constitute Current Assets, Current Liabilities, Shareholders' Funds, Capital Employed, etc.
• Practice One Category at a Time: First, master all Liquidity ratios, then move to Solvency, and so on. This builds confidence.
• Focus on Adjustments: Practice questions with missing figures or complex adjustments, as these are frequently asked in board exams.
• Solve PYQs: Solving Past Year Questions for Accounting Ratios is the best way to understand the exam pattern and important topics.
• Time Management: Time yourself while solving problems. Aim to solve a 6-mark question within 10-12 minutes.

Frequently Asked Questions (FAQs)

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