Accounting Ratios Class 12

Accounting ratios class 12 is an important part of the accountancy class 12 syllabus. Accounts form an integral part of the class 12 commerce stream. Therefore, you need to prepare well and be thorough with your notes. To make it easier for you, we have here notes on the chapter accounting ratios class 12. Read on to know more about this chapter!

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Ratio

Let us first look at meaning and definition of ratio.

• Ratio is an arithmetical relationship between two interdependent or related items.

Meaning of Accounting Ratio 

The chapter on accounting ratios class 12 describes the meaning of accounting ratio and its characteristics. They are mentioned below.

• Calculated on the basis of accounting information
• Expressed as an arithmetical relationship between two accounting variables.
• Relationship that exists between figures shown in a Balance Sheet, Statement of Profit and Loss or any other statements or reports.

Forms of expressing Ratios

There are several forms of expressing ratios as per the chapter on accounting ratios class 12. Let’s have a look:

• Pure : Ratios are expressed as quotient
• Percentage: Ratios are expressed as percentage
• Times : Ratios are expressed in number of times
• Fraction : Ratios are expressed in fraction

Meaning of Ratio Analysis

Since the chapter itself is about accounting ratios class 12, we must also find out the meaning of ratio analysis. The characteristic features of ratio analysis are mentioned below:

• It studies the various financial factors in a business.
• It analyses financial statements using accounting ratios.
• It helps determine and interpret relationships between items of financial statements and provides a meaningful understanding of the position and performance of an enterprise.

Objectives of Ratio Analysis

As per the chapter on accounting ratios class 23, there are several objectives of ratio analysis. They are mentioned below:

• Helps simplify the understanding of financial information.
• helps determine short-term and long-term solvency of the business.
• helps assess the operating efficiency of the business.
• Helps analyse profitability of the business.
• Assists with comparative analysis which can be either intra-firm or inter firm comparisons.

Advantages of Ratio Analysis

According the chapter on accounting ratios class 12, there are many advantages of ratio analysis. Let’s have a look:

• It is an essential tool for analysis of Financial Statements.
• It simplifies the information on the accounting data.
• It assists in business planning and forecasting
• It helps identify and interpret the favourable and unfavourable ratios which can be used to identify the weak areas in the enterprise.
• It facilitates Inter-firm and Intra-firm Comparison.

Limitations of Ratio Analysis

There are also certain limitations of ratio analysis and they find mention in the chapter on accounting ratios class 12. They are:

• If the information available is not correct, then that could hamper the reliability of the ratios.
• The ratios take into account only the quantitative factors, ignoring qualitative factors, which might also be very important.
• There is no single standard against which the ratio can be compared to determine the outcome.
• Preparation of financial statements involves personal judgments, therefore accounting ratios computed based on such information can be susceptible to personal bias.

Types of Ratios

Moving further in the chapter on accounting ratios class 12, we examine the types of ratios. The types of ratios are the following:

1. Liquidity (short-term solvency): Ratios show the ability of the enterprise to meet its short-term financial obligations. It includes:

a.Current Ratio
b. Quick Ratio

2. Solvency (long-term solvency): Ratios that assess the long-term financial position of the enterprise. It includes:

a.Debt to Equity Ratio
b.Total Assets to Debt Ratio
c. Proprietary Ratio
d. Interest Coverage Ratio

3. Activity/Turnover: Ratios that show how efficiently the enterprise resources are being used for business operations. It includes:

a.Inventory Turnover Ratio
b.Trade Receivables Turnover Ratio
c. Trade Payables Turnover Ratio
d. Working Capital Turnover Ratio

4. Profitability: These ratios display the profitability of the enterprise. It includes:

a.Gross Profit Ratio
b. Operating Ratio
c. Operating Profit Ratio
d. Net Profit Ratio
e. Return on Investment

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Understanding Current Ratio

The chapter on accounting ratios class 12 describes the importance and features of current ratio. Let us look at the important features of the current ratio.

• It calculates the relationship between the current assets and current liabilities and measures calculate the relationship between the current assets and current liabilities.

Steps to be taken to determine the effect of a transaction on Current Ratio

Step 1: Amounts of Current Assets and Current Liabilities are to be assumed.
Step 2: Consider the effects of a transaction and put it in the assumed amounts of Current Assets and Current Liabilities. After accommodating such effect in the assumed amounts, new amounts of Current Assets and Current Liabilities are to be calculated.
Step 3: Using these new amounts, a new ratio is to be calculated. Such a new/revised ratio is to be compared with the old ratio to determine its effect on the Current Ratio, i.e., increase, decrease or no change in the ratio.

Understanding Liquid or Quick or Acid Test Ratio

The chapter on accounting ratios class 12 describes the importance of understanding liquid or quick or acid test ratio.

• It is a liquidity ratio that measures the enterprise’s ability to meet its short-term financial obligations, i.e., Current Liabilities, and indicates the short-term debt-paying capacity of an enterprise and is, therefore, a better indicator of liquidity.

Understanding Debt-to Equity Ratio

There are several features of debt-to equity ratio. They find mention in the chapter on accounting ratios class 12. It is mentioned below:

• It is a relationship between long-term external equities, i.e., external debts (includes long-term borrowings and long-term provisions) and internal equities (Shareholders’ Funds) of the enterprise.
• It measures the proportion of external funds and shareholders invested in the company.
• It assesses the enterprise’s long-term financial soundness and indicates the extent to which the enterprise depends on borrowed funds for its business.
• It is expressed as a Pure Ratio.

Meaning and Computation of Total Assets to Debt Ratio

According to the chapter on accounting ratios class 12, it is important to understand the meaning and computation of total assets to debt ratio. The essential features of the same are mentioned below:

• It is a relationship between total assets and long-term debts of the enterprise.
• It measures the extent to which debt (Long-term) is covered by the assets.
• It measures the ‘Safety Margin’ available to the lenders of the long-term debts.
• A higher ratio means higher safety for lenders and a lower ratio means lower safety for lenders.
• It is expressed as a Pure Ratio

Understanding Proprietary Ratio

Let’s move further in the chapter on accounting ratios class 12 and understand the features of proprietary ratio.

• It is a relationship between the proprietor’s fund and total assets.
• It shows the financial strength of the entity.
• It is used to find the proportion of total assets financed by Proprietors’ Funds.
• It is an important ratio for the creditors. It helps them identify the portion of shareholders’ funds in the total assets employed in the firm and the safety margin available to them.
• A very high ratio indicates an improper mix of proprietors’ funds and loan funds that result in a lower return on investment. A higher ratio means adequate safety for creditors and lenders. On the other hand, a lower ratio means inadequate safety for creditors and lenders.
• It can be expressed either as ‘Pure Ratio’ or a ‘Percentage Ratio’.

Meaning and Computation of Interest Coverage Ratio

Mentioned below is the meaning and computation of interest coverage ratio as per the chapter on accounting ratios class 12.

• It is a relationship between Net Profit before Interest and Tax and Interest on Long Term Debts.
• It is calculated to ascertain the amount of profit available to cover the interest on long term debts.
• A higher Interest Coverage Ratio is considered better for lenders as it signifies a higher margin to meet interest cost.

Meaning and Computation of Inventory Turnover Ratio

As per the chapter on accounting ratios class 12, there are many features of inventory turnover ratio. Its features are mentioned below:

• It is a relationship between Cost of Revenue from Operations, i.e., Cost of Goods Sold and average inventory carried during that period.
• It ascertains whether the stock investment is appropriate and that only the required amount is invested in the stock.
• It measures the number of times an enterprise sells and replaces its inventory. Therefore, it is an activity and efficiency ratio that measures the efficiency of inventory management.
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• A high ratio shows that more sales are being produced by a rupee of investment in the inventories. A very high ratio indicates overtrading, which may result in a working capital shortage. Only an optimum Inventory Turnover Ratio ensures adequate working capital and helps firms earn a reasonable margin.

Understanding Trade Receivables Turnover Ratio 

The trade receivables ratio is an integral part of the chapter on accounting ratios class 12. Its features are mentioned below:

• The relationship between Credit Revenue from Operations (i.e., Net Credit Sales) and Average Trade Receivables (i.e., Average of debtors and bills receivable of the year).
• It indicates the number of times trade receivables are turned over in a year about credit sales.
• It identifies how quickly trade receivables are converted into Cash and Cash Equivalents and, therefore, indicates the efficiency in collecting amounts due against trade receivables.
• A higher ratio shows that debts are collected more promptly, and a lower ratio shows inefficiency in the collection or increased credit period or more investment in debtors.
• It should be computed that provision for doubtful debts is not deducted from trade receivables since the purpose is to calculate the number of days for which sales are tied up in trade receivables and not to ascertain the realizable value of debtors.

Understanding Trade Payables Turnover Ratio

Moving further in the chapter on accounting ratios class 12, we look at the trade psyables turnover ratio.

• It is a relationship between the net credit purchases and total payables or average payables.
• It identifies the number of times the creditors are turned over in relation to credit purchases.
• A high ratio indicates that the enterprise is not availing a full credit period, which boosts up the credit worthiness of the enterprise.It is expressed in Times.

Meaning of Working Capital Turnover Ratio

We now look at the meaning and characteristics of working capital turnover ratio as mentioned in the chapter on accounting ratios class 12.

• It is a relationship between working capital and revenue from operations.
• It shows the number of times a unit of Rupee invested in working capital produces sales.
• It helps to ascertain whether or not working capital has been effectively used in generating revenue.
• A higher ratio is considered as an ideal ratio, whereas a very high ratio indicates overtrading.

Understanding Gross Profit Ratio

As per the chapter on accounting ratios class 12, we move further to understand gross profit ratio.

• It is a relationship between the Gross Profit and Revenue from Operations (i.e., Net Sales).
• A change either in Revenue from Operations (i.e., Net Sales) or Cost of Revenue from Operations (i.e., Cost of goods sold) or both will have an impact on this ratio.
• It shows the average margin on goods sold.
• It determines the efficiency with which production and/or purchase operations and selling operations are carried on.
• It is a reliable guide for fixing selling prices.
• It is useful in determining the efficiency of trading activities.
• It can be compared with the ratio of earlier years or with that of other firms to compare the efficiency and growth of the business.

Understanding Operating Profit Ratio

The salient features of operating profit ratio and its meaning are mentioned below as per the chapter on accounting ratios lass 12.

• It is the relationship between Operating Profit and Revenue from Operations i.e., Net Sales.
• It determines the operational efficiency of the business.
• An increase in the ratio shows improvement in the operational efficiency of the entity.

Net Profit Ratio

Moving further in the chapter on accounting ratios class 12, we find out the meaning and features of net profit ratio. They are mentioned below:

• It is a relationship between Net Profit and Revenue from Operations, i.e., Net Sales.
• It helps in determining the operational efficiency of the business.
• It indicates the business’s actual status, as the higher the Net Profit Ratio, the better the business.
• An increase in the ratio over the past period shows improvement in operational efficiency.
• A decline in the ratio over the past period shows a fall in operational efficiency.
• It facilitates comparison of operation efficiency with that of industry standards.

Meaning and Computation of Net Profit Ratio

There is a method of computation of net profit ratio as mentioned in the chapter on accounting ratios class 12.

• It is a relationship between Net Profit and Revenue from Operations, i.e., Net Sales.
• It helps in determining the operational efficiency of the business.
• It indicates the business’s actual status, as the higher the Net Profit Ratio, the better the business. An increase in the ratio over the past period shows improvement in operational efficiency. A decline in the ratio over the past period shows a fall in operational efficiency.
• It facilitates comparison of operation efficiency with that of industry standards.

Return on Capital Employment and Investment

Last but not the least the chapter on accounting ratios class 12 ends with describing the return on capital employment and investment.

• It shows the relationship between Net Profit/Earnings before interest and tax with capital employed.
• It measures how efficiently the resources of the business are being used.
• It is a fair measure of the profitability of any concern with the result that the performance of different industries can be compared.
• It indicates whether the company or business is giving satisfactory returns.
• It assesses the overall performance of the enterprise.

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