Chapter 5 Accounting Ratios Solutions
Question - 1 : - What do you mean by Ratio Analysis?
Answer - 1 : -
It is a quantitative analysis of data present in a financial statement. It shows the relationship between items present in Balance sheet and the Income Statement. It helps in calculating operational efficiency, solvency and determining profitability of a firm. Ratio is a statistical measure which helps in comparing relationship between two or more figures. Analyzing ratio presents vital pieces of information to accounting users about the firm’s financial position, performance and viability. It also helps in setting up new policies and framework by the management.
Question - 2 : - What are the various types of ratios?
Answer - 2 : -
Ratios can be classified into two types:
1. Traditional Classification
2. Functional Classification
Traditional Classification: Traditional classification is based on the financial statements such as Balance Sheet and P & L Account. The ratios are divided on the basis of accounts of financial statements and are as follows:
i. Income Statement Ratios such as Gross Profit Ratios
ii. Balance Sheet Ratios such as Debt Equity Ratio, Current Ratio
iii. Composite Ratio: Ratios that contain elements from both Trading and P & L Account.
Functional Classification: These ratios are based on the functional need of calculating ratios. These ratio help calculate the solvency, liquidity, profitability and financial performance of a business. Such ratios are:
i. Liquidity Ratio: Ratios used to determine solvency of short term
ii. Solvency Ratio: Ratios used to determine solvency of long term
iii. Activity Ratio: Ratios used for determining operating efficiency of the business. These ratios are related to sales and cost of goods sold.
iv. Probability Ratio: Ratios used to determine financial performance and viability of the firm.
Question - 3 : - What relationships will be established to study:
a. Inventory Turnover
b. Trade Receivables Turnover
c. Trade Payables Turnover
d. Working Capital Turnover
Answer - 3 : -
a. Inventory Turnover Ratio: This ratio is a relationship between cost of goods sold and the average inventory maintained during a particular time period. It determines the efficiency with which a firm is able to manage its inventory.
b. Trade Receivables Turnover Ratio: Debtors turnover ratio is also known as Receivables Turnover Ratio is a measure used to check how quickly a credit sale is converted into cash. It shows efficiency of a business firm in collecting debts from customers.
c. Trade Payables Turnover Ratio: It is also known as Creditor’s turnover ratio or account payable turnover ratio and is a liquidity ratio that measures the average number of times a firm pays its creditors in the course of an accounting period. It is used to measure short term liquidity of the firm.
d. Working Capital Turnover Ratio: Working capital turnover ratio is used to measure the efficiency of a company in using its working capital to support the sales. It is a ratio where firms operations are funded and the corresponding revenue generated from business is calculated.
Question - 4 : - The liquidity of a business firm is measured by its ability to satisfy its long-term obligations as they become due. What are the ratios used for this purpose?
Answer - 4 : -
A firm’s liquidity is measured by its capability to pay long term dues. These dues include principal amount payment on due date and interest payment on regular basis. Long term solvency of a firm can be determined by the following ratios:
a. Debt-Equity Ratio: This ratio shows the relationship between owner funds (equity) and borrowed funds (debt). A lower debt-equity ratio provides more security to the people who are lending to the business. It also shows that a company is able to meet long term dues or responsibilities.
b. Total Assets to Debt Ratio- It is based on the relationship between total assets and long term loans. It shows what percentage of company’s total assets are financed by creditors. A higher total assets to debt ratio makes the firm able to meet long term requirements and provides more security to lenders.
c. Interest Coverage Ratio: This ratio is used to determine the easiness with which a company is able to pay interest on the outstanding debts. It is calculated by dividing earnings before interest and taxes with interest payments. Having a higher interest coverage ratio means that company is able to meet its obligations skilfully.
Question - 5 : - The average age of inventory is viewed as the average length of time inventory is held by the firm for which explain with reasons.
Answer - 5 : - Inventory Turnover Ratio: This ratio is a relationship between cost of goods sold and the average inventory maintained during a particular time period. It determines the efficiency with which a firm is able to manage its inventory.
Question - 6 : - What are liquidity ratios? Discuss the importance of current and liquid ratio.
Answer - 6 : -
For determining the short-term solvency of a business liquidity ratios are essential. There are two types of liquidity ratios:
1. Current Ratio
2. Liquid Ratio/ Quick Ratio
1. Current Ratio: This ratio deals with the relationship between current assets and liabilities. It is calculated as:
Current assets are those assets which can be easily converted into cash whereas Current liabilities are liabilities that need to paid within that accounting period
Importance of Current Ratio
Current ratio helps in determining a firm’s ability to pay off the current liabilities on time. If there is more of current assets as compared to current liabilities, it provides a source of security to the creditors. The ideal ratio is 2:1 (Current Assets: Current Liabilities)
2. Liquid Ratio– It deals with the relationship between liquid assets and current liabilities. This ratio determines if the firm has sufficient funds for paying off the current liabilities on an immediate basis. It can be calculated as:
Importance of Liquid Ratio
It is helpful in determining if a firm has funds that can be sufficient to pay off liabilities. It does not include stock or prepaid expenses as both these are not easily converted to cash. A ratio of 1:1 is ideal for maintaining the liquid ratio.
Question - 7 : - How would you study the solvency position of the firm?
Answer - 7 : -
A firm’s solvency position can be best studied with the help of group of ratios called as Solvency Ratios. These ratios measure the financial position of the firm by measuring its ability to pay long term liabilities, these long term liabilities include principal amount payments on due date and interest payments on a regular basis. Following ratios are used to determine long term solvency of a business.
1. Debt-Equity Ratio: This ratio shows the relationship between owner funds (equity) and borrowed funds (debt). A lower debt-equity ratio provides more security to the people who are lending to the business. It also shows that a company is able to meet long term dues or responsibilities.
2. Total Assets to Debt Ratio: It is based on the relationship between total assets and long term loans. It shows what percentage of company’s total assets are financed by creditors. A higher total assets to debt ratio makes the firm able to meet long term requirements and provides more security to lenders.
3. Interest Coverage Ratio: This ratio is used to determine the easiness with which a company is able to pay interest on the outstanding debts. It is calculated by dividing earnings before interest and taxes with interest payments. Having a higher interest coverage ratio means that company is able to meet its obligations skilfully.
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d. Proprietary Ratio– This ratio shows the relationship between Total Assets and Shareholders fund. It is helpful in revealing the financial position of a business. A higher ratio ensures a greater degree of security for creditors. It is shown as:
Question - 8 : - What are important profitability ratios? How are these worked out?
Answer - 8 : -
Profitability ratios are calculated on the basis of profit earned by a business. This ratio gives a percentage which is used to assess the financial condition of a business
1. Return on Assets: This ratio measures the earning per rupee from assets which are invested in the company. A higher profit ratio is good for the company.
Return on Assets = Net Profit ÷ Total Assets
2. Return on Equity: This ratio deals with measuring profitability of equity fund that is invested by the company. It also measures how owner’s funds are utilized profitably to generate company revenues. A high ratio represents the better position of a company.
Return on Equity = Profit after Tax ÷ Net worth
Where Net worth = Equity share capital, and Reserve and Surplus
3. Earnings per share: This ratio helps in measuring profitability from an ordinary shareholder’s viewpoint. A high ratio represents a well off company.
Earnings per share = Net Profit ÷ Total no of shares outstanding
4. Dividend per share: This ratio measures the amount of dividend that is distributed by the company to its shareholders at the end of an accounting period. A high ratio represents that the company is having surplus cash.
Dividend per share= Amount Distributed to Shareholders ÷ No of Shares outstanding
5. Price Earnings Ratio: A profitability ratio that is used by an investor to check for share price of the company which can be undervalued or overvalued. It also indicates an expectation about the company’s earning and payback period for the investors.
Price Earnings Ratio = Market Price of Share ÷ Earnings per share
6. Return on capital employed: This ratio is all about the returns earned by the company from the funds invested in the business by its owners. A high ratio is indicative of a better position for the company.
Return on capital employed = Net Operating Profit ÷ Capital Employed × 100
7. Gross Profit: Gross profit ratio or GP ratio is a profitability ratio that deals with the relationship between gross profit and the total net sales revenue. This ratio is used to evaluate the operational performance of the business.
8. Net Profit: This is a profitability ratio that deals with relationship between net profit after tax and net sales. It is calculated by dividing the net profit (after tax) by net sales.
Question - 9 : - 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 ratio is a preferred measure of overall liquidity. Explain.
Answer - 9 : -
Current Ratio: This ratio deals with the relationship between current assets and liabilities. It is calculated as:
Current assets are those assets which can be easily converted into cash whereas Current liabilities are liabilities that need to paid within that accounting period
Importance of Current Ratio
Current ratio helps in determining a firm’s ability to pay off the current liabilities on time. If there is more of current assets as compared to current liabilities, it provides a source of security to the creditors. The ideal ratio is 2:1 (Current Assets: Current Liabilities)
2. Liquid Ratio– It deals with the relationship between liquid assets and current liabilities. This ratio determines if the firm has sufficient funds for paying off the current liabilities on an immediate basis. It can be calculated as:
Importance of Liquid Ratio
It is helpful in determining if a firm has funds that can be sufficient to pay off liabilities. It does not include stock or prepaid expenses as both these are not easily converted to cash. A ratio of 1:1 is ideal for maintaining the liquid ratio.
Current ratio is best suited for businesses where the available stock or inventories cannot be converted to cash easily. Examples of such industries can be locomotive companies, heavy machinery manufacturing companies etc. as heavy machinery, tools which cannot be sold easily. Similarly, businesses that can easily convert or get sold off prefer the liquid ratio as a measure to determine their liquidity. A service company is more likely to use liquid ratio as no stock is maintained.
There will be some instances when companies tend to change the ratio method being used and chose accordingly. If a company is not maintaining any stock or inventory, liquid ratio is the best option, while if stock forms the majority of the company’s assets then current ratio is the best choice as the liquid ratio of such a firm will be very low and that can create a negative impact on creditors. In such case, current ratio is a better choice to determine the overall liquidity.
Question - 10 : - Following is the Balance Sheet of Title Machine Ltd. as at March 31, 2017. | Particulars | Amount ₹. |
| I. Equity and Liabilities | |
| 1. Shareholders’ funds | |
| a) Share capital | 24,00,000 |
| b) Reserves and surplus | 6,00,000 |
| 2. Non-current liabilities | |
| a) Long-term borrowings | 9,00,000 |
| 3. Current liabilities | |
| a) Short-term borrowings | 6,00,000 |
| b) Trade payables | 23,40,000 |
| c) Short-term provisions | 60,000 |
| Total | 69,00,000 |
| II. Assets | |
| 1. Non-current Assets | |
| a) Fixed assets | |
| Tangible assets | 45,00,000 |
| 2. Current Assets | |
| a) Inventories | 12,00,000 |
| b) Trade receivables | 9,00,000 |
| c) Cash and cash equivalents | 2,28,000 |
| d) Short-term loans and advances | 72,000 |
| Total | 69,00,000 |
| | |
Answer - 10 : -
Calculate Current Ratio and Liquid Ratio.
1. Current Ratio
Current Assets = Inventories +Trade Receivables + Cash + Short term Loans and Advances
= 12, 00,000 + 9, 00,000 + 2, 28,000 + 72,000
= ₹ 24, 00,000
Current Liabilities = Trade Payables + Short-term Borrowings + Short-term Provisions
= 23, 40,000 + 6, 00,000 + 60,000
= ₹ 30, 00,000
2. Quick Ratio
Quick Assets = Trade Receivables + Cash + Short term Loans and Advances
= 9, 00,000 + 2, 28,000 + 72,000
= ₹ 12, 00,000