Chapter 5 — Accounting Ratios

CBSE Class 12 Accountancy Chapter 5 covers Accounting Ratios, an important tool of financial statement analysis. It explains the meaning, objectives, advantages, and limitations of ratio analysis, and covers liquidity, solvency, activity, and profitability ratios with their formulae and significance.

Accounting ratios are mathematical numbers expressing the relationship between two accounting figures derived from financial statements, and can be expressed as a fraction, proportion, percentage, or number of times. Chapter 5 of CBSE Class 12 Accountancy Part II explains that ratio analysis helps assess profitability, liquidity, solvency, and efficiency of a business, and enables intra-firm and inter-firm comparisons, SWOT analysis, and future projections. Ratios are classified functionally into four types: liquidity ratios (current ratio and quick/liquid ratio) measure short-term solvency; solvency ratios (debt-equity, proprietary, total assets to debt, and interest coverage) assess long-term debt-servicing capacity; activity or turnover ratios (inventory, trade receivables, trade payables, working capital, and fixed assets turnover) measure efficiency of resource utilisation; and profitability ratios (gross profit, operating, net profit, return on investment, EPS, book value per share, dividend payout, and P/E ratio) analyse earning capacity.

1. 01A ratio is a mathematical number expressing the relationship between two accounting numbers from financial statements; it can be expressed as a fraction, proportion, percentage, or number of times.
2. 02Ratio analysis serves key objectives: identifying problem and bright areas of the business, providing deeper analysis of profitability, liquidity, solvency and efficiency, enabling cross-sectional comparisons with industry standards, and supporting projections and estimates for the future.
3. 03Liquidity ratios measure short-term solvency: Current Ratio = Current Assets / Current Liabilities (safe range 2:1); Quick (Acid-Test) Ratio = Quick Assets / Current Liabilities (safe range 1:1), where quick assets exclude inventories and prepaid expenses.
4. 04Solvency ratios measure long-term debt-servicing capacity and include Debt-Equity Ratio = Long-term Debts / Shareholders' Funds (safe ratio 2:1), Proprietary Ratio = Shareholders' Funds / Capital Employed, Total Assets to Debt Ratio = Total Assets / Long-term Debts, and Interest Coverage Ratio = Net Profit before Interest and Tax / Interest on Long-term Debts.
5. 05Activity (Turnover) Ratios measure efficiency of resource utilisation: Inventory Turnover = Cost of Revenue from Operations / Average Inventory; Trade Receivables Turnover = Net Credit Revenue from Operations / Average Trade Receivable; Trade Payables Turnover = Net Credit Purchases / Average Trade Payable; Fixed Assets Turnover = Net Revenue from Operations / Net Fixed Assets; Working Capital Turnover = Net Revenue from Operations / Working Capital.
6. 06Profitability Ratios analyse earning capacity: Gross Profit Ratio = Gross Profit / Net Revenue from Operations × 100; Net Profit Ratio = Net Profit / Revenue from Operations × 100; Return on Investment = Profit before Interest and Tax / Capital Employed × 100; Return on Shareholders' Funds = Profit after Tax / Shareholders' Funds × 100; EPS = Profit available for equity shareholders / Number of Equity Shares; P/E Ratio = Market Price of a Share / Earnings per Share.
7. 07Key limitations of ratio analysis include dependence on the quality of underlying accounting data, ignoring price-level changes and qualitative or non-monetary factors, variations in accounting practices across enterprises, lack of standardised definitions for concepts such as liquid liabilities, and the absence of universally accepted standard levels for ideal ratios.