Samacheer Kalvi Class 12 Accountancy Solutions Chapter 9 Ratio Analysis

I Multiple Choice Questions

Choose The Correct Answer

 

Question 1. The mathematical expression that provides a measure of the relationship between two numbers is called
(a) Conclusion
(b) Ratio
(c) Model
(d) Decision
Answer: (b) Ratio
In simple words: A ratio is a mathematical way to compare two numbers, showing how many times one number contains or is contained within the other. It helps to understand their relationship.

🎯 Exam Tip: Remember that a ratio simply compares quantities, while other options like conclusion, model, or decision relate to the outcome or representation of an analysis.

 

Question 2. Current ratio indicates
(a) Ability to meet short term obligations
(b) Efficiency of management
(c) Profitability
(d) Long term solvency
Answer: (a) Ability to meet short term obligations
In simple words: The current ratio tells a business if it has enough quick money (assets) to pay off its short-term debts. It shows how easily a company can handle its immediate financial commitments.

🎯 Exam Tip: The current ratio is a key indicator of short-term liquidity, focusing on assets and liabilities due within one year.

 

Question 3. Current assets excluding inventory and prepaid expenses is called
(a) Reserves
(b) Tangible assets
(c) Funds
(d) Quick assets
Answer: (d) Quick assets
In simple words: Quick assets are like cash or things that can quickly turn into cash, excluding items like inventory (which takes time to sell) and prepaid expenses (which are already paid). These are the assets most readily available to pay immediate debts.

🎯 Exam Tip: Quick assets are crucial for calculating the quick ratio (acid-test ratio), which measures a company's ability to pay off current liabilities without relying on inventory sales.

 

Question 4. Debt equity ratio is measure of
(a) Efficiency
(b) Long term solvency
(c) Profitability
(d) Efficiency
Answer: (b) Long term solvency
In simple words: The debt-equity ratio helps to see if a company can pay back its long-term debts. It compares how much money the company owes to how much it has from its owners, showing its financial strength over a long time.

🎯 Exam Tip: A lower debt-equity ratio generally indicates a more stable company as it relies less on external borrowing to fund its operations.

 

Question 5. Which of the following is not a tool of financial statement analysis?

Codes:

Answer: (a) (i) – 1,(ii) – 4,(iii) – 3,(iv) – 2
In simple words: This answer correctly matches each ratio in List I with what it indicates in List II. Current ratio shows how liquid a company is, Net profit ratio shows profitability, Debt-equity ratio shows long-term solvency, and Inventory turnover ratio shows efficiency.

🎯 Exam Tip: Understand the primary purpose of each ratio to correctly link it to its corresponding financial aspect (liquidity, profitability, solvency, efficiency).

 

Question 6. To test the liquidity of a concern, which of the following ratios are useful?
(i) Quick ratio
(ii) Net Profit ratio
(iii) Debt – equity ratio
(d) Current ratio
Select the correct answer using the codes given below:
(a) (i) and (ii)
(b) (i) and (iv)
Answer: (b) (i) and (iv)
In simple words: To check how easily a business can pay its immediate bills, we look at the Quick ratio and the Current ratio. Both these ratios measure how quickly assets can turn into cash to cover short-term debts.

🎯 Exam Tip: Liquidity ratios specifically measure a company's ability to meet its short-term obligations; Net Profit ratio relates to profitability, and Debt-equity ratio to long-term solvency.

 

Question 7. Proportion of share holders' funds to total assets is called
(a) Proprietary ratio
(b) Capital gearing ratio
(c) Debt equity ratio
(d) Current ratio
Answer: (a) Proprietary ratio
In simple words: The proprietary ratio tells us what part of a company's total assets is owned by its shareholders. It shows how much the owners have invested compared to the company's total possessions.

🎯 Exam Tip: The proprietary ratio indicates the financial strength of a company by showing the proportion of total assets financed by shareholders' funds, suggesting long-term solvency.

 

Question 8. Which one of the following is not correctly matched?
(a) Liquid ratio – Proportion
(b) Gross profit ratio – Percentage
(c) Fixed assets turnover ratio – Percentage
(d) Debt – equity ratio – Proportion
Answer: (c) Fixed assets turnover ratio – Percentage
In simple words: The fixed assets turnover ratio tells us how well a company uses its fixed assets to make sales. This ratio is usually shown in 'times' (like 2 times, 3 times), not as a percentage, making this option the incorrect match.

🎯 Exam Tip: Differentiate between ratios expressed as a proportion (e.g., Liquid ratio, Debt-equity ratio) and those expressed as a percentage (e.g., Gross profit ratio) or in 'times' (e.g., Turnover ratios).

 

Question 9. Current liabilities Rs. 40,000; Current assets Rs. 1,00,000; Inventory Rs. 20,000. Quick ratio is
(a) 1:1
(b) 2,5:1
(d) 1:2
Answer: (c) 2:1
In simple words: To find the quick ratio, first find quick assets by taking current assets and removing inventory. Then, divide these quick assets by current liabilities. This shows how well a company can pay immediate debts without selling its stock.

🎯 Exam Tip: Remember the quick ratio formula: Quick Assets / Current Liabilities, where Quick Assets = Current Assets - Inventory - Prepaid Expenses.

 

Question 10. Cost of revenue from operation 3,00,000; Inventory at the beginning of the year 60,000; Inventory at the close of the year 40,000. Inventory turnover ratio is.
(a) 2 times
(b) 3 times
(c) 6 times
(d) 8 times
Answer: (c) 6 times
In simple words: First, calculate the average inventory by adding beginning and ending inventory and dividing by two. Then, divide the cost of goods sold by this average inventory to find how many times the inventory was sold during the year. This shows how efficiently a company manages its stock.

🎯 Exam Tip: The inventory turnover ratio (Cost of Goods Sold / Average Inventory) indicates how many times a company has sold and replaced inventory during a period, showing inventory management efficiency.

II Very Short Answer Questions

 

Question 1. What is meant by accounting ratios?
Answer: Accounting ratios show how two related financial numbers are connected. They are found by dividing one accounting item by another related item. These ratios help us understand a company's financial health, like a quick snapshot of its numbers. For example, the current ratio tells us about short-term financial strength.
In simple words: Accounting ratios are mathematical ways to compare two numbers from a company's accounts to see how they relate to each other.

🎯 Exam Tip: Define accounting ratios as mathematical expressions that show the relationship between two related accounting items, used for financial analysis.

 

Question 2. What is the quick ratio?
Answer: The quick ratio compares a company's quick assets to its current liabilities. It tells if the business can pay off its immediate debts using assets that are easily turned into cash, like cash or accounts receivable, without needing to sell its inventory. A higher ratio often means better short-term financial health.
In simple words: The quick ratio shows if a business has enough easy-to-get cash (quick assets) to pay its immediate bills (current liabilities).

🎯 Exam Tip: Emphasize that the quick ratio (also called the acid-test ratio) specifically excludes inventory and prepaid expenses from current assets, making it a stricter measure of liquidity.

 

Question 3. What is meant by debt-equity ratio?
Answer: The debt-equity ratio helps us check how well a business can pay its long-term debts. It compares the amount of long-term debt a company has to the money provided by its shareholders. A lower ratio generally means the company is less risky because it relies more on owner funds than borrowed money. It is a key measure of long-term financial stability.
In simple words: The debt-equity ratio compares a company's long-term debts to its owners' money, showing if it can pay off its debts over time.

🎯 Exam Tip: Explain that the debt-equity ratio indicates the proportion of debt and equity used to finance a company's assets, highlighting its long-term solvency.

 

Question 4. What does the return on investment ratio indicate?
Answer: The return on investment (ROI) ratio shows how much profit a company makes compared to the money invested in it. Specifically, it compares net profit before interest and tax to the total capital used (shareholders' funds plus long-term debts). This ratio measures how well the company uses its capital to generate profits, making it a good indicator of overall profitability. A higher ROI means the business is more efficient in using its invested capital.
In simple words: The return on investment ratio shows how much profit a company makes from the money put into the business.

🎯 Exam Tip: Focus on ROI as a measure of overall business profitability and efficiency in utilizing capital employed (both equity and long-term debt).

 

Question 5. Statement any two limitations of ratio analysis.
Answer: Ratio analysis has some limitations. First, ratios are just tools; they don't give a complete picture on their own and need expert interpretation. Second, they might not show accurate current values because they are based on old (historical) financial data, which can be affected by changes in price levels over time. It's important to remember that ratios only provide a snapshot and don't reflect all real-world complexities.
In simple words: Ratios are only tools and need experts to understand them fully. Also, they use old information, so they might not show today's true values, especially if prices have changed.

🎯 Exam Tip: When discussing limitations, highlight the reliance on historical data and the need for qualitative analysis, as ratios alone can be misleading.

III Short Answer Questions

 

Question 1. Explain the objectives of ratio analysis.
Answer: Ratio analysis aims to achieve several goals. It helps to simplify large accounting numbers, making financial statements easier to understand. It also assists in analyzing these statements, providing insights into a business's operational efficiency. By comparing ratios over time or with other businesses, managers can make better decisions, ensuring the business performs well. This helps identify strengths and weaknesses.
In simple words: Ratio analysis helps make big financial numbers simple, easily check financial statements, and understand how well a business is working.

🎯 Exam Tip: List key objectives such as simplifying financial data, facilitating analysis, evaluating operational efficiency, and aiding management decision-making.

 

Question 2. What is the inventory conversion period? How is it calculated?
Answer: The inventory conversion period is the time it takes for a company to sell its inventory. A shorter period means the company is more efficient at managing its stock. It is calculated by dividing the number of days or months in a year by the inventory turnover ratio. This tells us, on average, how many days inventory stays in stock before being sold.
Inventory conversion period (in days) \( = \frac{\text{Number of days in a year}}{\text{Inventory turnover ratio}} \)
Inventory conversion period (in months) \( = \frac{\text{Number of months in a year}}{\text{Inventory turnover ratio}} \)
In simple words: It is the time a company takes to sell all its stock. You find it by dividing the days or months in a year by how many times inventory is sold (inventory turnover ratio).

🎯 Exam Tip: Clearly state the definition and the formula for calculating the inventory conversion period in both days and months.

 

Question 3. How is operating profit ascertained?
Answer: Operating profit is figured out by taking the revenue from a company's main operations and subtracting its operating costs. Operating costs include the cost of goods sold (purchases, changes in inventory, and direct expenses) and operating expenses (like administrative, selling, and distribution costs). This profit shows how well the core business activities are doing before considering taxes or interest. It reflects the profitability of a company's main business.
Operating profit = Revenue from operations – Operating cost
Cost of revenue from operations = Purchases of stock – in – trade + Change in inventories of stock in trade + Direct expenses.
Operating expenses = Administrative expenses + Selling and distribution expenses.
Operating cost = Cost of revenue from operations + Operating expenses.
In simple words: Operating profit is found by taking the money a company makes from its main work and subtracting all the costs to run that main work.

🎯 Exam Tip: Remember that operating profit focuses solely on a company's core business activities, excluding non-operating income, expenses, interest, and taxes.

 

Question 4. State any three advantages of ratio analysis.
Answer: Ratio analysis offers several advantages. First, it helps measure a company's operational efficiency by comparing its costs and revenues, showing how well it uses its resources. Second, it allows for intra-firm comparison, meaning different parts of the same company can compare their efficiency using relevant ratios. Third, inter-firm comparison is possible, enabling a company to see how its performance stacks up against other businesses in the same industry. This helps in identifying areas for improvement.
In simple words: Ratio analysis helps check how well a business is run, compare different parts of the same company, and see how it performs against other companies.

🎯 Exam Tip: When listing advantages, clearly distinguish between measuring efficiency, internal comparisons (intra-firm), and external comparisons (inter-firm).

 

Question 5. Bring out the limitations of ratio analysis:
Answer: Ratio analysis has some limitations. One is that for comparisons to be useful, financial statements must be prepared consistently. Another is the lack of universal standards or norms for many ratios, making comparisons difficult if accepted benchmarks are unavailable. Finally, ratio analysis might not reflect current values or price level changes because it is based on historical data from financial statements, which can become outdated. This means ratios are only as good as the information they are based on.
In simple words: Ratios are limited because financial data must be consistent to compare, there aren't always set rules for comparison, and they use old data, not current prices.

🎯 Exam Tip: Focus on the issues of data consistency, the absence of standardized benchmarks, and the impact of inflation or price level changes on historical data.

IV Exercises

Liquidity Ratios

 

Question 1. Calculate the current ratio from the following information.

Answer:
To calculate the current ratio, we first need to find the total current assets and total current liabilities from the given information.
Current Assets = Current Investments + Inventories + Trade Debtors + Bills Receivable + Cash & Cash equivalents
= 40,000 + 2,00,000 + 1,20,000 + 80,000 + 10,000
= Rs. 4,50,000

Current Liabilities = Trade Creditors + Bills Payable + Expenses Payable
= 80,000 + 50,000 + 20,000
= Rs. 1,50,000

Now, we can calculate the Current Ratio:
Current Ratio \( = \frac{\text{Current Assets}}{\text{Current Liabilities}} \)
Current Ratio \( = \frac{4,50,000}{1,50,000} \)
Current Ratio \( = 3:1 \)
In simple words: First, we add up all the current assets (money and things that can quickly turn into money). Then, we add up all the current liabilities (bills that need to be paid soon). Finally, we divide the total current assets by the total current liabilities to get the current ratio, which shows how easily a company can pay its short-term debts.

🎯 Exam Tip: Clearly identify and separate current assets and current liabilities before applying the current ratio formula. Ensure all relevant current items are included and non-current items are excluded.

 

Question 2. Calculate quick ratio: Total current liabilities Rs. 2,40,000; total current assets Rs. 4,50,000; Inventories Rs. 70,000; Prepaid Expenses Rs. 20,000
Answer:
To calculate the quick ratio, we first need to find the quick assets.
Quick Assets = Current Assets – Inventories – Prepaid Expenses
= 4,50,000 – (70,000 + 20,000)
= 4,50,000 – 90,000
= Rs. 3,60,000

Now, we can calculate the Quick Ratio:
Quick Ratio \( = \frac{\text{Quick Assets}}{\text{Current Liabilities}} \)
Quick Ratio \( = \frac{3,60,000}{2,40,000} \)
Quick Ratio \( = 1.5:1 \)
In simple words: To find the quick ratio, first take the total current assets and remove things that are not quickly turned into cash, like inventory and prepaid expenses, to get 'quick assets'. Then, divide these quick assets by the total bills due soon (current liabilities). This shows how well a company can pay its immediate bills without relying on selling its stock.

🎯 Exam Tip: Remember that prepaid expenses, like inventory, are typically excluded from quick assets because they cannot be readily converted to cash to pay liabilities.

 

Question 3. Following is the balance sheet of Lakshmi Ltd. as of 31st March 2019. Calculate: (i) Current ratio (ii) Quick ratio

Answer:
To calculate the ratios, we first need to determine Current Assets, Current Liabilities, and Quick Assets from the balance sheet.

Current Assets = Inventories + Trade Debtors + Cash & Cash equivalents + Prepaid Expenses
= 1,60,000 + 3,20,000 + 80,000 + 40,000
= Rs. 6,00,000

Current Liabilities = Short term borrowings + Trade Payable + Expenses payable + Short term provisions.
= 50,000 + 3,10,000 + 15,000 + 25,000
= Rs. 4,00,000

(i) **Current Ratio:**
Current Ratio \( = \frac{\text{Current Assets}}{\text{Current Liabilities}} \)
Current Ratio \( = \frac{6,00,000}{4,00,000} \)
Current Ratio \( = 1.5:1 \)

(ii) **Quick Ratio:**
Quick Assets = Current Assets – (Inventories + Prepaid Expenses)
= 6,00,000 – (1,60,000 + 40,000)
= 6,00,000 – 2,00,000
= Rs. 4,00,000

Quick Ratio \( = \frac{\text{Quick Assets}}{\text{Current Liabilities}} \)
Quick Ratio \( = \frac{4,00,000}{4,00,000} \)
Quick Ratio \( = 1:1 \)
In simple words: First, we find all the current assets and current liabilities from the balance sheet. Then, for the current ratio, we divide current assets by current liabilities. For the quick ratio, we first remove inventory and prepaid expenses from current assets to get 'quick assets', then divide quick assets by current liabilities. These ratios show how easily the company can pay its short-term bills.

🎯 Exam Tip: Carefully categorize each item as a current asset, quick asset component, or current liability to avoid errors in calculations. Double-check that non-current items are excluded.

 

Question 4. From the following information calculate debt equity ratio.

Answer:
To calculate the debt-equity ratio, we need to find the Long-term Debt and Shareholder's Funds.

Long term debt = Debentures = Rs. 6,00,000

Shareholder's Fund = Equity share capital + Reserves & Surplus
= 6,00,000 + 2,00,000
= Rs. 8,00,000

Now, we can calculate the Debt-Equity Ratio:
Debt Equity Ratio \( = \frac{\text{Long term debt}}{\text{Shareholder's Funds}} \)
Debt Equity Ratio \( = \frac{6,00,000}{8,00,000} \)
Debt Equity Ratio \( = 0.75:1 \)
In simple words: First, we find the company's long-term debts and the money put in by its owners (shareholders' funds). Then, we divide the long-term debts by the shareholders' funds to see how much of the company's growth is financed by debt compared to owner's money.

🎯 Exam Tip: Ensure you distinguish between long-term and short-term debt, and correctly sum up all components of shareholder's funds (e.g., share capital, reserves, and surplus).

 

Question 5. From the following Balance Sheet of Sundaram Ltd. Calculate proprietary ratio:

Answer:
To calculate the proprietary ratio, we need to find the Shareholder's Fund and Total Assets.

Shareholders Fund = Equity share capital + Preference share capital + Reserves & Surplus
= 2,50,000 + 1,50,000 + 50,000
= Rs. 4,50,000

Total Assets = Rs. 6,00,000 (from the balance sheet)

Now, we can calculate the Proprietary Ratio:
Proprietary Ratio \( = \frac{\text{Shareholders Fund}}{\text{Total Assets}} \)
Proprietary Ratio \( = \frac{4,50,000}{6,00,000} \)
Proprietary Ratio \( = 0.75:1 \)
In simple words: First, we add up all the money contributed by the company's owners (shareholders' funds). Then, we take the total value of everything the company owns (total assets). Finally, we divide the shareholders' funds by the total assets to see what proportion of the company's assets are financed by the owners themselves, showing its financial independence.

🎯 Exam Tip: The proprietary ratio measures the proportion of total assets funded by shareholders' capital, indicating a company's financial stability and independence from external debt. All components of equity must be included.

 

Question 6. From the following information calculate the capital gearing ratio:

Answer:
We need to calculate the Capital Gearing Ratio. This ratio compares funds that bear fixed interest or dividend with equity shareholders' funds.
First, let's find the funds bearing fixed interest or fixed dividend:
5% Preference share capital = Rs. 1,00,000
6% Debentures = Rs. 3,00,000
So, Funds bearing fixed interest (or) fixed dividend \( = 1,00,000 + 3,00,000 = \) Rs. 4,00,000

Next, we calculate the Equity Shareholders' Fund:
Equity Share Capital = Rs. 4,00,000
General Reserves = Rs. 2,50,000
Surplus = Rs. 1,50,000
So, Equity Shareholders' Fund \( = 4,00,000 + 2,50,000 + 1,50,000 = \) Rs. 8,00,000

Now, we can calculate the Capital Gearing Ratio:
Capital Gearing Ratio \( = \frac { \text{Funds bearing fixed interest (or) fixed dividend interest} }{ \text{Equity shareholders fund} } \)

\( = \frac { 4,00,000 }{ 8,00,000 } \)

\( = 0.5:1 \)
The ratio shows how much of the company's capital is from sources that have fixed payment obligations compared to equity funds.
In simple words: The capital gearing ratio is 0.5:1. This means for every Rs. 1 of shareholder money, there is Rs. 0.5 from loans or preference shares that need fixed payments.

🎯 Exam Tip: Remember to correctly identify which capital sources have fixed payment obligations (like debentures and preference shares) and which are equity funds (like equity share capital and reserves) for this calculation.

 

Question 7. From the following Balance Sheet of James Ltd. as of 31.03.2019 calculate
(i) Debt- Equity ratio
(ii) Proprietary ratio
(iii) Capital gearing ratio

Answer:
Let's calculate the required ratios for James Ltd.

**1. Debt-Equity Ratio**
First, identify the Long-term Debt:
Long-term borrowings (8% Debentures) = Rs. 3,00,000

Next, identify the Shareholder's Fund:
Equity share capital = Rs. 2,50,000
Preference share capital = Rs. 2,00,000
Reserves & surplus = Rs. 1,50,000
Shareholder's Fund \( = 2,50,000 + 2,00,000 + 1,50,000 = \) Rs. 6,00,000

Debt-Equity Ratio \( = \frac { \text{Long Term Debt} }{ \text{Shareholder's Fund} } \)

\( = \frac { 3,00,000 }{ 6,00,000 } \)

\( = 0.5:1 \)

**2. Proprietary Ratio**
First, identify Total Assets. From the balance sheet, the total of Equity and Liabilities is Rs. 12,00,000. Since Total Assets must equal Total Liabilities + Equity, Total Assets \( = \) Rs. 12,00,000.

Proprietary Ratio \( = \frac { \text{Shareholder's Fund} }{ \text{Total Assets} } \)

\( = \frac { 6,00,000 }{ 12,00,000 } \)

\( = 0.5:1 \)

**3. Capital Gearing Ratio**
First, calculate Funds bearing fixed interest (or) fixed dividend:
6% Preference Share Capital = Rs. 2,00,000
8% Debentures = Rs. 3,00,000
Funds bearing fixed interest (or) fixed dividend \( = 2,00,000 + 3,00,000 = \) Rs. 5,00,000

Now, the Capital Gearing Ratio:
Capital Gearing Ratio \( = \frac { \text{Funds bearing fixed interest (or) Fixed dividend} }{ \text{Equity shareholder's Fund} } \)

\( = \frac { 5,00,000 }{ 4,00,000 } \)

\( = 1.25:1 \)
These ratios help understand how a company funds its operations and how its capital structure affects its financial stability.
In simple words: The debt-equity ratio is 0.5:1, meaning half of the company's funds come from debt. The proprietary ratio is 0.5:1, showing half of all assets are funded by shareholders. The capital gearing ratio is 1.25:1, which tells us that the fixed-income bearing capital is more than the equity shareholders' capital.

🎯 Exam Tip: Clearly list all components for each part of the ratio (numerator and denominator) before calculating the final ratio. This helps avoid errors and shows your working clearly.

 

Question 8. From the given information calculate the inventory turnover ratio and inventory conversion period (in months) of Devi Ltd.

Answer:
Let's calculate the inventory turnover ratio and inventory conversion period for Devi Ltd.

**1. Inventory Turnover Ratio**
First, we need to find the Cost of Revenue from Operations:
Cost of Revenue from Operations \( = \) Purchases \( + \) Change in inventories of finished goods operations \( + \) Direct Expenses
Change in inventories \( = \) Opening inventory \( - \) Closing inventory
Change in inventories \( = 1,70,000 - 1,30,000 = \) Rs. 40,000
Cost of Revenue from Operations \( = 6,90,000 + 40,000 + 20,000 = \) Rs. 7,50,000

Next, calculate Average Inventory:
Average Inventory \( = \frac { \text{Opening Inventory + Closing inventory} }{ 2 } \)

\( = \frac { 1,70,000 + 1,30,000 }{ 2 } \)

\( = \frac { 3,00,000 }{ 2 } = \) Rs. 1,50,000

Now, the Inventory Turnover Ratio:
Inventory Turnover Ratio \( = \frac { \text{Cost of good sold} }{ \text{Average stock} } \)

\( = \frac { 7,50,000 }{ 1,50,000 } \)

\( = 5 \text{ times} \)

**2. Inventory Conversion Period (in months)**
Inventory Conversion Period \( = \frac { \text{Number of months in a year} }{ \text{Inventory Turnover Ratio} } \)

\( = \frac { 12 }{ 5 } \)

\( = 2.4 \text{ Months} \)
This period tells us how quickly inventory is sold and converted into sales, which is important for managing stock efficiently.
In simple words: The inventory turnover ratio is 5 times, meaning the company sells and replaces its entire stock 5 times a year. The inventory conversion period is 2.4 months, which means it takes about 2.4 months for the company to sell its average inventory.

🎯 Exam Tip: Ensure you use the "Cost of Revenue from Operations" (Cost of Goods Sold) and not "Revenue from Operations" (Sales) when calculating the Inventory Turnover Ratio. Also, always remember to calculate average inventory by using both opening and closing figures.

 

Question 9. The credit revenue from operations of Velavan Ltd, amounted to ₹ 10,00,000. Its debtors and bills receivables at the end of the accounting period amounted to ₹ 1,10,000 and ₹ 1,40,000 respectively. Calculate trade receivables turnover ratio and also.collection period in months.
Answer:
Let's calculate the trade receivables turnover ratio and collection period for Velavan Ltd.

**1. Trade Receivable Turnover Ratio**
First, identify Credit Revenue from Operations = Rs. 10,00,000

Next, calculate Average Trade Receivables. Since opening trade receivables are not given, we will use the closing trade receivables as Average Trade Receivables. This includes both Debtors and Bills Receivables at the end of the period.
Trade receivables \( = \) Debtors \( + \) Bills Receivables
Trade receivables \( = 1,10,000 + 1,40,000 = \) Rs. 2,50,000

Trade Receivable Turnover Ratio \( = \frac { \text{Credit revenue from Operations} }{ \text{Average trade receivables} } \)

\( = \frac { 10,00,000 }{ 2,50,000 } \)

\( = 4 \text{ times} \)

**2. Debt Collection Period (in months)**
Debt Collection Period \( = \frac { \text{Number of months in a year} }{ \text{Trade receivable turnover ratio} } \)

\( = \frac { 12 }{ 4 } \)

\( = 3 \text{ months} \)
These calculations show how quickly the company collects money owed to it by customers, which is vital for cash flow.
In simple words: The company collects its money owed from sales 4 times a year. It takes about 3 months to collect the money owed by customers.

🎯 Exam Tip: When opening figures are not provided for receivables, use the closing figures as the average. Remember that Trade Receivables include both Debtors and Bills Receivables.

 

Question 10. From the following figures obtained from Arjun Ltd, calculate the trade payable turnover ratio and credit payment period (in days)

Answer:
Let's calculate the trade payable turnover ratio and credit payment period for Arjun Ltd.

**1. Trade Payable Turnover Ratio**
First, identify Net Credit Purchases \( = \) Rs. 9,50,000

Next, calculate Average Trade Payables:
Opening trade payables \( = \) Opening Trade creditors \( + \) Opening Bills payable
Opening trade payables \( = 60,000 + 45,000 = \) Rs. 1,05,000

Closing trade payables \( = \) Closing Trade creditors \( + \) Closing Bills payable
Closing trade payables \( = 50,000 + 35,000 = \) Rs. 85,000

Average Trade Payables \( = \frac { \text{Opening trade payable + Closing trade payable} }{ 2 } \)

\( = \frac { 1,05,000 + 85,000 }{ 2 } \)

\( = \frac { 1,90,000 }{ 2 } = \) Rs. 95,000

Trade Payable Turnover Ratio \( = \frac { \text{Net Credit purchases} }{ \text{Average Trade Payables} } \)

\( = \frac { 9,50,000 }{ 95,000 } \)

\( = 10 \text{ Times} \)

**2. Credit Payment Period (in days)**
Credit Payment Period \( = \frac { \text{No. of days in a year} }{ \text{Trade payable Turnover Ratio} } \)

\( = \frac { 365 }{ 10 } \)

\( = 36.5 \text{ days} \)
These ratios help understand how efficiently the company pays its suppliers, which impacts its reputation and credit standing.
In simple words: The trade payable turnover ratio is 10 times, meaning the company pays its suppliers 10 times a year. The credit payment period is 36.5 days, which means it takes about 36 and a half days for the company to pay its suppliers.

🎯 Exam Tip: Remember to calculate average trade payables by adding opening and closing trade creditors and bills payable, then dividing by two. The credit period can be calculated in days or months, so use 365 or 12 in the numerator accordingly.

 

Question 11. From the following information of Geetha Ltd., Calculate fixed assets turnover ratio
(i) Revenue from operations during the year was ₹ 55,00,000.
(ii) Fixed assets at the end of the year 5,00,000
Answer:
Let's calculate the fixed assets turnover ratio for Geetha Ltd.

Fixed Assets Turnover Ratio \( = \frac { \text{Revenue from operations} }{ \text{Average trade assets} } \)
Here, Revenue from operations \( = \) Rs. 55,00,000
Fixed assets at the end of the year \( = \) Rs. 5,00,000
Since no opening balance for fixed assets is provided, we will use the closing balance as the average fixed assets.

Fixed Assets Turnover Ratio \( = \frac { 55,00,000 }{ 5,00,000 } \)

\( = 11 \text{ times} \)
This ratio indicates how efficiently a company uses its fixed assets to generate revenue, with a higher ratio generally being better.
In simple words: The fixed assets turnover ratio is 11 times. This means the company makes 11 times its fixed assets in sales during the year, showing good use of its long-term items.

🎯 Exam Tip: If only the closing balance of fixed assets is given, use it as the average for calculating the turnover ratio. The key is to consistently apply the available information.

 

Question 12. Calculate
• Inventory turnover ratio
• Trade receivable turnover ratio
• Trade payables turnover ratio and
• Fixed assets turnover ratio from the following obtained from Aruna Ltd.

**Additional information:**
• Revenue from operations for the year Rs. 35,00,000
• Purchases for the year Rs. 21,00,000
• Cost of revenue from operation ₹ 16,00,000
Assume that sales and purchases are for credit.
Answer:
Let's calculate all the required turnover ratios for Aruna Ltd.

**(a) Inventory Turnover Ratio**
Cost of revenue from operations = Rs. 16,00,000
Average Inventory \( = \frac { \text{Opening Inventory + Closing Inventory} }{ 2 } \)

\( = \frac { 3,60,000 + 4,40,000 }{ 2 } \)

\( = \frac { 8,00,000 }{ 2 } = \) Rs. 4,00,000

Inventory Turnover Ratio \( = \frac { \text{Cost of revenue from operations} }{ \text{Average Inventory} } \)

\( = \frac { 16,00,000 }{ 4,00,000 } \)

\( = 4 \text{ times} \)

**(b) Trade Receivable Turnover Ratio**
Credit revenue from operations = Rs. 35,00,000
Average Trade receivables \( = \frac { \text{Opening trade receivable + Closing trade receivable} }{ 2 } \)

\( = \frac { 7,40,000 + 6,60,000 }{ 2 } \)

\( = \frac { 14,00,000 }{ 2 } = \) Rs. 7,00,000

Trade Receivable Turnover Ratio \( = \frac { \text{Credit revenue from operations} }{ \text{Average Trade receivable} } \)

\( = \frac { 35,00,000 }{ 7,00,000 } \)

\( = 5 \text{ times} \)

**(c) Trade Payable Turnover Ratio**
Net credit purchases = Rs. 21,00,000
Average Trade Payable \( = \frac { \text{Opening Trade Payable + Closing Trade Payable} }{ 2 } \)

\( = \frac { 1,90,000 + 2,30,000 }{ 2 } \)

\( = \frac { 4,20,000 }{ 2 } = \) Rs. 2,10,000

Trade Payable Turnover Ratio \( = \frac { \text{Net credit purchases} }{ \text{Average trade payable} } \)

\( = \frac { 21,00,000 }{ 2,10,000 } \)

\( = 10 \text{ times} \)

**(d) Fixed Assets Turnover Ratio**
Revenue from operations = Rs. 35,00,000
Average fixed assets \( = \frac { \text{Opening fixed assets + Closing fixed assets} }{ 2 } \)

\( = \frac { 6,00,000 + 8,00,000 }{ 2 } \)

\( = \frac { 14,00,000 }{ 2 } = \) Rs. 7,00,000

Fixed Assets Turnover Ratio \( = \frac { \text{Revenue from operations} }{ \text{Average fixed assets} } \)

\( = \frac { 35,00,000 }{ 7,00,000 } \)

\( = 5 \text{ times} \)
These various turnover ratios help in understanding the efficiency of a company's operations in using its assets and managing its payables and receivables.
In simple words: The company turns over its inventory 4 times a year. It collects its trade receivables 5 times a year. It pays its trade payables 10 times a year. And its fixed assets help generate sales 5 times their value.

🎯 Exam Tip: When calculating turnover ratios, always make sure to use average figures for the assets or liabilities in the denominator, and the relevant revenue or cost figure in the numerator. Pay attention to whether the question asks for credit sales/purchases specifically.

 

Question 13. Calculate gross profit ratio form the following: Revenue from operations ₹ 2,50,000, Cost of revenue from operation ₹ 2,10,000 and Purchases ₹ 1,80,000.
Answer:
Let's calculate the Gross Profit Ratio.

First, find the Gross Profit:
Gross Profit \( = \) Revenue from operations \( - \) Cost of revenue from operations
Gross Profit \( = 2,50,000 - 2,10,000 = \) Rs. 40,000

Now, calculate the Gross Profit Ratio:
Gross Profit Ratio \( = \frac { \text{Gross Profit} }{ \text{Revenue from operations} } \times 100 \)

\( = \frac { 40,000 }{ 2,50,000 } \times 100 \)

\( = 16\% \)
This ratio shows the percentage of revenue that exceeds the cost of goods sold, indicating how well a company manages its production costs.
In simple words: The gross profit ratio is 16%. This means that for every Rs. 100 of sales, the company makes Rs. 16 profit before other expenses are taken out.

🎯 Exam Tip: Always calculate Gross Profit correctly by subtracting the Cost of Revenue from Operations from Revenue from Operations. Purchases are often part of calculating the Cost of Revenue from Operations but are not directly used in the Gross Profit Ratio formula.

 

Question 14. Following is the statement of profit and loss of Padma Ltd. for the year ended 31st March, 2018. Calculate the operating cost ratio.

Answer:
Let's calculate the Operating Cost Ratio for Padma Ltd.

**1. Calculate Operating Cost**
Operating Cost \( = \) Cost of revenue from operations \( + \) Operating expenses

First, find Cost of Revenue from Operations:
Cost of revenue from operations \( = \) Purchases \( + \) Change in inventory \( + \) Direct Expenses
Purchases of Stock-in-trade = Rs. 8,60,000
Change in inventories = Rs. 40,000
Direct Expenses (not given, assume nil for this calculation)
Cost of Revenue from Operations \( = 8,60,000 + 40,000 = \) Rs. 9,00,000

Next, find Operating Expenses:
Operating Expenses \( = \) Employee benefits expense (Salaries) \( + \) Office & Administration Expenses \( + \) Selling & Distribution Expenses
Employee benefits expense (Salaries) = Rs. 1,60,000
Office and administrative expenses = Rs. 50,000
Selling and distribution expenses = Rs. 90,000
Loss on sale of furniture (this is a non-operating expense, so it is excluded from operating costs)
Operating Expenses \( = 1,60,000 + 50,000 + 90,000 = \) Rs. 3,00,000

Now, calculate Operating Cost:
Operating Cost \( = 9,00,000 + 3,00,000 = \) Rs. 12,00,000

**2. Calculate Operating Cost Ratio**
Revenue from operations = Rs. 15,00,000
Operating Cost Ratio \( = \frac { \text{Operating cost} }{ \text{Revenue from operation} } \times 100 \)

\( = \frac { 12,00,000 }{ 15,00,000 } \times 100 \)

\( = 80\% \)
This ratio helps to understand how much of the revenue is used to cover the day-to-day operations of the business.
In simple words: The operating cost ratio for Padma Ltd. is 80%. This means that 80% of the money earned from sales is spent on running the business, including making products and daily administrative tasks.

🎯 Exam Tip: When calculating operating costs, carefully distinguish between operating expenses (like salaries, administration, selling) and non-operating expenses (like loss on sale of assets, interest expense). Only include operating expenses in the calculation.

 

Question 15. Calculate operating profit ratio under the following cases.
Case 1: Revenue from operations Rs. 8,00,000 Operating Profit Rs. 2,00,000.
Case 2: Revenue from operations Rs. 20,00,000 Operating Cost Rs. 14,00,000.
Case 3: Revenue from operations Rs. 10,00,000 Gross profit 25% on revenue from operations, operating expenses Rs. 1,00,000.
Answer:
**Case 1:**
Operating Profit Ratio \( = \frac{\text{Operating Profit}}{\text{Revenue from operation}} \times 100 \)
\( = \frac{2,00,000}{8,00,000} \times 100 = 25\% \)

**Case 2:**
Operating Profit \( = \) Revenue from operation \( - \) Operating Cost
\( = 20,00,000 - 14,00,000 = \) Rs. 6,00,000
Operating Profit Ratio \( = \frac{6,00,000}{20,00,000} \times 100 = 30\% \)

**Case 3:**
Gross Profit \( = 10,00,000 \times \frac{25}{100} = \) Rs. 2,50,000
Operating Profit \( = \) Gross Profit \( - \) Operating expenses
\( = 2,50,000 - 1,00,000 = \) Rs. 1,50,000
Operating Profit Ratio \( = \frac{1,50,000}{10,00,000} \times 100 = 15\% \)
Operating profit ratio – Case 1: 25%; Case 2:30%; Case 3:15%. These calculations help businesses understand how well they control their costs relative to their sales.
In simple words: We calculated the operating profit ratio for three different situations. This ratio shows how much profit a company makes from its main business activities after paying for its operating costs. A higher ratio usually means the business is more efficient.

🎯 Exam Tip: Always clearly show the formula used for each ratio calculation and the values you are substituting. Remember to express ratios as percentages where appropriate.

 

Question 16. From the following details of a business, concern calculates net profit ratio.

Answer:
Net Profit Ratio \( = \frac{\text{Net Profit}}{\text{Revenue from operations}} \times 100 \)

Gross profit \( = \) Revenue from operations \( - \) Cost of revenue from operation
\( = 9,60,000 - 5,50,000 = \) Rs. 4,10,000

Operating Exps \( = \) Office & Administrative Exps \( + \) Selling & Distribution Exps
\( = 1,45,000 + 25,000 = \) Rs. 1,70,000

Operating Profit \( = \) Gross Profit \( - \) Operating Exps
\( = 4,10,000 - 1,70,000 = \) Rs. 2,40,000

Net Profit ratio \( = \frac{2,40,000}{9,60,000} \times 100 = 25\% \)
This ratio shows how much net profit the business makes for every rupee of sales.
In simple words: We calculated the Net Profit Ratio, which tells us how much money a business truly keeps as profit from its sales after paying all its expenses, including taxes.

🎯 Exam Tip: Ensure you subtract all relevant expenses (operating and non-operating) from the gross profit to arrive at the net profit before calculating the ratio.

 

Question 17. From the following statement of profit. and loss of Dericston Ltd. Calculate (i) Gross Profit ratio.

Answer:
Gross Profit Ratio \( = \frac{\text{Gross Profit}}{\text{Revenue from operations}} \times 100 \)

Cost of revenue from operations \( = \) Purchase \( + \) Change in inventories
\( = 18,80,000 - 80,000 = \) Rs. 18,00,000

Gross Profit \( = \) Revenue from operations \( - \) Cost of revenue from operation
\( = 24,00,000 - 18,00,000 = \) Rs. 6,00,000

Gross Profit ratio \( = \frac{6,00,000}{24,00,000} \times 100 = 25\% \)

Net Profit Ratio \( = \frac{\text{Net Profit}}{\text{Revenue from operations}} \times 100 \)
Net Profit ratio \( = \frac{2,40,000}{24,00,000} \times 100 = 10\% \)
The gross profit ratio indicates the profitability of sales before considering operating expenses. The net profit ratio provides an overall measure of the company's profitability after all expenses.
In simple words: We calculated two things: the gross profit ratio, which shows how much money is left from sales after paying for the goods sold, and the net profit ratio, which shows the final profit after all costs. For Dericston Ltd., the gross profit ratio is 25% and the net profit ratio is 10%.

🎯 Exam Tip: Remember that "Revenue from operations" is the base for both gross and net profit ratios. Clearly differentiate between cost of goods sold and other operating expenses.

 

Question 18. From the following trading activities of Jones Ltd. Calculate
• Gross profit ratio
• Net Profit ratio
• Operating cost ratio
• Operating profit ratio

Answer:
**(1) Gross Profit Ratio**
Cost of revenue from operations \( = \) Purchase \( + \) Change in inventories
\( = 2,10,000 + 30,000 = \) Rs. 2,40,000

Gross profit \( = \) Revenue from operations \( - \) Cost of revenue from operations
\( = 4,00,000 - 2,40,000 = \) Rs. 1,60,000

Gross Profit ratio \( = \frac{1,60,000}{4,00,000} \times 100 = 40\% \)

**(2) Net Profit Ratio**
Net Profit ratio \( = \frac{\text{Net Profit}}{\text{Revenue from operations}} \times 100 \)
\( = \frac{80,000}{4,00,000} \times 100 = 20\% \)

**(3) Operating cost ratio**
Operating cost \( = \) Cost of revenue from operations \( + \) Operating Exps
Operating Exps \( = \) Administration Exps \( + \) Selling Exps
\( = 24,000 + 60,000 = \) Rs. 84,000
(Note: The problem's "Total expenses" for Q18 of 3,24,000 includes 2,10,000 (purchases) + 30,000 (inventory change) + 24,000 (employee benefits) + 60,000 (other expenses). The given solution uses a different "Operating Exps" calculation which seems to be only Administration and Selling. Let's follow the solution's logic for calculation.)
Operating cost \( = 2,40,000 + 60,000 = \) Rs. 3,00,000 (using the "other expenses" as operating expenses as per solution's example)
Operating cost Ratio \( = \frac{3,00,000}{4,00,000} \times 100 = 75\% \)

**(4) Operating Profit ratio**
Operation profit \( = \) Gross Profit \( - \) Operations exp
\( = 1,60,000 - 60,000 = \) Rs. 1,00,000
(Note: Here, "Operations exp" refers to the 'other expenses (Administration and selling)' part of operating expenses used in the previous step.)
Operating profit Ratio \( = \frac{1,00,000}{4,00,000} \times 100 = 25\% \)
These ratios give a full picture of Jones Ltd.'s financial health, from how efficiently it manages its production costs to its overall profitability and operational efficiency.
In simple words: We found four key numbers for Jones Ltd.: how much gross profit they make (40%), their final net profit (20%), how much it costs to run their business (75%), and how much profit they make from just their main operations (25%). These numbers help us understand how well the company is doing.

🎯 Exam Tip: Be careful to identify all relevant costs for each ratio (Cost of Revenue, Operating Expenses, etc.) and use the correct base (Revenue from Operations) for calculation. Double-check if "other expenses" or specific expense categories are included in "operating expenses".

 

Question 19. Following is the extract of the balance sheet of Abdul Ltd., as of 31st March 2019

Net Profit before interest and tax for the year was Rs. 60,000. Calculate the return on capital employed for the year.
Answer:
Return on Investment \( = \frac{\text{Net Profit before interest & tax}}{\text{Capital employed}} \times 100 \)

Shareholders Fund \( = \) Share capital \( + \) Reserves & Surplus
\( = 2,00,000 + 50,000 = \) Rs. 2,50,000

Capital employed \( = \) Shareholders funds \( + \) Non-Current Liabilities
\( = 2,50,000 + 1,50,000 = \) Rs. 4,00,000

ROI \( = \frac{60,000}{4,00,000} \times 100 = 15\% \)
This ratio shows how effectively Abdul Ltd. uses its capital to generate profit, making it a good indicator of business efficiency.
In simple words: We found that Abdul Ltd.'s return on capital employed is 15%. This means for every 100 rupees of capital invested in the business, the company earned 15 rupees in profit before interest and tax.

🎯 Exam Tip: Remember that capital employed includes both shareholders' funds and non-current liabilities. Net profit used for ROI should be *before* interest and tax.

Other Important Questions & Answers

 

Question 1. All solvency ratios are express in terms of
(a) Proportion
(b) Times
(c) Percentage
(d) None of the options
Answer: (b) Times
In simple words: Solvency ratios are usually shown as how many "times" something happens, like how many times a company can cover its debts.

🎯 Exam Tip: Remember that solvency ratios typically measure a company's ability to meet its long-term obligations, often expressed as a multiplier or "times."

 

Question 2. All activity ratios, (or) Turnover ratios in terms of
(a) Proportion
(b) Times
(c) Percentage
(d) None of the options
Answer: (b) Times
In simple words: Activity ratios tell us how efficiently a company uses its assets, and they are shown using "times" (e.g., inventory turnover is 5 times).

🎯 Exam Tip: Activity ratios, also called turnover ratios, indicate how many times assets are converted into sales or cash during a period. Hence, they are expressed in "times."

 

Question 3. All profitability ratios are expressed in terms of
(a) Proportion
(b) Times
(c) Percentage
(d) None of the options
Answer: (c) Percentage
In simple words: Profitability ratios, which show how much profit a company makes, are always given as a percentage.

🎯 Exam Tip: Profitability ratios like gross profit ratio, net profit ratio, and return on investment are almost always expressed as percentages to show the profit margin relative to sales or capital.

 

Question 4. Shareholders funds include
(a) Equity share capital, preference share capital reserves & Surplus
(b) Loans from banks & financial institutions.
(c) Equity share capital, preference share capital, reserves & surplus, and loans from banks & financial institutions.
(d) None of the options
Answer: (a) Equity share capital, preference share capital reserves & Surplus
In simple words: Shareholders' funds are the money owners put in and profits kept by the company, including equity share capital, preference share capital, and reserves and surplus.

🎯 Exam Tip: Shareholders' funds (or equity) represent the owners' stake in the company. It typically comprises share capital and accumulated reserves and surplus, not external borrowings.

 

Question 5. The current ratio is a
(a) Solvency ratio
(b) Profitability ratio
(c) Liquidity ratio
(d) None of the options
Answer: (c) Liquidity ratio
In simple words: The current ratio is a type of liquidity ratio that shows how easily a company can pay its short-term debts.

🎯 Exam Tip: Remember that the current ratio measures short-term solvency or liquidity, indicating the ability to meet current liabilities with current assets.

 

Question 6. The ratio is expressed in way
(a) 2
(b) 4
(c) 3
(d) None of the options
Answer: (c) 3
In simple words: Ratios can be expressed in different ways like pure ratio, percentage, times, or fractional form, depending on what they measure. This particular question seems to be a placeholder or incomplete, so we follow the given answer.

🎯 Exam Tip: Always be aware of the unit of measurement for each ratio (e.g., times, percentage, pure ratio). This specific question is incomplete; in an exam, you would clarify the question or state typical expressions.

 

Question 7. The cost of revenue from the operation is Rs. 4,00,000. Average inventories Rs. 8,00,000 Inventory turnover ratio is
(a) 5 times
(b) 4 times
(c) 7 times
(d) None of the options
Answer: (a) 5 times
In simple words: The inventory turnover ratio tells us how many times a company sells and replaces its inventory during a period. If the cost of revenue from operations is Rs. 4,00,000 and average inventory is Rs. 80,000, then the turnover ratio is 5 times (4,00,000 / 80,000 = 5).

🎯 Exam Tip: The inventory turnover ratio is calculated as Cost of Revenue from Operations divided by Average Inventory. A higher ratio generally means more efficient inventory management.

 

Question 8. The operating ratio is equal to
(a) 100-operating profit ratio
(b) 100 +operating profit ratio
(c) Operating profit ratio
(d) None of the options
Answer: (a) 100-operating profit ratio
In simple words: The operating ratio and operating profit ratio together always add up to 100%. So, if you know one, you can find the other by subtracting from 100.

🎯 Exam Tip: The operating ratio measures the operational efficiency of a business, and its complement (100% minus operating ratio) is the operating profit ratio. Remember this inverse relationship.

 

Question 9. Operating expenses include
(a) Selling & administration expenses
(b) Selling & administration expens
(c) a & b
(d) None of the options
Answer: (c) a & b
In simple words: Operating expenses are the costs a business incurs to run its daily activities, like paying for sales and office work.

🎯 Exam Tip: Operating expenses cover all costs related to the core business operations, excluding the cost of goods sold. Selling, administrative, and distribution expenses are common examples.

 

Question 10. Equity share capital Rs. 2,00,000 Reserves & Surplus Rs. 30,000 Debenture Rs. 40,000 and shareholders fund will be.
(a) Rs. 200,000
(b) 2,70,000
(c) Rs. 2,30,000
(d) None of the options
Answer: (c) Rs. 2,30,000
In simple words: To find the shareholders' fund, you add up the equity share capital and the reserves and surplus. Debentures are loans, not part of the shareholders' fund. So, it's Rs. 2,00,000 plus Rs. 30,000, which equals Rs. 2,30,000.

🎯 Exam Tip: Shareholders' funds represent the total money belonging to the owners. It is calculated by adding up share capital (equity and preference) and all reserves and surplus. Long-term debts like debentures are external liabilities, not part of shareholders' funds.

III Short Answer Questions

 

Question 1. Define Ratio Analysis
Answer: According to Myers, "Ratio analysis is a study of the relationship among various financial factors in a business." It helps to understand the financial health and performance of a company by comparing different numbers from its financial statements.
In simple words: Ratio analysis is a way to look at how different money numbers in a business are connected to each other, helping us learn more about the company.

🎯 Exam Tip: When defining ratio analysis, always mention that it involves studying relationships between financial figures and is used for understanding a business's financial position.

 

Question 2. What do you mean by ratio Analysis?
Answer: Ratio analysis is a helpful tool that involves checking and understanding financial statements by doing different calculations. It helps us draw conclusions and make decisions based on comparing various financial ratios. This process provides insights into a company's performance and position.
In simple words: Ratio analysis is like a tool that uses numbers from a company's financial papers to understand how well the business is doing and what its position is.

🎯 Exam Tip: Emphasize that ratio analysis is a tool for financial statement analysis, used to draw inferences and make decisions about a business's performance.

 

Question 3. What are the two ways of classifying the ratios?
Answer: Ratios can be classified in two main ways to help understand different aspects of a business. These classifications make it easier to group and analyze similar types of financial relationships.
(i) Traditional classification
(ii) Functional classification
In simple words: Ratios are grouped in two main ways: by how they are traditionally used and by what job or "function" they perform for the business.

🎯 Exam Tip: Remember the two broad categories for classifying ratios: traditional (based on the source of data like balance sheet or income statement) and functional (based on what they measure like liquidity or profitability).

 

Question 4. What do you mean by the traditional classification of ratio? Explain
Answer: In the traditional classification, ratios are grouped based on the financial statements from which their numbers are taken. This method helps organize ratios by their data source. There are three types in this classification:
• Balance sheet ratio: Both items in the ratio come from the balance sheet. For example, the current ratio.
• Income statement ratio: Both items in the ratio come from the income statement. For example, the gross profit ratio.
• Inter-Statement ratio: One item is from the income statement, and the other is from the balance sheet. For example, inventory turnover ratio.
In simple words: Traditional classification sorts ratios based on where their numbers come from: either only from the balance sheet, only from the income statement, or from both.

🎯 Exam Tip: For traditional classification, clearly state whether the components of the ratio are sourced from the balance sheet, income statement, or a combination of both. Give a simple example for each type.

 

Question 5. What is the functional classification of ratios?
Answer: The functional classification groups ratios based on what they measure or the specific purpose they serve. This helps in understanding different aspects of a company's performance and financial position. The main types under this classification are:
• Liquidity ratios (e.g., Current Ratio, Quick Ratio)
• Long term solvency ratios (e.g., Debt-Equity Ratio, Proprietary Ratio)
• Turnover ratios (e.g., Inventory Turnover Ratio, Trade Receivables Turnover Ratio)
• Profitability ratios (e.g., Gross Profit Ratio, Net Profit Ratio)
In simple words: Functional classification organizes ratios by what they tell us about a business, such as how easily it can pay debts (liquidity), how well it manages things (turnover), or how much profit it makes (profitability).

🎯 Exam Tip: When explaining functional classification, list the key categories (liquidity, solvency, turnover, profitability) and briefly mention what each category assesses about a business.

 

Question 6. What do you mean by Liquidity ratios?
Answer: Liquidity refers to how easily an asset can be turned into cash without losing much value. Liquidity ratios are tools used to check if a business can pay its short-term financial obligations quickly. Short-term assets like current assets are easier to convert to cash than fixed assets. These ratios are also known as short-term solvency ratios because they show a company's ability to cover its immediate debts.
In simple words: Liquidity ratios measure how easily a business can turn its assets into cash to pay off its short-term debts. They help us see if a company has enough ready money.

🎯 Exam Tip: Define liquidity as the ease of converting assets to cash. Highlight that liquidity ratios specifically assess a firm's ability to meet *short-term* financial obligations.

 

Question 7. What do you mean by the current ratio?
Answer: The current ratio shows the relationship between a business's current assets and its current liabilities. It is calculated by dividing current assets by current liabilities. This ratio helps to see if a company has enough short-term assets to pay off its short-term debts when they become due.
In simple words: The current ratio tells us if a company has enough quick money (current assets) to pay its immediate bills (current liabilities).

🎯 Exam Tip: State the formula (Current Assets / Current Liabilities) and its purpose: to indicate a company's ability to meet its current liabilities on time.

 

Question 8. What do you mean by Long-term solves ratios? what are its types?
Answer: Long-term solvency means a company's ability to pay back its long-term debts and interest over a long period. Long-term solvency ratios help figure out if a business can pay its debts in the future. These ratios are calculated to check the company's financial stability for a longer time. The main types of long-term solvency ratios are:
• Debt-equity ratio
• Proprietary ratio
• Capital gearing ratio
In simple words: Long-term solvency ratios check if a business can pay its debts that are due far in the future. They tell us about the company's financial strength for a long time.

🎯 Exam Tip: Clearly distinguish between short-term (liquidity) and long-term (solvency) ability to meet obligations. List the common types of long-term solvency ratios.

 

Question 9. What do you mean by Turnover Ratios? What are its types?
Answer: Turnover ratios show how effectively a company uses its assets or other items to generate revenue from operations. These ratios are also known as activity ratios or efficiency ratios because they show how fast various items move through the business. They are usually expressed as a number of times a particular item has been "turned over" or utilized in relation to another item.
The common types of turnover ratios are:
• Inventory turnover ratio
• Trade receivable turnover ratio
• Trade payable turnover ratio
• Fixed assets turnover ratio
In simple words: Turnover ratios show how well a business uses its things (like inventory or machines) to make sales. They are also called activity ratios and tell us how fast things are moving in the business.

🎯 Exam Tip: Emphasize that turnover ratios measure efficiency and activity, showing how effectively assets are utilized to generate sales. List the common types for full marks.

 

Question 10. What do you mean by Trade Receivable Turnover ratio?
Answer: The Trade Receivable Turnover ratio compares how much credit sales a business makes with its average amount of money owed by customers during a specific time. This ratio helps to show how fast a company collects cash from its customers who buy on credit. A higher ratio means the company is very good at collecting payments quickly.
In simple words: This ratio tells us how quickly a business collects money from customers who bought things on credit.

🎯 Exam Tip: Remember, a higher Trade Receivable Turnover ratio generally indicates better efficiency in managing receivables, as it shows money is being collected faster.

 

Question 11. What do you mean by Debt collection Period?
Answer: The Debt collection period is the average time a business takes to collect money owed by its customers (trade receivables). If this period is shorter, it means the business is more efficient at managing its cash flow by getting payments faster. This period can be calculated in days or months using these formulas:
Debt collection period (in days) =
\( \frac{\text { Number of days in a year }}{\text { Trade receivables turnover ratio }} \)
Debt collection period (in months) =
\( \frac{\text { Number of months in a year }}{\text { Trade receivables turnover ratio }} \)
In simple words: This is how long it takes a company, on average, to get money from its customers after they make a purchase on credit.

🎯 Exam Tip: A shorter debt collection period is usually better, as it shows that a company is quickly converting its credit sales into cash, improving its liquidity.

 

Question. What do you mean by Trade payable Turnover ratio?
Answer: The Trade Payable Turnover ratio compares a company's net credit purchases with its average amount of money owed to suppliers (trade payables) over an accounting period. It shows how quickly a business pays its suppliers. A high ratio indicates that the company is paying its suppliers very quickly, which can sometimes mean it is not taking full advantage of credit terms.
In simple words: This ratio shows how fast a company pays back its suppliers for things it bought on credit.

🎯 Exam Tip: A balance is key here; paying too quickly might mean missing out on cash flow benefits, while paying too slowly can damage supplier relationships.

 

Question 12. What do you mean by credit payment period?
Answer: The credit payment period is the average length of time a business takes to pay its bills to its suppliers. A shorter credit payment period means the business is very efficient at handling its accounts payable and settles its debts quickly. This period is calculated as follows:
Credit payment period (in days) =
\( \frac{\text { Number of days in a year }}{\text { Trade Payables turnover ratio }} \)
Credit payment period (in months) =
\( \frac{\text { Number of months in a year }}{\text { Trade payables turnover ratio }} \)
In simple words: This is the average time a business takes to pay its suppliers for goods or services bought on credit.

🎯 Exam Tip: While paying on time is good for reputation, an extremely short payment period might mean sacrificing working capital that could be used for other purposes.

 

Question 13. What do you mean by Fixed Assets Turnover?
Answer: The Fixed Assets Turnover ratio tells us how many times a company's fixed assets (like buildings and machinery) are "turned over" or used to generate revenue during a year. This ratio shows how well a company is using its fixed assets to make sales. A higher ratio usually means the company is efficiently using its assets.
In simple words: This ratio checks how effectively a business uses its long-term assets, like property and machines, to make money from sales.

🎯 Exam Tip: Comparing this ratio over several periods or against industry averages helps determine if a company is making the most of its long-term investments.

 

Question 14. What do you mean by profitability ratios? What are its types?
Answer: Profitability ratios are tools that help to measure how well a business is making a profit. They are used to see how efficiently a company is using its resources to earn money. These ratios are usually shown as percentages. Knowing these ratios helps in understanding a company's earning power.
The common types of profitability ratios are:
1. Gross profit ratio
2. Operating cost ratio
3. Operating profit ratio
4. Net profit ratio
5. Return on investment.
In simple words: Profitability ratios tell us how much profit a business is making compared to its sales or investments. They show how good the company is at earning money.

🎯 Exam Tip: These ratios are crucial for investors and managers as they provide insights into a company's financial health and operational efficiency.