Chapter 5 — Accounting Ratios

Chapter 5 of the Class 12 Accountancy NCERT textbook, "Accounting Ratios," covers 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.

• What accounting ratios are and why they help — A ratio simply expresses the relationship between two figures from the financial statements, shown as a fraction, percentage or number of times. Analysing them exposes a firm's strong and weak areas and supports comparison with rivals and industry norms.
• Judging short-term and long-term financial strength — Liquidity ratios like the current and quick ratios test whether a firm can meet immediate obligations, while solvency ratios such as debt-equity and interest coverage reveal its capacity to service long-term borrowings and stay financially stable.
• Measuring efficiency and earning power — Activity or turnover ratios show how effectively inventory, receivables and assets are put to work, whereas profitability ratios — from gross and net profit margins to return on investment and EPS — reveal how much earning the business generates.
• Where ratio analysis falls short — Ratios are only as reliable as the accounting data behind them. They ignore price-level changes and qualitative factors, differ with each firm's accounting practices, and lack universally agreed ideal levels, so they must be read with care.

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.