Class 12 Accountancy Part 2 Chapter 5 Accounting Ratios

Meaning of Accounting Ratio

Accounting ratios also referred to as financial ratios, are applied to compute the performance and profitability of a firm grounded on its financial statements. They furnish a way of stating the association between one accounting data point to another and are the source of ratio analysis.

To put it in other words, an Accounting ratio implies a quantitative agreement which is employed for the purpose of decision making and analysis. It furnishes the basis for intra-firm as well as inter-firm comparisons. Further, in order to make the ratios efficient, they are compared with ratios of base period or with the industry average ratios or with criteria.

Types of Accounting Ratios:

Ratios in accounting can be classified into traditional and functional types.

Based on traditional classification

  1. Profit and Loss Ratio
  2. Balance Sheet Ratio
  3. Composite Ratio

Based on functional classification

  1. Liquidity Ratio
  2. Profitability Ratio
  3. Leverage Ratio
  4. Activity Ratio
  5. Coverage Ratios or Solvency Ratios

Also Read: DK Goel Solutions for Accounting Ratios

Objectives of Accounting Ratio:

Ratio analysis is a vital part of the analysis of outcomes unveiled by financial statements. It furnishes the users with essential financial data and points out the areas which demand research. Ratio analysis is a method which includes regrouping of information by utilisation of arithmetical associations, though its interpretation is a complicated concern. It needs a fine knowledge and the laws used for outlining the financial statements. Once it is done efficiently, it furnishes a lot of data which helps the analyst :

  • To be aware of the areas of the trade which requires more concentration
  • To know about the possible areas which can be developed with the effort in the solicited direction
  • To furnish a deeper analysis of liquidity, solvency, efficiency and profitability degrees in the trading concern
  • To furnish data for making a cross-sectional investigation by comparing the achievement with the valid business models
  • To furnish data procured from financial statements beneficial for making forecasts and estimations for the prospect

Additional Reading: Types of Financial Ratios

Computation of Liquidity Ratios

Liquidity The ability of the firm to meet its short term obligations.
Liquidity Ratio Calculating the ratio for liquidity.
Types of Liquidity Ratios
  • Quick Ratio
  • Current Ratio
Current Ratio It is the relationship between current assets and current liabilities of the firm.

Mathematically it is represented as:

Current Ratio =

\(\begin{array}{l}\large \frac{current \, Assets }{current \, liabilities}\end{array} \)
Liquid Ratio It is the relationship between liquid assets or quick assets and current liabilities of the firm.

Mathematically it is represented as:

Liquid ratio or quick ratio or acid test ratio =

\(\begin{array}{l}\large \frac{Liquid \, Assets \,or \, Quick Assets }{current \, liabilities}\end{array} \)

Methods of Expressing Accounting Ratios

1. Proportion Ratio: In this form, the relationship between the two items is directly expressed in proportion. For e.g. Current Ratio explains the relationship between Current Assets and Current Liabilities.

2. Times: In this form, the ratio is expressed in a number of times, a particular item in comparison to other items.

3. Percentage: In this form, the relationship between the two items is expressed in percentage. For e.g. Net Profit expresses the relationship between Net profit and Revenue from Operations.

Ratio Analysis

  • Analysis of financial statement with the help of ratio can be termed as ratio analysis.
  • Examination and interpretation of the relationship between numerical figures.

What Are the Objectives of Ratio Analysis?

  • Provides analysis of profitability, liquidity, the solvency of the business.
  • Traces the area which seeks more attention
  • Helps in making estimates
  • Supports in comparing the performance with best industry standards.

What Are the Advantages of Ratio Analysis?

  • Assists in comparative studies.
  • Simplifies complex figures.
  • Supports financial analysis.
  • Helpful in forecasting
  • Helps in judging the operating efficiency of a business.

Also Read: Advantages and Disadvantages of Ratio Analysis

Limitations of Ratio Analysis?

  • The analysis will give a false picture of the affairs if financial statements are not true & fair.
  • It ignores qualitative factors which can be important in decision making.
  • Ratio analysis is not free from personal bias.
  • If two companies follow different accounting policies then ratios cannot be compared.
Multiple Choice Questions
Q-1. Current Ratio is calculated by:/
(a). Current Liabilities/Current Assets.

(b). Current Assets/Current Liabilities.

(c). Current Assets/Long Term Liabilities.

(d). Long term assets/ Long term liabilities.

Q-2. The Ideal Current ratio is:
(a). 1.25:1

(b). 2:1

(c). 1:2

(d). 10%

Q-3. The liquid ratio is calculated by:
(a). Current ratio/ Net Profit Ratio.

(b). Current assets/ Liquid Liabilities.

(c). Liquid Assets OR Quick Assets/ Current Liabilities.

(d). Current Liabilities/ Liquid Assets

Answer Key
1-b, 2-b, 3-c.

The above mentioned is the concept, that is elucidated in detail about the Accounting Ratios, its meaning and objectives for the Class 12 Commerce students. To know more, stay tuned to BYJU’S.


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