**ACCOUNTANCY**

**B**

**UNIT -5**

**RATIO ANALYSIS**

**1. What is ratio analysis?**

**Ans:**Ratio analysis is a technique of analysis and interpretation of financial statements. It is the process of establishing and interpreting various ratios for helping in making certain decisions. Ratio analysis is not an end in itself. It is only a means of better understanding of financial strength and weakness of a firm.

**2. What are the advantages or importance or uses or objectives of ratio analysis?**

**Ans:**Following are the advantages or importance or uses or objectives of ratio analysis:

**a**.

__Simplifies financial statements:__Ratio analysis simplifies the comprehension of financial statements. Ratios tell the whole story of changes in the financial condition of a business.

**b**.

__Facilitates inter firm comparison:__Analysis provides data for inter firm comparison. Ratios high-light the factors associated with successful and unsuccessful firms.

**c**.

__Make intra-firm comparison possible:__Ratio analysis also makes possible comparison of the performance of the different divisions of the firm.

**d.**

__Helps in planning:__Ratio analysis helps in planning and forecasting. Over a period of time a firm or industry develops certain norms that may indicates future success of failure.

**3. What are the limitations of ratio analysis?**

**Ans:**Following are the limitations of ratio analysis:

a.

__Lack of adequate standards:__There are no well accepted standards or rules for all ratios which can be accepted as norms. It renders interpretation of the ratios difficult.
b.

__Change of accounting procedure:__Change in accounting procedure by a firm often makes ratio analysis misleading.
c.

__Price level changes:__Changes in price levels often make comparison of figures for various years difficult.
d.

__Inherent limitations of accounting:__Like financial statements, ratios also suffer from the inherent weakness of accounting records such as their historical nature. Ratios of the past are not necessarily true indicators of the future.
e.

__Personal Bias:__Ratios are only means of financial analysis and not an end in itself. Ratios have to be interpreted and different people may interpret the same ratio in different way.**4. What are the categories of which various ratios are grouped?**

**Ans:**(i) Liquidity ratios (ii) Solvency ratios

(iii) Efficiency ratios (iv) Profitability ratios.

**5. What are Liquidity ratios? Mention the ratios used for analysing the liquidity position of a firm.**

**Ans:**Liquidity ratios are the ratios meant for testing short term financial positions of a business. Liquidity ratios measure the ability of the unit to meet its short-term obligations and reveal the short term financial strength and weakness.

To measure the liquidity position of a firm, the following ratios can be
calculated:

**a.**Current ratio

**b.**Quick or Acid Test or Liquid ratio.

**c.**Absolute Liquid Ratio or Cash position ratio

**d.**Interval measure or defensive interval ratio.

**6. What are solvency ratios?**

**Ans:**Solvency ratio are also known as leverage ratio. These meant for testing long term financial soundness of any relationship between owned funds and loan funds. These ratios help us to interpreting capacity of the business to make periodic payment of interest and to repay long-term debt as per instalments stipulated in the contract.

Types of solvency ratio:

**a.**Dept equity ratio

**b.**Capital gearing ratio

**c.**Total asset to debt ratio

**d.**Proprietary ratio

**e.**Interest coverage or debt service ratio

**7. What are activity ratios? Explain the method of calculating any one of activity ratios.**

**Ans:**Activity or turnover ratios are concerned with measuring the efficiency in assets management. Efficiency implies effective utilization of available resources. The term turnover refers to the utilization of a resources or an asset in the process of business activity.

Types of activity ratios:

**a.**Inventory turnover ratio

**b.**Debtors turnover ratio

**c.**Creditors turnover ratio

**d.**Total asset turnover ratio

**e.**Fixed assets turnover ratio

**f.**Current turnover ratio

**g.**Working capital turnover ratio

**Inventory turnover ratio:**This ratio establishes a relationship between costs of goods sold and average inventory. The objective of computing this ratio is to ascertain the efficiency with which the inventory is utilised. This ratio is computed by dividing the costs of goods sold by the average inventory. This ratio is generally expressed as number of times. Formula for calculating

**8. What are profitability ratios?**

**Ans:**The main objective of business is to earn profit. Profitability ratio measures the working results of the units during the accounting periods. Profits are compared with sales level and investment level.

Following ratios are known as profitability ratios:

**a.**Gross profit ratio

**b.**Operating ratio.

**c.**Operating profit ratio.

**d.**Net profit ratio.

**9. What is the significance of gross profit and operating profit ratio?**

**Ans.**

__Gross profit ratio__: Gross profit ratio measures the relationship of gross profit to net sales and is usually represented as a percentage. Gross profit ratio provides guidelines to the concern whether it is earning sufficient profit to cover indirect expenses and is able to cover its direct expenses.

__Operating profit ratio:__Operating profit ratio shows the relationship between operating profit and net sales. Operating profit ratio is calculated by dividing operating profit by sales. Operating profit ratio indicates the earning capacity of the organisation on the basis of its business operations.

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