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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