- Why This Chapter Matters
- 1. Meaning of Accounting Ratios
- Key Understanding:
- Example:
- 2. What Makes Ratios Useful (Reality)
- Important Rule:
- 3. Objectives of Ratio Analysis
- 1. Identifying Problem Areas
- 2. Improving Performance
- 3. Analysing Profitability
- 4. Measuring Liquidity
- 5. Evaluating Solvency
- 6. Enabling Comparisons
- 7. Supporting Future Planning
- 4. Advantages of Ratio Analysis
- 1. Simplifies Complex Data
- 2. Helps Decision Making
- 3. Enables Comparison
- 4. Identifies Strengths and Weaknesses
- 5. Supports SWOT Analysis
- 6. Improves Financial Understanding
- 5. Limitations of Ratio Analysis
- 1. Based on Financial Statements
- 2. Ignores Inflation
- 3. Ignores Qualitative Factors
- 4. Different Accounting Policies
- 5. No Universal Standards
- 6. Cannot Predict Future Accurately
- 7. Only Indicates Problems
- 6. Types of Accounting Ratios (Core Classification)
- A. Traditional Classification
- 1. Statement of Profit & Loss Ratios
- 2. Balance Sheet Ratios
- 3. Composite Ratios
- B. Functional Classification (Most Important)
- 1. Liquidity Ratios
- 2. Solvency Ratios
- 3. Activity (Efficiency) Ratios
- 4. Profitability Ratios
- 7. Liquidity Ratios
- 1. Current Ratio
- Interpretation:
- 2. Quick Ratio (Acid-Test Ratio)
- Interpretation:
- 8. Solvency Ratios
- 1. Debt-Equity Ratio
- Interpretation:
- 2. Interest Coverage Ratio
- Interpretation:
- 9. Activity (Efficiency) Ratios
- 1. Inventory Turnover Ratio
- Interpretation:
- 2. Trade Receivables Turnover Ratio
- Interpretation:
- 3. Trade Payables Turnover Ratio
- Interpretation:
- 4. Working Capital Turnover
- Interpretation:
- 10. Profitability Ratios
- 1. Gross Profit Ratio
- 2. Net Profit Ratio
- 3. Return on Capital Employed (ROCE)
- 4. Earnings Per Share (EPS)
- 5. Price-Earning Ratio (P/E)
- 11. How to Actually Use Ratios (Real Skill)
- Final Understanding
Why This Chapter Matters
This is the chapter where numbers start telling a story.
Financial statements give raw data.
Accounting ratios convert that data into:
- Performance insights
- Strength and weakness indicators
- Decision-making tools
This chapter is the bridge between accounting and real-world analysis.
1. Meaning of Accounting Ratios
An accounting ratio is a mathematical relationship between two financial figures taken from financial statements.
A ratio is a numerical relationship between two accounting numbers used to analyse financial performance.
Key Understanding:
- Ratio = Relationship, not just a number
- It can be expressed as:
- Fraction
- Percentage
- Ratio (e.g., 2:1)
- Times (e.g., 5 times)
Example:
If:
- Gross Profit = ₹10,000
- Revenue = ₹1,00,000
Gross Profit Ratio = 10%
This shows profit efficiency, not just numbers.
2. What Makes Ratios Useful (Reality)
Ratios are not useful because they are formulas.
They are useful because they:
- Simplify complex data
- Highlight relationships
- Show trends
- Reveal hidden problems
Important Rule:
If the base numbers are wrong → ratios will also be wrong
3. Objectives of Ratio Analysis
Ratio analysis helps in:
1. Identifying Problem Areas
Shows where business is weak
2. Improving Performance
Helps management take corrective action
3. Analysing Profitability
Shows earning capacity
4. Measuring Liquidity
Checks short-term financial health
5. Evaluating Solvency
Checks long-term stability
6. Enabling Comparisons
- With past years
- With other firms
- With industry standards
7. Supporting Future Planning
Helps in projections and estimates
4. Advantages of Ratio Analysis
1. Simplifies Complex Data
Large financial data becomes easy to understand
2. Helps Decision Making
Shows whether decisions taken are effective
3. Enables Comparison
- Intra-firm (same company)
- Inter-firm (different companies)
4. Identifies Strengths and Weaknesses
Highlights both positive and negative areas
5. Supports SWOT Analysis
Helps identify:
- Strengths
- Weaknesses
- Opportunities
- Threats
6. Improves Financial Understanding
Makes financial statements meaningful
5. Limitations of Ratio Analysis
This is where most students ignore reality.
1. Based on Financial Statements
If statements are incorrect → ratios are misleading
2. Ignores Inflation
Price level changes are not considered
3. Ignores Qualitative Factors
- Brand value
- Employee quality
- Market reputation
4. Different Accounting Policies
Different companies follow different methods → comparison becomes difficult
5. No Universal Standards
No fixed “ideal ratio” for all businesses
6. Cannot Predict Future Accurately
Past trends ≠ future guarantee
7. Only Indicates Problems
Does NOT provide solutions
6. Types of Accounting Ratios (Core Classification)
A. Traditional Classification
Based on financial statements:
1. Statement of Profit & Loss Ratios
- Both figures from P&L
- Example: Gross Profit Ratio
2. Balance Sheet Ratios
- Both figures from balance sheet
- Example: Current Ratio
3. Composite Ratios
- One from P&L + one from balance sheet
- Example: Debtors Turnover Ratio
B. Functional Classification (Most Important)
1. Liquidity Ratios
Measure short-term solvency
2. Solvency Ratios
Measure long-term stability
3. Activity (Efficiency) Ratios
Measure operational efficiency
4. Profitability Ratios
Measure earning capacity
7. Liquidity Ratios
Measure ability to pay short-term obligations.
1. Current Ratio
Current Ratio = Current Assets / Current Liabilities
Interpretation:
- Ideal: Around 2:1
- Too high → idle resources
- Too low → risk of default
2. Quick Ratio (Acid-Test Ratio)
Quick Ratio = Quick Assets / Current Liabilities
Quick Assets = Current Assets – Inventory – Prepaid expenses
Interpretation:
- Ideal: 1:1
- More reliable than current ratio
8. Solvency Ratios
Measure long-term financial strength.
1. Debt-Equity Ratio
Debt-Equity Ratio = Long-term Debt / Shareholders’ Funds
Interpretation:
- Ideal: Around 2:1
- High → risky
- Low → safe
2. Interest Coverage Ratio
Interest Coverage Ratio = Profit before Interest and Tax / Interest
Interpretation:
- Higher ratio = safer
- Shows ability to pay interest
9. Activity (Efficiency) Ratios
Measure how efficiently resources are used.
1. Inventory Turnover Ratio
Inventory Turnover = Cost of Goods Sold / Average Inventory
Interpretation:
- High → efficient
- Low → overstocking
2. Trade Receivables Turnover Ratio
Receivables Turnover = Credit Sales / Average Receivables
Interpretation:
- High → faster collection
- Low → poor recovery
3. Trade Payables Turnover Ratio
Payables Turnover = Credit Purchases / Average Payables
Interpretation:
- Low → delayed payments
- High → quick payments
4. Working Capital Turnover
Working Capital Turnover = Sales / Working Capital
Interpretation:
- Shows efficiency of short-term funds
10. Profitability Ratios
Measure earning capacity.
1. Gross Profit Ratio
Gross Profit Ratio = Gross Profit / Revenue × 100
2. Net Profit Ratio
Net Profit Ratio = Net Profit / Revenue × 100
3. Return on Capital Employed (ROCE)
ROCE = Profit before Interest and Tax / Capital Employed × 100
4. Earnings Per Share (EPS)
EPS = Profit for Equity Shareholders / Number of Shares
5. Price-Earning Ratio (P/E)
P/E Ratio = Market Price / EPS
11. How to Actually Use Ratios (Real Skill)
Ratios alone mean nothing.
You must:
- Compare with past years
- Compare with competitors
- Understand industry standards
- Analyse trends
Only then they become useful.
Final Understanding
This chapter is about interpreting financial reality using numbers.
If you understand:
- Types of ratios
- What they measure
- How to interpret them
Then:
- You can analyse any business
- You can identify risks and opportunities
- You move from student → financial thinker
Sushant Kumar
Founder
As a current B.Com (Hons) student at DU SOL and an active Chartered Accountancy (CA) aspirant, I understand the exact pressure, syllabus confusion, and administrative hurdles students face daily. TheSushant.in was built to provide first-hand, stress-tested guidance. Every DU SOL update, exam strategy, and CA study note shared here comes directly from my personal academic journey, official notifications, and real-time student experience. No generic advice: practical, student-to-student blueprints to help you clear your exams and level up.
