--- title: "Chapter 9: Accounting Ratios" type: "Article" site_name: "TheSushant." publisher: "TheSushant." published_status: "publish" content_format: "markdown" author: "Sushant Kumar" published: "2026-04-17 23:23:59" modified: "2026-10-04 10:09:55" slug: "chapter-9-accounting-ratios" canonical: "https://thesushant.in/chapter-9-accounting-ratios/" excerpt: "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..." reading_time: 5 word_count: 822 featured_image: "" featured_image_alt: "" categories: - "Accounts" - "Chapters" - "Class 12th" - "Commerce" tags: generator: "WP Markdown TS" generator_version: "1.1" language: "en-US" --- # Chapter 9: Accounting Ratios ![Chapter 9: Accounting Ratios](https://thesushant.in/img/og.php?id=3442&w=768&h=403) ## 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 ---   **Enjoyed this?** Share it with others S ### [Sushant Kumar](https://thesushant.in/author/sushant/) 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. 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