Chapter accounting-ratios: Accounting Ratios Short Questions | accountancy Class 12 CBSE

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Chapter accounting-ratios: Accounting Ratios Short Questions | accountancy Class 12 CBSE | ByteNotes.in

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Question 1

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Define accounting ratio and explain how it is expressed.

An accounting ratio is a mathematical number calculated as a reference to the relationship between two accounting numbers derived from the financial statements of a business.
A ratio can be expressed in multiple forms: as a fraction (e.g., 1/2), as a proportion or pure ratio (e.g., 2:1), as a percentage (e.g., 10%), or as a number of times (e.g., 3 times).
For a ratio to be meaningful, the two numbers used must be meaningfully correlated — using unrelated figures (e.g., furniture and purchases) results in a ratio that serves no analytical purpose.

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Question 2

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State any three objectives of ratio analysis.

To provide a deeper analysis of the profitability, liquidity, solvency and efficiency levels in the business, enabling a clearer view of financial health.
To identify problem areas as well as bright areas of the business, helping management direct attention and resources where needed.
To provide information for making cross-sectional analysis by comparing the performance of the firm with the best industry standards and for making projections and estimates for the future.

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Question 3

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Explain the traditional classification of ratios based on financial statements.

Statement of Profit and Loss Ratios: When both variables used to compute the ratio are taken from the statement of profit and loss, for example, gross profit ratio.
Balance Sheet Ratios: When both variables are taken from the balance sheet, for example, the current ratio (current assets to current liabilities).
Composite Ratios: When one variable is taken from the statement of profit and loss and the other from the balance sheet, for example, trade receivables turnover ratio.

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Question 4

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What is current ratio? State the items included in current assets and current liabilities for its computation.

Current ratio is the proportion of current assets to current liabilities (Current Assets / Current Liabilities) and measures the degree to which current assets cover current liabilities.
Current assets include current investments, inventories, trade receivables, cash and cash equivalents, short-term loans and advances, prepaid expenses, advance tax and accrued income.
Current liabilities include short-term borrowings, trade payables (creditors and bills payables), other current liabilities and short-term provisions.

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Medium

Question 5

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What is quick ratio? Why is it considered a better measure of liquidity than the current ratio?

Quick ratio is the ratio of quick assets to current liabilities (Quick Assets / Current Liabilities), also called Acid-Test Ratio. Quick assets are current assets minus inventories and other non-liquid items like prepaid expenses and advance tax.
It is considered better than current ratio because it excludes inventories and other non-liquid current assets which cannot be quickly converted into cash, giving a more stringent test of short-term liquidity.
The ideal quick ratio is 1:1; it serves as a supplementary check on the liquidity position and indicates the capacity of the business to meet short-term obligations without relying on inventory conversion.

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Question 6

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State the significance of the current ratio. What does a very high and a very low current ratio indicate?

Current ratio measures the degree to which current assets cover current liabilities and provides a measure of the safety margin available against uncertainty in realisation of current assets.
A very high current ratio implies heavy investment in current assets, reflecting under-utilisation or improper utilisation of resources, which is not a good sign.
A very low current ratio endangers the business as it may not be able to pay short-term debts on time, adversely affecting the firm's creditworthiness. Normally, a ratio within the range of 2:1 is considered safe.

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Question 7

Quick Recall

Explain Debt-Equity Ratio with its formula and significance.

Debt-Equity Ratio measures the relationship between long-term debt and equity (shareholders' funds). Formula: Long-term Debts / Shareholders' Funds. A debt-equity ratio of 2:1 is normally considered safe.
A low debt-equity ratio reflects more security for outsiders (lenders) as it indicates a smaller debt component in the total long-term funds, reducing chances of bankruptcy.
A high ratio is considered risky as it may put the firm into difficulty in meeting obligations; however, from the owners' perspective, greater use of debt (trading on equity) may ensure higher returns if earnings on capital employed exceed the interest rate payable.

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Medium

Question 8

Quick Recall

What is Interest Coverage Ratio? How is it calculated and what does a higher ratio indicate?

Interest Coverage Ratio is a measure of the security of interest payable on long-term debts. It expresses the relationship between profits available for payment of interest and the amount of interest payable.
Formula: Net Profit before Interest and Tax / Interest on long-term debts. The result is expressed as the number of times interest is covered by available profits.
A higher ratio ensures greater safety of interest payments to debt holders, indicating that the business generates sufficient profits to comfortably service its interest obligations.

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Medium

Question 9

Quick Recall

What is Inventory Turnover Ratio? Explain its formula and significance.

Inventory Turnover Ratio determines the number of times inventory is converted into revenue from operations during the accounting period. Formula: Cost of Revenue from Operations / Average Inventory.
Average inventory is the arithmetic average of opening and closing inventory; cost of revenue from operations equals revenue from operations minus gross profit.
A low turnover may signal bad buying or obsolete inventory; a high turnover is generally good but may also indicate buying in small lots or selling quickly at low margins. It is also used as a measure of liquidity.

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Medium

Question 10

Quick Recall

Explain Trade Receivables Turnover Ratio and how the Average Collection Period is derived from it.

Trade Receivables Turnover Ratio indicates the number of times receivables are turned over and converted into cash in an accounting period. Formula: Net Credit Revenue from Operations / Average Trade Receivables.
Average Trade Receivables = (Opening Debtors and Bills Receivable + Closing Debtors and Bills Receivable) / 2. Debtors should be taken before making any provision for doubtful debts.
Average Collection Period = Number of days or months in a year / Trade Receivables Turnover Ratio. A higher turnover and a lower collection period indicate more efficient and speedy collection from trade receivables.

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Medium

Question 11

Quick Recall

What is Trade Payables Turnover Ratio and what is its significance?

Trade Payables Turnover Ratio indicates the pattern of payment to trade payables. Formula: Net Credit Purchases / Average Trade Payables, where Average Trade Payables = (Opening + Closing Creditors and Bills Payable) / 2.
Average Payment Period = Number of days/months in a year / Trade Payables Turnover Ratio. A lower ratio means credit allowed by suppliers is for a longer period.
A very low ratio may also reflect delayed payment to suppliers, which is not a good policy as it may harm the reputation of the business. This ratio is closely monitored by lenders and suppliers.

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Medium

Question 12

Quick Recall

Explain the Gross Profit Ratio with its formula and state what its change may indicate.

Gross Profit Ratio expresses gross profit as a percentage of net revenue from operations. Formula: Gross Profit / Net Revenue from Operations × 100. It indicates the gross margin on products sold.
It also indicates the margin available to cover operating expenses and non-operating expenses. Higher gross profit ratio is always a good sign for the business.
A change in gross profit ratio may be due to a change in selling price, a change in cost of revenue from operations, or a combination of both. A low ratio may indicate unfavourable purchase and sales policy.

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Question 13

Quick Recall

Distinguish between Operating Ratio and Operating Profit Ratio.

Operating Ratio measures the total cost of operations as a percentage of net revenue from operations. Formula: (Cost of Revenue from Operations + Operating Expenses) / Net Revenue from Operations × 100. A lower operating ratio is a healthy sign.
Operating Profit Ratio reveals the operating margin available on revenue from operations. Formula: Operating Profit / Revenue from Operations × 100. Alternatively, Operating Profit Ratio = 100 minus Operating Ratio.
Operating expenses include office, administrative, selling, distribution expenses and depreciation; the cost of operation is determined by excluding non-operating items like loss on sale of assets, interest paid, dividend received, and speculation gain.

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Chapter accounting-ratios: Accounting Ratios | Short Questions

Define accounting ratio and explain how it is expressed.

State any three objectives of ratio analysis.

Explain the traditional classification of ratios based on financial statements.

What is current ratio? State the items included in current assets and current liabilities for its computation.

What is quick ratio? Why is it considered a better measure of liquidity than the current ratio?

State the significance of the current ratio. What does a very high and a very low current ratio indicate?

Explain Debt-Equity Ratio with its formula and significance.

What is Interest Coverage Ratio? How is it calculated and what does a higher ratio indicate?

What is Inventory Turnover Ratio? Explain its formula and significance.

Explain Trade Receivables Turnover Ratio and how the Average Collection Period is derived from it.

What is Trade Payables Turnover Ratio and what is its significance?

Explain the Gross Profit Ratio with its formula and state what its change may indicate.

Distinguish between Operating Ratio and Operating Profit Ratio.

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