NCERT Solutions Class 12 Accountancy Chapter 5 Accounting Ratios

State which of the following statements are True or False.

Question (a). The only purpose of financial reporting is to keep the managers informed about the progress of operations.
Answer: False
In simple words: Financial reports are not meant only for internal managers; they also provide crucial information to external users like investors, tax authorities, and creditors.

Exam Tip: Remember that financial statements serve both internal users (management) and external stakeholders (creditors, investors, and regulatory bodies).

Question (b). Analyses of data provided in the financial statements a is termed as financial analysis.
Answer: True
In simple words: Financial analysis is the process of examining and interpreting the numbers in financial reports to understand how well a business is performing.

Exam Tip: Financial analysis involves the simplification and interpretation of complex financial figures to make them useful for decision-making.

Question (c). Long term creditors are concerned about the ability of a firm to discharge its obligations to pay interest and repay the principal amount of term.
Answer: True
In simple words: Lenders who provide long-term funds want to be sure that the company can pay regular interest and return the main borrowed amount when it becomes due.

Exam Tip: Solvency ratios, like the interest coverage ratio and debt-equity ratio, are specifically monitored by long-term lenders to evaluate default risk.

Question (d). A ratio is always expressed as a quotient of one number divided by another.
Answer: False
In simple words: Ratios do not have to be written as basic divisions. They can also be shown as percentages, times (rates), or standard proportions like 2:1.

Exam Tip: Accounting ratios are expressed in four main formats: pure ratios, percentages, times (rates), or fractions.

Question (e). Ratios help in comparisons of a firm’s results over a number of accounting periods as well as with other business enterprises.
Answer: True
In simple words: Using ratios makes it easy to compare a company's performance over different years or against rival companies in the same industry.

Exam Tip: Ratios are vital for two types of evaluation: intra-firm comparison (comparing a firm's own past years) and inter-firm comparison (comparing with other businesses).

Question (f). One ratios reflect both quantitative and qualitative aspects.
Answer: False
In simple words: Accounting ratios only calculate numerical and financial figures, which means they do not capture qualitative features like brand value or worker dedication.

Exam Tip: Qualitative aspects are completely ignored in financial ratio analysis, which is considered one of its primary limitations.

Do It Yourself I

Question 1. Current ratio =4.5:1, quick ratio =3:1, Inventory is Rs.36,000. Calculate the current assets and current liabilities.
Answer:
Let the current liabilities be \( x \).
Since the current ratio is \( 4.5 : 1 \), the current assets are equal to \( 4.5x \).
Since the quick ratio is \( 3 : 1 \), the quick (liquid) assets are equal to \( 3x \).

We know the mathematical relationship:
\[ \text{Inventory} = \text{Current Assets} - \text{Liquid Assets} \]
\[ 36,000 = 4.5x - 3x \]
\[ 36,000 = 1.5x \]
\[ x = \frac{36,000}{1.5} \]
\[ x = 24,000 \]

Therefore:
\[ \text{Current Liabilities} = \text{Rs. } 24,000 \]
\[ \text{Current Assets} = 4.5 \times 24,000 = \text{Rs. } 1,08,000 \]
In simple words: Subtracting quick assets from current assets gives us inventory. By using the given ratios in a simple algebraic formula, we find that current liabilities are Rs. 24,000 and current assets are Rs. 1,08,000.

Exam Tip: Always remember that the difference between current assets and quick assets is represented by stock (inventory) plus prepaid expenses.

Question 2. Current liabilities of a company are Rs. 5,60,000 current ratio is 5 : 2 and quick ratio is 2 : 1. Find the value of the stock.
Answer:
Given:
\[ \text{Current Liabilities (CL)} = \text{Rs. } 5,60,000 \]
\[ \text{Current Ratio} = 5 : 2 \]
\[ \text{Quick Ratio} = 2 : 1 \]

(i) Calculation of Current Assets (CA):
\[ \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} \]
\[ \frac{5}{2} = \frac{\text{CA}}{5,60,000} \]
\[ 2 \times \text{CA} = 5 \times 5,60,000 \]
\[ \text{CA} = \frac{28,00,000}{2} = \text{Rs. } 14,00,000 \]

(ii) Calculation of Quick Assets (QA):
\[ \text{Quick Ratio} = \frac{\text{Quick Assets}}{\text{Current Liabilities}} \]
\[ \frac{2}{1} = \frac{\text{QA}}{5,60,000} \]
\[ \text{QA} = 2 \times 5,60,000 = \text{Rs. } 11,20,000 \]

(iii) Calculation of Stock:
\[ \text{Stock} = \text{Current Assets} - \text{Quick Assets} \]
\[ \text{Stock} = 14,00,000 - 11,20,000 = \text{Rs. } 2,80,000 \]
In simple words: Using the current ratio, we find that the current assets are Rs. 14,00,000. Using the quick ratio, we find the quick assets are Rs. 11,20,000. Subtracting the two values gives the stock amount of Rs. 2,80,000.

Exam Tip: Calculate current assets and quick assets separately before subtracting them to find the value of stock. This step-by-step layout keeps your workspace clear and earns full marks.

Question 3. Current assets of a company are Rs. 5,00,000. Current ratio is 2.5 : 1 and quick ratio is 1 : 1. Calculate the value of current liabilities, liquid assets and stock.
Answer:
Given:
\[ \text{Current Assets (CA)} = \text{Rs. } 5,00,000 \]
\[ \text{Current Ratio} = 2.5 : 1 \]
\[ \text{Quick Ratio} = 1 : 1 \]

(i) Calculating Current Liabilities (CL):
\[ \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} \]
\[ 2.5 = \frac{5,00,000}{\text{CL}} \]
\[ \text{CL} = \frac{5,00,000}{2.5} = \text{Rs. } 2,00,000 \]

(ii) Calculating Liquid (Quick) Assets:
\[ \text{Quick Ratio} = \frac{\text{Quick Assets}}{\text{Current Liabilities}} \]
\[ 1 = \frac{\text{Quick Assets}}{2,00,000} \]
\[ \text{Quick Assets} = \text{Rs. } 2,00,000 \]

(iii) Calculating Stock:
\[ \text{Stock} = \text{Current Assets} - \text{Quick Assets} \]
\[ \text{Stock} = 5,00,000 - 2,00,000 = \text{Rs. } 3,00,000 \]
In simple words: First, we divide our current assets of Rs. 5,00,000 by 2.5 to find that current liabilities are Rs. 2,00,000. Since the quick ratio is 1:1, quick assets are also Rs. 2,00,000. The leftover amount of Rs. 3,00,000 is our stock.

Exam Tip: If the quick ratio is 1:1, it always implies that quick assets are exactly equal to current liabilities. Keeping this rule in mind lets you verify your calculations instantly.

Test Your Understanding II

Question (i). The following groups of ratios primarily measure risk
(a) liquidity, activity and profitability
(b) liquidity, activity and common stock
(c) liquidity, activity and debt
(d) activity, debt and profitability
Answer: (c) liquidity, activity and debt
In simple words: Risk is assessed by checking how easily a business pays immediate bills (liquidity), manages its core processes (activity), and handles long-term loans (debt).

Exam Tip: Examiners look for these three key pillars when discussing financial risk - short-term obligations (liquidity), operational turnover (activity), and long-term borrowing (debt).

Question (ii). The ________ ratios are primarily measures of return.
(a) liquidity
(b) activity
(c) debt
(d) profitability
Answer: (b) activity
In simple words: These ratios are used to check how efficiently assets are used to generate business activities and operations.

Exam Tip: According to the NCERT textbook, activity ratios evaluate how effectively a business utilizes its assets to generate operational turnover and returns.

Question (iii). The ____________ of a business firm is measured by its ability to satisfy its short term obligations as they come due.
(a) activity
(b) liquidity
(c) debt
(d) profitability
Answer: (b) liquidity
In simple words: Liquidity is a measure of how prepared a firm is to pay off its short-term debts and running expenses as soon as they are due.

Exam Tip: Always associate short-term debt-paying capacity with liquidity ratios, whereas long-term payment capacity is linked to solvency ratios.

Question (iv). ____________ ratios are a measure of the speed with which various accounts are converted into sales or cash.
(a) Activity
(b) Liquidity
(c) Debt
(d) Profitability
Answer: (a) Activity
In simple words: Activity ratios show how fast a company can turn its accounts receivable, inventory, or working capital into actual sales or cash.

Exam Tip: Activity ratios are also called efficiency or turnover ratios because they show how fast a company cycles its assets.

Question (v). The two basic measure of liquidity are
(a) inventory turnover and current ratio
(b) current ratio and liquid ratio
(c) gross profit margin and operating ratio
(d) current ratio and average collection period
Answer: (b) current ratio and liquid ratio
In simple words: The two key tools used to measure a company's short-term financial strength are its current ratio and its liquid (or quick) ratio.

Exam Tip: When asked to calculate liquidity in numerical problems, always calculate both the current ratio and the quick ratio to provide a complete picture.

Question (vi). The ____________ is a measure of liquidity which excludes ____________, generally the least liquid asset.
(a) current ratio, accounts debtors
(b) liquid ratio, accounts debtors
(c) current ratio, inventory
(d) liquid ratio, inventory
Answer: (d) liquid ratio, inventory
In simple words: The liquid ratio measures immediate cash safety, and it ignores inventory because stock takes the longest time to sell and convert back into cash.

Exam Tip: Remember that inventory is excluded when moving from current assets to quick assets because it cannot be readily turned into cash in an emergency.

Do It Yourself II

Question 1. Calculate the amount of gross profit
Average stock = Rs.80,000
Stock turnover ratio = 6 times
Selling price = 25% above cost
Answer:
Given:
\[ \text{Average Stock} = \text{Rs. } 80,000 \]
\[ \text{Stock Turnover Ratio (STR)} = 6 \text{ times} \]
\[ \text{Selling Price} = \text{Cost} + 25\% \]

(i) Calculating Cost of Goods Sold (COGS):
\[ \text{Stock Turnover Ratio} = \frac{\text{Cost of Goods Sold}}{\text{Average Stock}} \]
\[ 6 = \frac{\text{COGS}}{80,000} \]
\[ \text{COGS} = 80,000 \times 6 = \text{Rs. } 4,80,000 \]

(ii) Calculating Gross Profit:
Since Gross Profit is 25% on cost (COGS):
\[ \text{Gross Profit} = 25\% \text{ of COGS} \]
\[ \text{Gross Profit} = \frac{25}{100} \times 4,80,000 = \text{Rs. } 1,20,000 \]

(iii) Calculating Selling Price:
\[ \text{Selling Price} = \text{COGS} + \text{Gross Profit} \]
\[ \text{Selling Price} = 4,80,000 + 1,20,000 = \text{Rs. } 6,00,000 \]
In simple words: First, we find the cost of goods sold by multiplying the average stock of Rs. 80,000 by the stock turnover of 6 to get Rs. 4,80,000. Since profit is 25% of this cost, we take 25% of Rs. 4,80,000, which gives Rs. 1,20,000.

Exam Tip: Pay close attention to whether the profit percentage is based on 'cost' or 'selling price'. In this problem, 'above cost' means you apply the percentage directly to the Cost of Goods Sold.

Question 2. Calculate stock Turnover Ratio
Annual sales = Rs. 2,00,000
Gross profit = 20% on cost of Goods sold
Opening stock = Rs. 38,500
Closing stock = Rs. 41,500
Answer:
Given:
\[ \text{Annual Sales} = \text{Rs. } 2,00,000 \]
\[ \text{Gross Profit (GP)} = 20\% \text{ on Cost of Goods Sold (COGS)} \]
\[ \text{Opening Stock} = \text{Rs. } 38,500 \]
\[ \text{Closing Stock} = \text{Rs. } 41,500 \]

Let COGS be \( x \).
Since Gross Profit is 20% of COGS, we have:
\[ \text{Gross Profit} = 20\% \text{ of } x = \frac{20}{100} \times x = 0.2x \]

We know:
\[ \text{Sales} = \text{COGS} + \text{Gross Profit} \]
\[ 2,00,000 = x + 0.2x \]
\[ 2,00,000 = 1.2x \]
\[ x = \frac{2,00,000}{1.2} \approx \text{Rs. } 1,66,667 \]
So, \( \text{COGS} = \text{Rs. } 1,66,667 \).

(i) Calculating Average Stock:
\[ \text{Average Stock} = \frac{\text{Opening Stock} + \text{Closing Stock}}{2} \]
\[ \text{Average Stock} = \frac{38,500 + 41,500}{2} = \frac{80,000}{2} = \text{Rs. } 40,000 \]

(ii) Calculating Stock Turnover Ratio:
\[ \text{Stock Turnover Ratio} = \frac{\text{Cost of Goods Sold}}{\text{Average Stock}} \]
\[ \text{Stock Turnover Ratio} = \frac{1,66,667}{40,000} \approx 4.17 \text{ times} \]
In simple words: Since gross profit is 20% of the cost, we calculate that our cost of goods sold is about Rs. 1,66,667. The average value of inventory we keep is Rs. 40,000. Dividing these gives us a stock turnover ratio of about 4.17 times.

Exam Tip: When the profit percentage is given 'on cost' but only sales are known, use algebraic formulas or the fraction trick (\( 20\% \text{ on cost} = \frac{1}{5} \text{ of cost} = \frac{1}{6} \text{ of sales} \)) to quickly find the COGS.

Test Your Understanding III

Question (i). The ________ is useful in evaluating credit and collection policies.
(a) average payment period (b) current ratio
(c) average collection period (d) current asset turnover
Answer: (c) average collection period
In simple words: The average collection period tracks how many days it takes for a firm to collect cash from customers, showing if the credit system is working well.

Exam Tip: A shorter average collection period is preferred because it indicates prompt payments and highly effective credit policies.

Question (ii). The ________ measures the activity of a firm’s inventory.
(a) average collection period (b) inventory turnover
(c) liquid ratio (d) current ratio
Answer: (b) inventory turnover
In simple words: Inventory turnover evaluates how fast a business can sell and restock its goods throughout an accounting period.

Exam Tip: Activity ratios are also known as velocity ratios because they measure the speed or frequency with which business assets are utilized.

Question (iii). The ________ ratio may indicate the firm is experiencing stock outs and lost sales.
(a) average payment period (b) inventory turnover
(c) average collection period (d) quick
Answer: (d) quick
In simple words: A high quick ratio show that a business has very low stock levels, which might lead to stock shortages and missed sales opportunities.

Exam Tip: While high liquidity means low financial risk, keep in mind that a very high quick ratio could point to under-investment in inventory, causing frequent stock shortages.

Question (iv). ABC Co extends credit terms of 45 days to its customer, its credit collection would be considered poor if its average collection period was
(a) 30 days (b) 36 days
(c) 47 days (d) 57 days
Answer: (c) 47 days
In simple words: Since customers are given 45 days to make their payments, any collection time longer than that, like 47 days, represents slow and poor collection.

Exam Tip: To evaluate credit terms, compare the allowed credit period with the actual collection period. Any excess time is a sign of operational delay.

Question (v). ____________ are especially interested in the average payment period, since it provides them with a sense of the bill-paying patterns of the firm.
(a) Customers (b) Stockholders
(c) Lenders and suppliers (d) Borrowers and buyers
Answer: (c) Lenders and suppliers
In simple words: Suppliers and short-term lenders look at the payment period to see how quickly a company pays its bills and settled its accounts.

Exam Tip: Suppliers and trade creditors use the average payment period to check creditworthiness and confirm payment reliability.

Question (vi). The ____________ ratios provide the information critical to the long-run operation of the firm
(a) liquidity (b) activity
(c) solvency (d) profitability
Answer: (c) Solvency
In simple words: Solvency ratios tell us if a business is stable enough to survive in the long run and keep up with its long-term financial commitments.

Exam Tip: Clearly distinguish liquidity (short-term obligations) from solvency (long-term survival and obligations) in your descriptive answers.

Short Answer Type Questions

Question 1. What do you mean by Ratio Analysis?
Answer:
Ratio analysis is a highly effective methodology used to evaluate financial statements. A ratio is simply a mathematical metric that expresses one number in relation to another. It serves as a quantitative standard that allows analysts to compare and measure the relationships between different financial values. By dividing one financial figure by another, we can discover how these numbers relate to each other and assess the financial health of the business.
In simple words: Ratio analysis is a technique used to compare different numbers from financial reports to see how well a business is performing. It reveals the exact mathematical connection between key business metrics.

Exam Tip: Define ratio analysis as a tool for financial statement analysis and state that it helps in comparing different accounting figures across periods or industries.

Question 2. What are various types of ratios?
Answer:
Accounting ratios can be classified under two main frameworks: (i) Traditional Classification: This system groups ratios depending on which financial statements the figures are taken from: (a) Income Statement Ratios: These use numbers exclusively from the Trading and Profit and Loss account, such as the Gross Profit Ratio. (b) Balance Sheet Ratios: These are formulated using numbers entirely from the Balance Sheet, like the Current Ratio or Debt-Equity Ratio. (c) Composite Ratios: These combine figures from both the balance sheet and the income statement, such as the Debtors Turnover Ratio. (ii) Functional Classification: This system classifies ratios based on the specific purpose and operational need they address: (a) Liquidity Ratios: These assess the short-term cash position and payment capacity of the business. (b) Solvency Ratios: These evaluate the company's ability to honor long-term liabilities. (c) Activity Ratios: These measure operational efficiency by checking how fast assets are turned into sales. (d) Profitability Ratios: These analyze the overall success and earning capacity of the business operations.
In simple words: Ratios are grouped either by where the numbers come from in financial reports (traditional) or by what they are trying to measure, such as profits, debts, or short-term bills (functional).

Exam Tip: Present both frameworks (traditional and functional) clearly using bullet points to show a comprehensive understanding of classification.

Question 3. What relationships will be established to study? (a) Inventory Turnover (b) Debtor Turnover (c) Payables Turnover (d) Working Capital Turnover
Answer:
The following relationships are examined through these functional ratios: (a) Inventory Turnover Ratio: This ratio establishes the relationship between the cost of goods sold and the average inventory kept in stock. It measures how many times inventory is sold and replaced during a period, showing how efficiently stock is managed. \[ \text{Inventory Turnover Ratio} = \frac{\text{Cost of Goods Sold}}{\text{Average Inventory}} \] (b) Debtor Turnover Ratio: This compares net credit sales with the average trade debtors during the year. It measures the velocity of cash collection from credit customers. \[ \text{Debtor Turnover Ratio} = \frac{\text{Net Credit Sales}}{\text{Average Trade Debtors}} \] (c) Creditors/Payables Turnover Ratio: This shows the relationship between credit purchases and the average trade creditors of the company. It measures how quickly the business settles its bills with suppliers. \[ \text{Creditors Turnover Ratio} = \frac{\text{Net Credit Purchases}}{\text{Average Trade Creditors}} \] (d) Working Capital Turnover Ratio: This ratio measures the relationship between the cost of sales (or net sales) and the net working capital of the firm, showing how effectively operating funds are utilized to generate revenue. \[ \text{Working Capital Turnover Ratio} = \frac{\text{Cost of Sales}}{\text{Net Working Capital}} \]
In simple words: These ratios check how fast a business rotates its stock, collects cash from customers, pays its suppliers, and uses its working cash to run daily operations.

Exam Tip: For all turnover ratios, write the formulas clearly and state your answers in "times." Be sure to define what components like average stock or debtors consist of.

Question 4. Why would the inventory turnover ratio be more important when analysing a grocery store than an insurance company?
Answer:
The nature of operations determines the importance of the inventory turnover ratio. A grocery store is a retail trading business that must purchase, hold, and sell physical goods regularly. Checking how fast these food items sell is vital to avoid spoilage and manage cash flow. In contrast, an insurance company is a service business. Because services are consumed instantly and cannot be kept in a warehouse, there is no physical stock to track. Consequently, the inventory turnover ratio is highly critical for a grocery store but entirely irrelevant for an insurance provider.
In simple words: A grocery store must track how fast food is sold and restocked before it goes bad. Since an insurance company sells services instead of physical goods, it has no stock to track.

Exam Tip: Point out the fundamental difference between trading concerns (dealing with physical, perishable goods) and service industries (dealing with intangible, non-storable services) to make your answer complete.

Question 5. The liquidity of a business firm is measured by its ability to satisfy its long term obligations as they become due? Comment.
Answer:
Yes, the firm's long-term safety is measured by its capability to honor its commitments over a long period. Long-term obligations involve paying back the main borrowed capital on its maturity date and paying regular interest. To evaluate this long-run solvency, we use the following ratios: 1. Debt-Equity Ratio: This shows the proportion of long-term debt to the owners' capital, reflecting the safety margin for lenders. \[ \text{Debt-Equity Ratio} = \frac{\text{External Debt}}{\text{Shareholders' Funds}} \] 2. Proprietary Ratio: This ratio measures the share of total assets funded by the owners. \[ \text{Proprietary Ratio} = \frac{\text{Shareholders' Funds}}{\text{Total Assets}} \] 3. Fixed Assets to Proprietor's Fund Ratio: This establishes how much of the owners' capital is invested in fixed assets. \[ \text{Fixed Assets to Proprietor's Fund Ratio} = \frac{\text{Fixed Assets}}{\text{Proprietor's Funds}} \] 4. Interest Coverage Ratio: This evaluates if profit is high enough to pay annual interest on long-term loans. \[ \text{Interest Coverage Ratio} = \frac{\text{Net Profit before Interest and Tax}}{\text{Interest on Long-Term Loans}} \]
In simple words: Long-term solvency ratios are used to check if a business can comfortably pay back its long-term loans and handle yearly interest payments on its borrowings.

Exam Tip: Clarify that short-term payment capacity is termed 'liquidity' while long-term capability is termed 'solvency'. Lenders look closely at solvency ratios to check long-term creditworthiness.

Question 6. The average age of inventory is viewed as the average length of time inventory is held by the firm or as the average number of day’s sales in inventory. Explain.
Answer:
The average age of inventory shows the average number of days that goods remain unsold in the warehouse. It is directly related to the Inventory Turnover Ratio, which calculates how many times a business replaces and sells its stock over a year: \[ \text{Inventory Turnover Ratio} = \frac{\text{Cost of Goods Sold}}{\text{Average Inventory}} \] Using this ratio, we can calculate the average age of inventory: \[ \text{Average Age of Inventory} = \frac{365}{\text{Inventory Turnover Ratio}} \] This reveals how long stock sits before being sold. A shorter average age of inventory means goods are selling quickly, indicating strong demand and efficient stock management.
In simple words: The average age of inventory is the number of days stock sits on shelves before being sold. We find this by dividing 365 days by the inventory turnover ratio.

Exam Tip: Show the mathematical connection between the inventory turnover ratio and the average age of inventory to explain this concept clearly and secure full marks.

Long Answer Type Questions

Question 1. Who are the users of financial ratio analysis? Explain the significance of ratio analysis to them.
Answer:
Various stakeholders use financial ratios to make essential business decisions. The main users and the importance of ratio analysis to them are detailed below: (i) Management: The company's leadership team uses ratios to make strategic decisions, plan for future growth, and monitor operating efficiency. They analyze how effectively resources are utilized. Consequently, they look closely at activity and profitability ratios, such as the Net Profit Ratio and Debtors Turnover Ratio, to evaluate and direct operations. (ii) Equity Investors: Current and potential shareholders are concerned with the safety of their investment and the returns they will receive. Because safety and returns depend on the business's profitability, they track profitability ratios like Earnings Per Share (EPS), Return on Investment (ROI), and Return on Equity (ROE). (iii) Long-Term Creditors: Lenders who provide funds for over a year want to ensure the company can pay regular interest and return the principal amount when it is due. They analyze long-term solvency ratios, including the Debt-Equity Ratio, Proprietary Ratio, and Interest Coverage Ratio, to evaluate long-term financial health. (iv) Short-Term Creditors: Suppliers and short-term lenders (providing credit for less than a year) want to make sure they are paid promptly in the short run. They evaluate liquidity ratios, like the Current Ratio and Quick Ratio, to check if the company has enough cash or liquid assets to cover immediate bills.
In simple words: Different groups track ratios for their own goals: managers plan operations, investors look at profit returns, long-term lenders check safety, and suppliers make sure their short-term bills are paid on time.

Exam Tip: Use distinct headings for each user group and list the specific financial ratios they focus on to write a highly professional and complete answer.

Question 2. What are liquidity ratios? Discuss the importance of current and liquid ratio.
Answer:
Liquidity ratios are used to evaluate a company's ability to satisfy its short-term financial commitments as they fall due. They measure the availability of liquid resources to meet immediate claims. 1. Current Ratio (Working Capital Ratio): This ratio shows the relationship between total current assets and total current liabilities. The standard ideal value is \( 2 : 1 \). \[ \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} \] Importance: It shows the safety margin available to cover short-term debts. A very high current ratio can indicate that cash is lying idle or stock is piled up, reflecting poor resource management. It is also subject to manipulation (window-dressing), such as paying off a creditor just before the balance sheet date to artificially improve the ratio. 2. Liquid Ratio (Quick Ratio or Acid-Test Ratio): This matches highly liquid assets (quick assets) against current liabilities. Quick assets are those that can be turned into cash almost instantly, excluding inventory and prepaid expenses because they cannot be sold off immediately. The standard ideal value is \( 1 : 1 \). \[ \text{Quick Ratio} = \frac{\text{Quick Assets}}{\text{Current Liabilities}} \] Where: \[ \text{Quick Assets} = \text{Current Assets} - (\text{Stock} + \text{Prepaid Expenses}) \] Importance: It offers a more reliable test of immediate solvency because it excludes slow-moving stock. It checks if the company can settle its immediate debts even if sales stop completely. Sometimes, quick liabilities are used as the denominator, which are calculated by deducting bank overdrafts from current liabilities: \[ \text{Quick Liabilities} = \text{Current Liabilities} - \text{Bank Overdraft} \]
In simple words: Liquidity ratios check if a business has enough cash to pay its short-term bills. The current ratio measures general short-term safety (ideally 2:1), while the quick ratio measures immediate cash safety by ignoring slow-moving stock (ideally 1:1).

Exam Tip: State the ideal benchmarks for both ratios clearly, write down the formula for quick assets, and mention the risk of window-dressing to write a high-scoring answer.

Question 3. How would you study the solvency position of the firm?
Answer:
A company's long-term solvency position is evaluated using solvency ratios. These ratios indicate the firm's capability to meet its long-term financial commitments and service its interest obligations over time. Solvency is measured in two main ways: checking the security of the debt principal, and checking the safety of regular interest payments. The primary ratios calculated to analyze long-term solvency include: 1. Debt-Equity Ratio: This compares external debt with internal shareholders' equity, showing how much the company relies on borrowed funds. \[ \text{Debt-Equity Ratio} = \frac{\text{External Debt}}{\text{Shareholders' Funds}} \] 2. Proprietary Ratio: This shows the relationship between owners' capital and total assets, indicating how much of the assets are funded by the shareholders. \[ \text{Proprietary Ratio} = \frac{\text{Shareholders' Funds}}{\text{Total Assets}} \] Shareholders' funds consist of share capital and reserves. Total assets include all assets, though some analysts exclude intangible assets like goodwill. 3. Fixed Assets to Proprietor's Fund Ratio: This measures the relationship between fixed assets and shareholders' equity, showing what percentage of the owners' capital is invested in fixed assets. \[ \text{Fixed Assets to Proprietor's Fund Ratio} = \frac{\text{Fixed Assets}}{\text{Proprietor's Funds}} \] 4. Interest Coverage Ratio: This compares operating profit with the interest on long-term loans. It measures the company's ability to cover its interest costs. \[ \text{Interest Coverage Ratio} = \frac{\text{Net Profit before Interest and Tax}}{\text{Interest on Long-Term Loans}} \] A high ratio indicates that the business can comfortably pay its interest costs from its earnings.
In simple words: We check a company's long-term safety by using solvency ratios. These tell us if the company has too much debt compared to its own capital, and if its profits are high enough to cover annual interest payments easily.

Exam Tip: Clearly separate capital structure solvency ratios (debt-equity, proprietary) from debt-servicing ratios (interest coverage) to show a thorough understanding of solvency analysis.

Question 4. What are important profitability ratios? How are they worked out?
Answer:
Profitability ratios measure the earning power and overall efficiency of a company's operations. The key profitability ratios and their calculation methods are: 1. Gross Profit Ratio: This ratio establishes the relationship between gross profit and net sales, expressed as a percentage. \[ \text{Gross Profit Ratio} = \frac{\text{Gross Profit}}{\text{Net Sales}} \times 100 \] Where: \[ \text{Net Sales} = \text{Sales} - \text{Sales Return} \] \[ \text{Gross Profit} = \text{Net Sales} - \text{Cost of Goods Sold} \] \[ \text{Cost of Goods Sold} = \text{Opening Stock} + \text{Purchases} + \text{Direct Expenses} - \text{Closing Stock} \] 2. Net Profit Ratio: This indicates the proportion of net profit to net sales, showing how much profit is generated per rupee of sales after all operating and non-operating expenses have been met. \[ \text{Net Profit Ratio} = \frac{\text{Net Profit}}{\text{Net Sales}} \times 100 \] Net profit is calculated after deducting income taxes and adjusting for non-operating incomes and expenses. 3. Operating Profit Ratio: This focuses on the profit earned purely from core business activities, excluding non-operating items like loss by fire or income from non-core investments. \[ \text{Operating Profit Ratio} = \frac{\text{Operating Profit}}{\text{Net Sales}} \times 100 \] Where: \[ \text{Operating Profit} = \text{Net Profit} + \text{Non-Operating Expenses} - \text{Non-Operating Incomes} \] 4. Operating Ratio: This ratio shows the percentage of sales consumed by operational costs (cost of goods sold and operating expenses). It measures the cost efficiency of sales operations. \[ \text{Operating Ratio} = \frac{\text{Cost of Goods Sold} + \text{Operating Expenses}}{\text{Net Sales}} \times 100 \] Operating expenses include office, administration, selling, and distribution costs. A lower operating ratio is preferred as it leaves more room for profit.
In simple words: Profitability ratios show how successful a company is at making money from its sales. They measure profit at different levels, such as factory-level profit (gross profit), core business profit (operating profit), or final leftover profit (net profit).

Exam Tip: Remember that while high values are ideal for Gross, Net, and Operating profit ratios, a lower Operating Ratio is preferred because it represents operational costs.

Question 5. Financial ratio analysis are conducted by four groups of analysts : managers, equity investors, long term creditors and short term creditors. What is the primary emphasis of each of these groups in evaluating ratios?
Answer: Ratio analysis is performed by various stakeholders, including internal management, shareholders, and long-term and short-term lenders. The primary goals and areas of focus for each of these categories are explained below:
(i) Management: Decision-makers within the firm use ratio computations to guide operational and strategic choices. Their focus remains on the long-term expansion of the firm, creating robust policy guidelines and strategic layouts. They aim to evaluate how productively resources are being deployed, which draws their focus to profitability and activity indexes, such as net profit, receivable velocities, and fixed asset utilisation rates.
(ii) Equity Investors: Shareholders prioritising safeguarding their principal capital alongside securing reasonable yields. Since the safety of capital is linked to operational performance and net gains, they track metrics reflecting profitability and productivity. Hence, their primary interest lies in tracking return on equity, earnings per share, and returns on capital employed.
(iii) Long Term Creditors: Parties lending capital for periods exceeding twelve months focus heavily on the entity's enduring solvency and capacity to meet interest commitments punctually. Consequently, they look closely at leverage metrics, including debt to equity, proprietary percentages, total assets to debt proportions, and interest coverage capability.
(iv) Short Term Creditors: Short-term lenders provide funding or goods on credit for shorter durations, typically under a year. Their main objective is to verify that the business can settle its near-term liabilities promptly. Hence, they concentrate on liquidity metrics such as the current and quick ratios, which reflect the immediate cash-generating capability from short-term resources.
In simple words: Different stakeholders look at different financial ratios depending on what they want to know. For example, owners care about profits and share value, while lenders want to make sure they get paid back on time.
Exam Tip: Clearly state the primary objective of each group alongside at least two specific ratios they analyze to score full marks in this descriptive question.

Question 6. The current ratio provides a better measure of overall liquidity only when a firm’s inventory cannot easily be converted into cash. If inventory is liquid, the quick ratio is a preferred measure of overall liquidity. Explain.
Answer: This statement is accurate. Both the current ratio and the quick ratio serve as measures of a company's short-term solvency, but the quick ratio provides a more stringent and refined assessment.
The current ratio establishes the relationship between all current assets and current liabilities. If short-term resources are sufficient to cover near-term obligations, liquidity is considered satisfactory. However, certain components of current assets, such as stock and prepaid expenses, cannot be instantly converted to cash.
In industries with slow-moving inventory - like heavy machinery manufacturing or locomotives - specialized stock cannot be liquidated easily or quickly. For such firms, using the current ratio is more appropriate because the slow-moving stock represents a significant portion of current assets that eventually supports liability settlement.
Conversely, for enterprises where stock can be rapidly sold off or is virtually absent (like service-sector businesses), the quick ratio is the superior metric. By excluding stock and prepaid items, it focuses on highly liquid resources. Additionally, if inventory levels fluctuate wildly or if stock valuations are unstable, the quick ratio remains more dependable, as excluding inventory prevents potential distortions in the liquidity assessment.
In simple words: The current ratio includes inventory, while the quick ratio leaves it out. If a company can sell its inventory very fast, the quick ratio is a better way to check its actual cash strength.
Exam Tip: When answering this, contrast a heavy manufacturing firm (where inventory is slow to sell) with a service firm (where inventory is highly liquid or non-existent) to demonstrate a practical understanding of the ratios.

Question 1. Following is the Balance Sheet of Rohit and Company as on March 31, 2006. Calculate Current Ratio.

Answer: To find the Current Ratio, we use the following formula:
\[ \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} \]
First, we sum up all Current Assets:
Current Assets = Stock + Debtors + Cash at Bank
Current Assets = \( 55,800 + 28,800 + 59,400 = \text{Rs. } 1,44,000 \)
Next, we sum up all Current Liabilities:
Current Liabilities = Bills Payable + Creditors
Current Liabilities = \( 18,000 + 54,000 = \text{Rs. } 72,000 \)
Now, we divide the assets by the liabilities:
Current Ratio = \( \frac{1,44,000}{72,000} = 2:1 \)
In simple words: The current ratio shows how many times our short-term resources can cover our short-term debts. Here, the company has Rs. 2 of liquid assets for every Rs. 1 of debt, which is a healthy position.
Exam Tip: Always list down individual components of Current Assets and Current Liabilities separately before showing the calculation to ensure you secure step-marks.

Question 2. Following is the Balance Sheet of Title Machine Limited as on March 31, 2006. Calculate Current Ratio and Liquid Ratio.

Answer: We calculate both the Current Ratio and Liquid Ratio using the following steps:
(i) Calculations for Current Assets and Current Liabilities:
Current Assets = Stock + Debtors + Cash in Hand + Prepaid Expenses
Current Assets = \( 12,000 + 9,000 + 2,280 + 720 = \text{Rs. } 24,000 \)
Current Liabilities = Bank Overdraft + Creditors + Provision for Taxation
Current Liabilities = \( 6,000 + 23,400 + 600 = \text{Rs. } 30,000 \)
Applying the Current Ratio formula:
\[ \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} = \frac{24,000}{30,000} = 0.8:1 \]
(ii) Calculations for Liquid Ratio:
Liquid Assets = Current Assets - (Stock + Prepaid Expenses)
Liquid Assets = \( 24,000 - (12,000 + 720) = \text{Rs. } 11,280 \)
Applying the Liquid Ratio formula:
\[ \text{Liquid Ratio} = \frac{\text{Liquid Assets}}{\text{Current Liabilities}} = \frac{11,280}{30,000} = 0.376:1 \]
In simple words: The current ratio compares all current items, while the liquid ratio ignores slower items like inventory and prepaid costs. This company's low liquid ratio of 0.376:1 suggests it might struggle to pay its immediate debts without selling stock.
Exam Tip: Keep in mind that Bank Overdraft is included in Current Liabilities when calculating both Current Ratio and Liquid Ratio under normal guidelines unless specified otherwise.

Question 3. Current Ratio is 3:5 Working Capital is Rs. 9,00,000. Calculate the amount of Current Assets and Current Liabilities.
Answer: Following standard practical corrections where a current ratio below 1 yields negative working capital, we solve this using the corrected parameters (Current Ratio = 3.5:1 and Working Capital = Rs. 90,000) as outlined in the textbook corrections:
Let the Current Liabilities be \( x \).
This implies:
Current Assets = \( 3.5x \)
We know that:
Working Capital = Current Assets - Current Liabilities
\( 90,000 = 3.5x - x \)
\( 90,000 = 2.5x \)

\( \implies x = \frac{90,000}{2.5} = 36,000 \)
Therefore:
Current Liabilities = Rs. 36,000
Current Assets = \( 3.5 \times 36,000 = \text{Rs. } 1,26,000 \)
In simple words: Working Capital is the difference between current assets and current liabilities. Using the corrected values, we find that Current Liabilities are Rs. 36,000 and Current Assets are Rs. 1,26,000.
Exam Tip: Be alert to typographical errors in questions; if the current ratio is less than 1, working capital (CA - CL) should theoretically be negative.

Question 4. Shine Limited has a current ratio 4.5:1 and quick ratio 3:1; if the stock is 36,000, calculate current liabilities and current assets.
Answer: Let the Current Liabilities be \( x \).
Based on the given ratios:
Current Assets = \( 4.5x \)
Quick Assets = \( 3x \)
We know that the difference between Current Assets and Quick Assets is equal to Stock:
Stock = Current Assets - Quick Assets
\( 36,000 = 4.5x - 3x \)
\( 36,000 = 1.5x \)

\( \implies x = \frac{36,000}{1.5} = 24,000 \)
Using \( x \) to find the required values:
Current Liabilities = Rs. 24,000
Current Assets = \( 4.5 \times 24,000 = \text{Rs. } 1,08,000 \)
In simple words: Since the difference between the current ratio and the quick ratio is caused solely by inventory (stock), we can use this difference to calculate the actual values of assets and liabilities.
Exam Tip: Remember that the difference between Current Assets and Liquid Assets is always equal to Stock (when prepaid expenses are nil). Use this direct relationship to find the unknown variables quickly.

Question 5. Current liabilities of a company are Rs. 75,000. If Current ratio is 4 : 1 and liquid ratio is 1:1, calculate value of current assets, liquid assets and stock.
Answer: Given data:
Current Liabilities = Rs. 75,000
Current Ratio = \( 4:1 \)
Liquid Ratio = \( 1:1 \)
We calculate the values as follows:
(i) Value of Current Assets:
Current Assets = \( 4 \times \text{Current Liabilities} \)
Current Assets = \( 4 \times 75,000 = \text{Rs. } 3,00,000 \)
(ii) Value of Liquid Assets:
Liquid Assets = \( 1 \times \text{Current Liabilities} \)
Liquid Assets = \( 1 \times 75,000 = \text{Rs. } 75,000 \)
(iii) Value of Stock:
Stock = Current Assets - Liquid Assets
Stock = \( 3,00,000 - 75,000 = \text{Rs. } 2,25,000 \)
In simple words: We multiply the given current liabilities by the ratios to find the total current assets and liquid assets. The remaining difference represents the value of unsold stock.
Exam Tip: Always double-check your subtraction: Current Assets minus Liquid Assets must equal the value of Stock.

Question 6. Handa Limited has stock of Rs. 20,000. Total liquid assets are Rs. 1,00,000 and quick ratio is 2:1 Calculate current ratio.
Answer: Let Current Liabilities be \( x \).
Using the Quick Ratio:
Quick Ratio = \( \frac{\text{Liquid Assets}}{\text{Current Liabilities}} \)
\( 2 = \frac{1,00,000}{x} \)

\( \implies x = \frac{1,00,000}{2} = 50,000 \)
So, Current Liabilities = Rs. 50,000
Next, we calculate Current Assets:
Current Assets = Liquid Assets + Stock
Current Assets = \( 1,00,000 + 20,000 = \text{Rs. } 1,20,000 \)
Now, we find the Current Ratio:
\[ \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} = \frac{1,20,000}{50,000} = 2.4:1 \]
In simple words: We find current liabilities first using the quick assets and quick ratio. Then, adding stock to quick assets gives us current assets, allowing us to compute the final current ratio.
Exam Tip: Don't forget that Quick Assets + Stock = Current Assets. Finding the current liabilities is the crucial intermediate step.

Question 7. Calculate debt equity ratio from the following information

Answer: The Debt Equity Ratio is determined using the formula:
\[ \text{Debt Equity Ratio} = \frac{\text{Debt}}{\text{Equity}} \]
First, we calculate Shareholders' Equity:
Equity = Total Assets - Total Debts
Equity = \( 15,00,000 - 12,00,000 = \text{Rs. } 3,00,000 \)
Next, we calculate Long-term Debt (referred to simply as Debt):
Debt = Total Debts - Current Liabilities
Debt = \( 12,00,000 - 6,00,000 = \text{Rs. } 6,00,000 \)
Now, calculating the Debt Equity Ratio:
Debt Equity Ratio = \( \frac{6,00,000}{3,00,000} = 2:1 \)
In simple words: Long-term debt is found by taking total debts and subtracting short-term liabilities. Equity is the remaining value when total debts are subtracted from total assets.
Exam Tip: Make sure you do not confuse "Total Debt" with "Long-term Debt" (Debt). "Debt" in the Debt-Equity Ratio specifically refers to long-term liabilities only.

Question 8. Calculate Current Ratio if Stock is Rs. 6,00,000; Liquid Assets Rs. 24,00,000; Quick Ratio 2:1.
Answer: Let the Current Liabilities be \( x \).
Using the Quick Ratio formula:
Quick Ratio = \( \frac{\text{Liquid Assets}}{\text{Current Liabilities}} \)
\( 2 = \frac{24,00,000}{x} \)

\( \implies x = \frac{24,00,000}{2} = 12,00,000 \)
Thus, Current Liabilities = Rs. 12,00,000.
Now, we calculate Current Assets:
Current Assets = Liquid Assets + Stock
Current Assets = \( 24,00,000 + 6,00,000 = \text{Rs. } 30,00,000 \)
Calculating the Current Ratio:
\[ \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} = \frac{30,00,000}{12,00,000} = 2.5:1 \]
In simple words: We use the quick ratio and liquid assets to find our current liabilities. Adding stock to our liquid assets gives our total current assets, which we divide by liabilities to get 2.5:1.
Exam Tip: Always express the final ratio in the form of "x : 1" (e.g., 2.5:1) rather than leaving it as a fraction.

Question 9. Compute Stock Turnover Ratio from the following information

Answer: The Stock Turnover Ratio is computed using the formula:
\[ \text{Stock Turnover Ratio} = \frac{\text{Cost of Goods Sold}}{\text{Average Stock}} \]
(i) First, calculate the Cost of Goods Sold (COGS):
COGS = Net Sales - Gross Profit
COGS = \( 2,00,000 - 50,000 = \text{Rs. } 1,50,000 \)
(ii) Next, calculate the Opening Stock and Average Stock:
Opening Stock = Closing Stock - Excess of Closing Stock over Opening Stock
Opening Stock = \( 60,000 - 20,000 = \text{Rs. } 40,000 \)
Average Stock = \( \frac{\text{Opening Stock} + \text{Closing Stock}}{2} \)
Average Stock = \( \frac{40,000 + 60,000}{2} = \text{Rs. } 50,000 \)
(iii) Compute the Stock Turnover Ratio:
Stock Turnover Ratio = \( \frac{1,50,000}{50,000} = 3 \text{ times} \)
In simple words: This ratio tells us how many times a business sells and replaces its stock over a year. Here, the company successfully rotated its stock 3 times.
Exam Tip: Clearly show how you computed the opening stock by deducting the excess from the closing stock to ensure you get full credit for the working notes.

Question 10. Calculate following ratios from the following information
(i) Current ratio (ii) Acid test ratio
(iii) Operating Ratio (iv) Gross Profit Ratio

Answer: We calculate the four requested ratios step-by-step:
(i) Current Ratio:
\[ \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} = \frac{35,000}{17,500} = 2:1 \]
(ii) Acid Test Ratio:
Liquid Assets = Current Assets - Stock
Liquid Assets = \( 35,000 - 15,000 = \text{Rs. } 20,000 \)
\[ \text{Acid Test Ratio} = \frac{\text{Liquid Assets}}{\text{Current Liabilities}} = \frac{20,000}{17,500} = 1.14:1 \]
(iii) Operating Ratio:
\[ \text{Operating Ratio} = \frac{\text{Cost of Goods Sold} + \text{Operating Expenses}}{\text{Net Sales}} \times 100 \]
Operating Ratio = \( \frac{30,000 + 20,000}{60,000} \times 100 = \frac{50,000}{60,000} \times 100 \approx 83.3\% \)
(iv) Gross Profit Ratio:
Gross Profit = Sales - Cost of Goods Sold
Gross Profit = \( 60,000 - 30,000 = \text{Rs. } 30,000 \)
\[ \text{Gross Profit Ratio} = \frac{\text{Gross Profit}}{\text{Net Sales}} \times 100 = \frac{30,000}{60,000} \times 100 = 50\% \]
In simple words: These ratios evaluate different aspects of a company: its short-term payment ability (Current and Acid Test) and its operational efficiency (Operating and Gross Profit).
Exam Tip: Remember that "Acid Test Ratio", "Quick Ratio", and "Liquid Ratio" are identical. When calculating the operating ratio, always express your answer as a percentage.

Question 11. From the following information calculate
(i) Gross Profit Ratio (ii) Inventory Turnover Ratio (iii) Current Ratio (iv) Liquid Ratio (v) Net Profit Ratio (vi) Working Capital Ratio

Answer: Based on the provided financials (where stock is given separately from other current assets), we perform the calculations as follows:
(i) Gross Profit Ratio:
Gross Profit = Sales - Cost of Sales
Gross Profit = \( 25,20,000 - 19,20,000 = \text{Rs. } 6,00,000 \)
\[ \text{Gross Profit Ratio} = \frac{\text{Gross Profit}}{\text{Sales}} \times 100 = \frac{6,00,000}{25,20,000} \times 100 \approx 23.81\% \]
(ii) Inventory Turnover Ratio:
\[ \text{Inventory Turnover Ratio} = \frac{\text{Cost of Goods Sold}}{\text{Average Stock}} = \frac{19,20,000}{8,00,000} = 2.4 \text{ times} \]
(iii) Current Ratio:
Total Current Assets = Given Current Assets + Average Stock
Total Current Assets = \( 7,60,000 + 8,00,000 = \text{Rs. } 15,60,000 \)
\[ \text{Current Ratio} = \frac{\text{Total Current Assets}}{\text{Current Liabilities}} = \frac{15,60,000}{6,00,000} = 2.6:1 \]
(iv) Liquid Ratio:
Liquid Assets = Given Current Assets (excluding stock) = Rs. 7,60,000
\[ \text{Liquid Ratio} = \frac{\text{Liquid Assets}}{\text{Current Liabilities}} = \frac{7,60,000}{6,00,000} \approx 1.27:1 \]
(v) Net Profit Ratio:
\[ \text{Net Profit Ratio} = \frac{\text{Net Profit}}{\text{Sales}} \times 100 = \frac{3,60,000}{25,20,000} \times 100 \approx 14.28\% \]
(vi) Working Capital Ratio (Working Capital Turnover Ratio):
Working Capital = Total Current Assets - Current Liabilities
Working Capital = \( 15,60,000 - 6,00,000 = \text{Rs. } 9,60,000 \)
\[ \text{Working Capital Ratio} = \frac{\text{Net Sales}}{\text{Working Capital}} = \frac{25,20,000}{9,60,000} \approx 2.625 \text{ times} \]
In simple words: When a question lists "Current Assets" and "Average Inventory" separately and implies stock was not included, we must sum them up to get total current assets. This allows us to find the correct current ratio and working capital.
Exam Tip: Always read the balance sheet items carefully. If stock is listed separately, treat the provided 'Current Assets' figure as liquid assets (other current assets) to calculate total current assets.

Question 12. Compute Gross Profit Ratio, Working Capital Turnover Ratio, Dept Equity Ratio and Proprietary Ratio from the following information

Answer: We evaluate each of the requested financial metrics:
(i) Gross Profit Ratio:
Gross Profit = Net Sales - Cost of Goods Sold
Gross Profit = \( 10,00,000 - 6,00,000 = \text{Rs. } 4,00,000 \)
\[ \text{Gross Profit Ratio} = \frac{\text{Gross Profit}}{\text{Net Sales}} \times 100 = \frac{4,00,000}{10,00,000} \times 100 = 40\% \]
(ii) Working Capital Turnover Ratio:
Working Capital = Current Assets - Current Liabilities
Working Capital = \( 4,00,000 - 2,80,000 = \text{Rs. } 1,20,000 \)
\[ \text{Working Capital Turnover Ratio} = \frac{\text{Net Sales}}{\text{Working Capital}} = \frac{10,00,000}{1,20,000} \approx 8.33 \text{ times} \]
(iii) Debt Equity Ratio:
Debt = 13% Debentures = Rs. 2,00,000
Equity = Shareholders' Funds (Paid-up Capital) = Rs. 5,00,000
\[ \text{Debt Equity Ratio} = \frac{\text{Debt}}{\text{Equity}} = \frac{2,00,000}{5,00,000} = 2:5 = 0.4:1 \]
(iv) Proprietary Ratio:
Total Assets = Equity + Debentures + Current Liabilities
Total Assets = \( 5,00,000 + 2,00,000 + 2,80,000 = \text{Rs. } 9,80,000 \)
\[ \text{Proprietary Ratio} = \frac{\text{Shareholders' Funds}}{\text{Total Assets}} = \frac{5,00,000}{9,80,000} \approx 0.51:1 \]
In simple words: This set of calculations shows both operating efficiency (gross profit and working capital velocity) and structural safety (debt-equity and proprietary ownership levels).
Exam Tip: Total Assets are always equal to the sum of all liabilities (Equity + Long-term Debt + Current Liabilities). Use this accounting equation when total assets are not directly given.

Question 13. Calculate Stock Turnover Ratio if Opening Stock is Rs. 76,250, Closing Stock is 98,500, Sales is Rs. 5 ,20,000, Sales Return is Rs.20,000, Purchase is Rs. 3,22,250.
Answer: We determine the Stock Turnover Ratio with the following steps:
(i) First, calculate the Cost of Goods Sold (COGS):
COGS = Opening Stock + Purchase - Closing Stock
COGS = \( 76,250 + 3,22,250 - 98,500 = \text{Rs. } 3,00,000 \)
(ii) Next, calculate the Average Stock:
Average Stock = \( \frac{\text{Opening Stock} + \text{Closing Stock}}{2} \)
Average Stock = \( \frac{76,250 + 98,500}{2} = \text{Rs. } 87,375 \)
(iii) Compute the Stock Turnover Ratio:
\[ \text{Stock Turnover Ratio} = \frac{\text{Cost of Goods Sold}}{\text{Average Stock}} = \frac{3,00,000}{87,375} \approx 3.43 \text{ times} \]
In simple words: We calculate how fast stock moves by dividing the cost of goods sold (found using opening stock, purchases, and closing stock) by the average stock on hand.
Exam Tip: Make sure you don't confuse Sales with Cost of Goods Sold when calculating the stock turnover ratio if the purchase and stock figures are available.

Question 14. Calculate Stock Turnover Ratio from the data given below
Answer: Using the values from the accompanying textbook solution data:
Opening Stock = Rs. 10,000
Purchases = Rs. 25,000
Carriage = Rs. 2,500
Closing Stock = Rs. 5,000

(i) Cost of Goods Sold = Opening Stock + Purchases + Carriage - Closing Stock
Cost of Goods Sold = \( 10,000 + 25,000 + 2,500 - 5,000 = \text{Rs. } 32,500 \)
(ii) Average Stock = \( \frac{\text{Opening Stock} + \text{Closing Stock}}{2} \)
Average Stock = \( \frac{10,000 + 5,000}{2} = \text{Rs. } 7,500 \)
(iii) Stock Turnover Ratio:
\[ \text{Stock Turnover Ratio} = \frac{\text{Cost of Goods Sold}}{\text{Average Stock}} = \frac{32,500}{7,500} \approx 4.33 \text{ times} \]
In simple words: Stock turnover ratio is calculated by dividing cost of goods sold (which includes purchases and direct costs like carriage) by the average stock.
Exam Tip: Remember that carriage inward is a direct expense and must be added to purchases when calculating the Cost of Goods Sold.

Question 15. A trading firm’s average stock is Rs. 20,000 (cost). If the stock turnover ratio is 8 times and the firm setts goods at a profit of 20% on sales, ascertain the profit of the firm.
Answer: Given data:
Average Stock = Rs. 20,000
Stock Turnover Ratio = 8 times
Profit = 20% on Sales
We calculate:
(i) Cost of Goods Sold (COGS):
COGS = Stock Turnover Ratio \(\times\) Average Stock
COGS = \( 8 \times 20,000 = \text{Rs. } 1,60,000 \)
(ii) Sales Value:
Let the Sales price be \( x \). Profit is 20% of sales (\( 0.20x \)).
COGS = Sales - Profit
\( 1,60,000 = x - 0.20x \)
\( 1,60,000 = 0.80x \)

\( \implies x = \frac{1,60,000}{0.80} = \text{Rs. } 2,00,000 \) (Total Sales)
(iii) Profit of the Firm:
Profit = Sales - COGS
Profit = \( 2,00,000 - 1,60,000 = \text{Rs. } 40,000 \)
In simple words: We find the cost of goods sold first. Since profit is 20% of sales, the cost represents 80% of sales. We use this to find the total sales, and then compute the 20% profit.
Exam Tip: When profit is given as a percentage of sales but you only have the Cost of Goods Sold, you can calculate the profit directly using: \( \text{Profit} = \text{COGS} \times \frac{\% \text{ Profit}}{100 - \% \text{ Profit}} \).

Question 16. You are able to collect the following information about a company for two years
Calculate Stock Turnover Ratio and Debtor Turnover Ratio if in the year 2004 stock in trade increased by Rs. 2,00,000.

Answer: We calculate the ratios for the year 2005 based on the provided trends:
(i) Stock Turnover Ratio (for 2005):
Gross Profit = \( 25\% \text{ of Sales} = 25\% \times 24,00,000 = \text{Rs. } 6,00,000 \)
Cost of Goods Sold = Sales - Gross Profit
Cost of Goods Sold = \( 24,00,000 - 6,00,000 = \text{Rs. } 18,00,000 \)
Opening Stock (for 2005) = Closing Stock of 2004 = Rs. 6,00,000
Closing Stock (for 2005) = Rs. 9,00,000
Average Stock = \( \frac{6,00,000 + 9,00,000}{2} = \text{Rs. } 7,50,000 \)
\[ \text{Stock Turnover Ratio} = \frac{18,00,000}{7,50,000} = 2.4 \text{ times} \]
(ii) Debtors Turnover Ratio (for 2005):
Average Debtors = \( \frac{\text{Opening Debtors (April 1, 2005)} + \text{Closing Debtors (March 30, 2005)}}{2} \)
Average Debtors = \( \frac{5,00,000 + 5,60,000}{2} = \text{Rs. } 5,30,000 \)
\[ \text{Debtors Turnover Ratio} = \frac{\text{Net Credit Sales}}{\text{Average Debtors}} = \frac{24,00,000}{5,30,000} \approx 4.53 \text{ times} \]
(Note: In the absence of separate cash sales figures, total sales are treated entirely as credit sales.)
In simple words: To calculate the ratios for 2005, we find the Cost of Goods Sold by subtracting the 25% gross profit from sales. Then we use the closing stocks of 2004 and 2005 to find the average stock.
Exam Tip: The closing stock of the previous year (2004) automatically becomes the opening stock of the current year (2005).

Question 17. The following Balance Sheet and other information, calculate following ratios
(i) Debt Equity Ratio (ii) Working Capital Turnover Ratio
(iii) Debtors Turnover Ratio

Answer: We proceed with the ratio calculations based on the provided Balance Sheet:
(i) Debt Equity Ratio:
Debt = 15% Loan = Rs. 2,40,000
Equity = Share Capital + General Reserve + Profit & Loss - Preliminary Expenses
Equity = \( 2,00,000 + 80,000 + 1,20,000 - 20,000 = \text{Rs. } 3,80,000 \)
\[ \text{Debt Equity Ratio} = \frac{\text{Debt}}{\text{Equity}} = \frac{2,40,000}{3,80,000} = 12:19 \]
(ii) Working Capital Turnover Ratio and (iii) Debtors Turnover Ratio:
These ratios cannot be determined as the question contains no financial details regarding sales.
In simple words: We find the equity by adding reserves and share capital, and subtracting any fictitious assets like preliminary expenses. Since sales data is missing, we cannot calculate the working capital or debtors turnover ratios.
Exam Tip: Remember to subtract preliminary expenses (fictitious assets) from shareholders' funds to find the real Equity/Shareholders' Funds.

Question 18. The following is the summarised Profit and Loss account and the Balance Sheet of Nigam Limited for the year ended March 31, 2007
Calculate
(i) Quick Ratio
(ii) Stock Turnover Ratio
(iii) Return on Investment

Balance Sheet of Nigam Limited as on March 31, 2007

Answer: We solve for each ratio using the given financial statements:
(i) Quick Ratio:
Quick Assets = Cash + Debtors
Quick Assets = \( 40,000 + 1,00,000 = \text{Rs. } 1,40,000 \)
Current Liabilities = Creditors + Outstanding Expenses
Current Liabilities = \( 1,90,000 + 70,000 = \text{Rs. } 2,60,000 \)
\[ \text{Quick Ratio} = \frac{\text{Quick Assets}}{\text{Current Liabilities}} = \frac{1,40,000}{2,60,000} \approx 0.54:1 \]
(ii) Stock Turnover Ratio:
Cost of Goods Sold = Sales - Gross Profit
Cost of Goods Sold = \( 4,00,000 - 1,94,000 = \text{Rs. } 2,06,000 \)
Average Stock = \( \frac{\text{Opening Stock} + \text{Closing Stock}}{2} \)
Average Stock = \( \frac{50,000 + 60,000}{2} = \text{Rs. } 55,000 \)
\[ \text{Stock Turnover Ratio} = \frac{\text{Cost of Goods Sold}}{\text{Average Stock}} = \frac{2,06,000}{55,000} \approx 3.74 \text{ times} \]
(iii) Return on Investment (ROI):
Profit before Interest and Tax = Rs. 1,40,000
Capital Employed = Equity Share Capital + Profit and Loss Account Balance
Capital Employed = \( 2,00,000 + 1,40,000 = \text{Rs. } 3,40,000 \)
\[ \text{Return on Investment} = \frac{\text{Profit before Interest & Tax}}{\text{Capital Employed}} \times 100 = \frac{1,40,000}{3,40,000} \times 100 \approx 41.17\% \]
In simple words: The quick ratio measures immediate liquidity, stock turnover tracks inventory sales speed, and Return on Investment measures the earnings generated by the long-term funds invested.
Exam Tip: When calculating capital employed from the liabilities side, sum up the equity share capital and reserves (including profit & loss balance).

Question 19. From the following, Calculate (a) Debt Equity Ratio (b) Total Assets to Debt Ratio (c) Proprietary Ratio.

Answer: We evaluate the long-term solvency ratios as follows:
First, determine Shareholders' Equity (Funds) and Total Assets:
Equity = Equity Share Capital + Preference Share Capital + General Reserve + Accumulated Profits - Preliminary Expenses
Equity = \( 75,000 + 25,000 + 50,000 + 30,000 - 5,000 = \text{Rs. } 1,75,000 \)
Debt = Debentures = Rs. 75,000
Total Assets = Equity + Debentures + Sundry Creditors + Outstanding Expenses
Total Assets = \( 1,75,000 + 75,000 + 40,000 + 10,000 = \text{Rs. } 3,00,000 \)

Now, we calculate the required ratios:
(a) Debt Equity Ratio:
\[ \text{Debt Equity Ratio} = \frac{\text{Debt}}{\text{Equity}} = \frac{75,000}{1,75,000} = 3:7 = 0.43:1 \]
(b) Total Assets to Debt Ratio:
\[ \text{Total Assets to Debt Ratio} = \frac{\text{Total Assets}}{\text{Debt}} = \frac{3,00,000}{75,000} = 4:1 \]
(c) Proprietary Ratio:
\[ \text{Proprietary Ratio} = \frac{\text{Shareholders' Funds}}{\text{Total Assets}} = \frac{1,75,000}{3,00,000} \approx 0.58:1 \]
In simple words: These ratios help assess the long-term solvency of the company by comparing the owners' funds to total debts and assets.
Exam Tip: Make sure to subtract preliminary expenses from the total of shareholders' funds, and include them when verifying the balance sheet total.

Question 20. Cost of Goods Sold is 1 1 ,50,000 Operating expenses are Rs. 60,000. Sales is Rs. 2,60,000 and Sales Return is Rs. 10,000. Calculate Operating Ratio.
Answer: Operating Ratio is calculated by analyzing operating expenses and COGS relative to net sales:
(i) First, calculate Net Sales:
Net Sales = Sales - Sales Return
Net Sales = \( 2,60,000 - 10,000 = \text{Rs. } 2,50,000 \)
(ii) Calculate the Operating Ratio:
Using the corrected value for Cost of Goods Sold = Rs. 1,50,000 (correcting the typographical error of "1 1 ,50,000"):
\[ \text{Operating Ratio} = \frac{\text{Cost of Goods Sold} + \text{Operating Expenses}}{\text{Net Sales}} \times 100 \]
Operating Ratio = \( \frac{1,50,000 + 60,000}{2,50,000} \times 100 = \frac{2,10,000}{2,50,000} \times 100 = 84\% \)
In simple words: The operating ratio measures the percentage of sales revenue swallowed up by direct and operational costs. An 84% operating ratio means 16% is left as operating profit.
Exam Tip: Always subtract sales returns from total sales to get net sales before calculating any profitability ratios.

Question 21. The following is the summarised transactions and Profit and Loss Account for the year ending March 31, 2007 and the Balance Sheet as on that date. Calculate (i) Gross Profit Ratio (ii) Current Ratio (iii) Acid Test Ratio (iv) Stock Turnover Ratio (v) Fixed Assets Turnover Ratio.

Balance Sheet

Answer: Based on the provided statements, we calculate the required ratios:
(i) Gross Profit Ratio:
\[ \text{Gross Profit Ratio} = \frac{\text{Gross Profit}}{\text{Net Sales}} \times 100 = \frac{25,000}{50,000} \times 100 = 50\% \]
(ii) Current Ratio:
Current Assets = Stock + Sundry Debtors + Bills Receivable + Cash in Hand and at Bank
Current Assets = \( 7,500 + 7,500 + 6,250 + 8,750 = \text{Rs. } 30,000 \)
Current Liabilities = Rs. 20,000
\[ \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} = \frac{30,000}{20,000} = 1.5:1 \]
(iii) Acid Test Ratio:
Liquid Assets = Current Assets - Stock
Liquid Assets = \( 30,000 - 7,500 = \text{Rs. } 22,500 \)
\[ \text{Acid Test Ratio} = \frac{\text{Liquid Assets}}{\text{Current Liabilities}} = \frac{22,500}{20,000} = 1.125:1 \]
(iv) Stock Turnover Ratio:
Cost of Goods Sold = Opening Stock + Purchase + Direct Expenses - Closing Stock
Cost of Goods Sold = \( 5,000 + 25,000 + 2,500 - 7,500 = \text{Rs. } 25,000 \)
Average Stock = \( \frac{\text{Opening Stock} + \text{Closing Stock}}{2} = \frac{5,000 + 7,500}{2} = \text{Rs. } 6,250 \)
\[ \text{Stock Turnover Ratio} = \frac{\text{Cost of Goods Sold}}{\text{Average Stock}} = \frac{25,000}{6,250} = 4 \text{ times} \]
(v) Fixed Assets Turnover Ratio:
Net Fixed Assets = Land & Building + Plant & Machinery + Furniture
Net Fixed Assets = \( 25,000 + 15,000 + 10,000 = \text{Rs. } 50,000 \)
\[ \text{Fixed Assets Turnover Ratio} = \frac{\text{Net Sales}}{\text{Net Fixed Assets}} = \frac{50,000}{50,000} = 1:1 \]
In simple words: This detailed set of ratios shows that the firm has strong gross profitability (50%) and stable asset use, but its general liquidity (1.5:1) is slightly below the ideal standard of 2:1.
Exam Tip: Be careful to sum up all components of fixed assets (Land, Plant, and Furniture) when calculating the Fixed Assets Turnover Ratio.

Question 22. From the following information calculate Gross Profit Ratio, Stock Turnover Ratio and Debtors Turnover Ratio.

Answer: We evaluate the three required business performance ratios:
(i) Gross Profit Ratio:
\[ \text{Gross Profit Ratio} = \frac{\text{Gross Profit}}{\text{Sales}} \times 100 = \frac{60,000}{3,00,000} \times 100 = 20\% \]
(ii) Stock Turnover Ratio:
Average Stock = \( \frac{\text{Opening Stock} + \text{Closing Stock}}{2} \)
Average Stock = \( \frac{58,000 + 62,000}{2} = \text{Rs. } 60,000 \)
\[ \text{Stock Turnover Ratio} = \frac{\text{Cost of Goods Sold}}{\text{Average Stock}} = \frac{2,40,000}{60,000} = 4 \text{ times} \]
(iii) Debtors Turnover Ratio:
Since only a single debtors figure is provided, it is treated directly as the Average Debtors value:
\[ \text{Debtors Turnover Ratio} = \frac{\text{Net Sales}}{\text{Average Debtors}} = \frac{3,00,000}{32,000} \approx 9.375 \text{ times} \]
In simple words: These ratios show that the company earns a 20% gross profit margin, rotates its stock 4 times a year, and recovers money from customers about 9.375 times a year.
Exam Tip: When opening and closing debtors are not separately given, treat the given debtors figure directly as the average debtors.