Accounting Ratios Test - 1

The correct answer is A, B AND D.

Important Points

• Ratio Analysis: It is the process of computing, determining and presenting the relationship of items and group of items in the financial statements. It is an important technique of financial analysis.
• It can be expressed in terms of "ratio", "times", "percentage" and "fraction".
• Objectives of Ratio analysis are:
  • ​To judge the earning capacity, financial soundness and operating efficiency of an enterprise.
  • To simplify the accounting information.
  • To help in comparative analysis.

Additional Information

• Uses of Ratio Analysis are as follows:
  • ​Analysis of financial statements.
  • Judging the profitability of the business.
  • Judging the liquidity or short-term solvency of the business.
  • Judging the long-term solvency of the business.
  • Judging the operating efficiency of the business.
  • Intra-firm and Inter-firm comparison.

• Limitations of Ratio Analysis are:

  •    ​Qualitative factors are ignored- Ratio analysis is a technique of qualitative analysis and thus, ignores qualitative factors.
  • Lack of Standard ratio- There is almost no single standard ratio against which the actual ratio may be measured and compared.
  • False Results if based on incorrect information- Conclusion drawn may be misleading if ratios are based on incorrect accounting information.
  • May be not Comparable- Ratios may not be comparable if different firms follow different accounting policies and procedures.

Key Points

• Inter-firm: When the comparison of the performance between two or more firms is being conducted.
• Intra-firm: When the comparison of the performance is done within itself.

The correct answer is CURRENT RATIO AND QUICK RATIO.

Important Points

• Liquidity Ratios- It is also known as "short-term solvency" as it is measured the firm's ability to pay its current dues.

• There are two types of Liquidity Ratios comprise are:

• Current Ratio- It is a ratio that shows the relationship of current assets to current liabilities. It can be computed as:

  • Current Ratio = Current Assets/Current liabilities
• Quick Ratio- It is a ratio that shows the relationship of liquid assets (also called quick assets) with current liabilities. It is also knowns as 'Liquidity ratio' or 'Acid-test ratio'. It can be computed as:
  •  Quick Ratio = Quick Assets/Current Liabilities

  • quick assets = current assets - (stock + prepaid expenses)

Additional Information

• Gross Profit Ratio: This ratio indicates the relationship between gross profit and net sales. It is a type of “Profitability Ratio”. It can be computed as:
  • Gross Profit Ratio = Gross Profit/Net Sales * 100
• Inventory/Stock Turnover Ratio: This ratio measures how fast the stock is moving through the firm and generating sales. Higher the ratio, the more efficient management of inventories and vice-versa. It is a type of "Activity Ratio". Stock Turnover Ratio (STR) can be computed as:
  • ITR/STR = Cost of Goods Sold (COGS)/Average Stock
  • Average stock = opening stock + closing stock / 2
• Operating Ratio: This ratio is calculated to judge the operational efficiency of the business. A decline in the operating ratio, is better because it would leave a high margin, which means more profit. It is a type of "Profitability Ratio". It can be computed as:
  • Operating Ratio = COGS + Operating Expenses / Net Sales * 100
  • Net Sales = Total sales - sales return
  • COGS = Sales - gross profit
               OR
  • COGS = opening stock + purchases + direct expenses - closing stock
  • Operating expenses can be factory expenses, office expenses and selling expenses.

The correct answer is Operating ratio.

Important Points

• The operating ratio is the ratio of operating expenses to net sales.
• The higher this ratio, higher would be the operating expense and the lower the operating profit.
• So a lower ratio is more favourable in terms of business.
• It is computed as:
  • Operating Ratio = COGS + Operating Expenses / Net Sales * 100
  • Net Sales = Total sales - sales return
  • COGS = Sales - gross profit
                OR
  • COGS = opening stock + purchases + direct expenses - closing stock
  • Operating expenses can be factory expenses, office expenses, and selling expenses.

Additional Information

Liquidity Ratios- It is also known as "short-term solvency" as it is measured the firm's ability to pay its current dues. There are two types of Liquidity Ratios comprise are:

• Current Ratio- It is a ratio that shows the relationship of current assets to current liabilities. It can be computed as:
  • Current Ratio = Current Assets/Current liabilities
• Quick Ratio- It is a ratio that shows the relationship of liquid assets (also called quick assets) with current liabilities. It is also knowns as 'Liquidity ratio' or 'Acid-test ratio'. It can be computed as:
  •  Quick Ratio = Quick Assets/Current Liabilities

  • quick assets = current assets - (stock + prepaid expenses)

Inventory/Stock Turnover Ratio: This ratio measures how fast the stock is moving through the firm and generating sales. The higher the ratio, the more efficient management of inventories and vice-versa. It is a type of "Activity Ratio". Stock Turnover Ratio (STR) can be computed as:

• ITR/STR = Cost of Goods Sold (COGS)/Average Stock
• Average stock = opening stock + closing stock / 2​

Net Profit Ratio: Net profit ratio (NP ratio) expresses the relationship between net profit after taxes and sales. This ratio is a measure of the overall profitability net profit is arrived at after taking into account both the operating and non-operating items of incomes and expenses. It is computed as:

• Net profit ratio = Net profit / Net sales * 100

The correct answer is earnings per share. 

Key Points

The following are the objectives of buyback of shares:

• To return surplus cash to investors. Companies want to have backed their shares since it facilitates them to manage their surplus cash. If it is paid as dividend, companies will have to pay dividend tax on the distribution on the other hand; if cash is distributed through buyback, the tax burden shifts to shareholders who have to pay capital gains tax.
• To increase underlying share value. Buyback reduces equity and enables the company to increase earnings per share, which would result in enhancing the share value. A share buyback may also be announced when share prices are depressed in the market.
• To prevent hostile takeover bids. By eliminating surplus cash through buyback such a bid can be avoided.
• Buy–backs also facilitate a company to maintain a target capital structure. Buyback aids a company to achieve an optimal debt-equity ratio.

The correct answer is 1.67 times.

Key Points Interest Coverage Ratio:

• The interest coverage ratio is a debt-to-profitability ratio that determines how readily a business can pay interest on its outstanding debt.
• The interest coverage ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) by its interest expense during a given period.

Important Points

Net Profit after Tax = Rs. 60,000

Tax Rate = 40%

Net Profit before tax = Net profit after tax × 100/(100 – Tax rate)

= Rs. 60,000 × 100/(100 – 40)

= Rs. 1,00,000

Interest on Long-term Debt = 15% of Rs. 10,00,000

= Rs. 1,50,000

Net profit before interest and tax = Net profit before tax + Interest

= Rs. 1,00,000 + Rs. 1,50,000

= Rs. 2,50,000

Interest Coverage Ratio = Net Profit before Interest and Tax/Interest on long-term debt

= Rs. 2,50,000/Rs. 1,50,000

= 1.67 times.

The correct answer is 20.72 %.

Important Point

Net Sales = Sales - Sales Return

= 13,00,000 - 50,000

= Rs. 12,50,000

Net Profit Ratio = PAT / Net Sales * 100

 = 230000 / 12,50,000 * 100

= 18.4 %

Additional Information

• Net Profit Ratio: Net profit ratio (NP ratio) expresses the relationship between net profit after taxes and sales. This ratio is a measure of the overall profitability net profit is arrived at after taking into account both the operating and non-operating items of incomes and expenses. It is computed as:

Net Profit Ratio = PAT / Net Sales * 100

Key Points

• Sales: The term is used for the sale of only those goods dealt by the firm. Those finished goods are meant for sale. 
• Sales Return/Return Inwards: Goods sold when returned by the purchaser due to any reason.

The correct answer is 6.25 times

Key Points Receivables turnover ratio/Debtors Turnover Ratio/Trade Receivables Turnover Ratio

• This ratio is used to evaluate the efficiency with which a company manages the credit it extends to its customers and how long it takes for the company to collect outstanding debts throughout an accounting period.
• A high receivables turnover ratio shows that the company's collection method is very efficient, and that the company has a high proportion of customers that pay their bills fast in order to avoid debt collection.
• A low receivables' ratio, on the other hand, suggests that the company has a clear collection process, a defined credit policy, and customers who are not financially sustainable and are defaulting on payments.
• Formula : Receivables turnover ratio = Net Credit Sales / Average Accounts Receivable

Important Points Calculation of Net credit sales:

Revenue from operations or sales = ₹60,000 (Given)

Cash sales are 20% of credit sales (Given)

Let Credit sales = x

Total Sales = Cash sales + Credit sales

60000 = 20% of x + x

60000 = 120x/100

(60000 x 100)/120 = x

x = 50000

Credit Sales = 50000 

Calculation of Average Accounts Receivable

 Closing trade receivables = ₹10,000 (Given)

 Excess of closing trade receivables over opening = ₹4,000 (Given)

Excess = closing trade receivables - Opening Trade Receivables

4000 = 10000 + Opening Trade Receivables

Opening Trade Receivables = 6000

Average Accounts Receivable = (Opening trade receivables + Closing Trade Receivables)/2

Average Accounts Receivable = (6000 + 10000)/2

Average Accounts Receivable = 8000

Calculation of Receivables turnover ratio

Receivables turnover ratio = Net Credit Sales / Average Accounts Receivable

Receivables turnover ratio = 50000 / 8000

Receivables turnover ratio = 6.25 times 

The correct answer is 0.79 ∶ 1.

Key Points Proprietary Ratio:

• The proprietary ratio (also known as the equity ratio) is the proportion of owners' equity to total assets, and it serves as an approximate measure of how much capital is currently being used to maintain a company.
• If the ratio is high, it means that a company has enough equity to maintain its operations and, more importantly, that it has flexibility in its financial structure to take on extra debt if needed.
• A low ratio suggests that a corporation is relying too heavily on debt or trade payables to fund operations rather than equity (which may place the company at risk of bankruptcy).

Important Points

Working Note:

Shareholders’ Funds = Equity share capital + Reserves & surplus + Preference share capital - Fictitious Assets.

Shareholders’ Funds = 20,00,000 + 20,00,000 + 11,00,000 - 1,00,000 = 50,00,000

Total Assets = Total Assets – Fictitious Assets

Total Assets = Fixed Assets + Stock + Debtors + Bills receivable + Cash - Fictitious Assets.

Total Assets = 55,00,000 + 1,75,000 + 3,50,000 + 50,000 + 2,25,000 - 1,00,000

Total Assets = 64,00,000 - 1,00,000 = 63,00,000

Solution:

Proprietary Ratio = Shareholders’ Funds / Total Assets

Proprietary Ratio = 50,00,000 / 63,00,000 = 0.79 ∶ 1

The correct answer is none of these.

Important Points

• The given current ratio is 2: 1. Let us assume that current assets are Rs. 50,000 and current liabilities are Rs. 25,000; Thus, the current ratio is 2: 1. Now we will analyze the effect of given transactions on the current ratio.
  • (a) Assume that Rs. 10,000 of creditors are paid by cheque. This will reduce the current assets to Rs. 40,000 and current liabilities to Rs. 15,000. The new ratio will be 2.67 : 1 (Rs. 40,000/Rs.15,000). Hence, it has improved.
  • (b) Assume that goods of Rs. 10,000 are purchased on credit. This will increase the current assets to Rs. 60,000 and current liabilities to Rs. 35,000. The new ratio will be 1.7:1 (Rs. 60,000/Rs. 35,000). Hence, it has reduced.
  • (c) Due to the sale of a computer (a fixed asset), the current assets will increase to Rs. 53,000 without any change in the current liabilities. The new ratio will be 2.12 : 1 (Rs. 53,000/Rs. 25,000). Hence, it has improved.
  • (d) This transaction will decrease the inventories by Rs. 10,000 and increase the cash by Rs. 11,000 thereby increasing the current assets by Rs. 1,000 without any change in the current liabilities. The new ratio will be 2.04 : 1 (Rs. 51,000/Rs. 25,000). Hence, it has improved.
  • (e) Assume that Rs. 5,000 is given by way of dividend. It will reduce the current assets to Rs. 45,000 without any change in the current liabilities. The new ratio will be 1.8 : 1 (Rs. 45,000/Rs. 25,000). Hence, it has reduced.

A liquidity ratio is a type of financial ratio used to determine a company’s ability to pay its short-term debt obligations. The metric helps determine if a company can use its current, or liquid, assets to cover its current liabilities.

Important Points

The liquidity ratio assumes more importance for financial institutions.

•  Liquidity ratios are most useful when they are used in comparative form.
• The external analysis involves comparing the liquidity ratios of one company to another or an entire industry.
• This information is useful to compare the company's strategic positioning in relation to its competitors when establishing benchmark goals.
• Liquidity ratio analysis may not be as effective when looking across industries as various businesses require different financing structures.
• Liquidity ratio analysis is less effective for comparing businesses of different sizes in different geographical locations.
• The liquidity ratio assumes more importance for financial institutions as compared to trading, industrial, or cooperative undertakings because financial institutions mainly deal in services like accepting deposits and lending money. 
• Financial institutions are required to maintain an optimum level of liquidity so that they can pay out demand deposits with appropriate interest as and when required. 

Additional Information

• Solvency ratios assume more importance to trading, industrial, or cooperative undertakings as they are concerned with a longer-term ability to pay ongoing debts.