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Accounting Ratios – Class 12 Accountancy notes, important questions and MCQs

NCERT Class 12 Accountancy, chapter 9. Notes, key terms, important questions with answers and MCQs.

Chapter overview

An accounting ratio is a mathematical relationship between two related items in financial statements, expressed as a pure ratio, a percentage or a number of times. Ratios are classified as liquidity ratios, solvency ratios, activity (turnover) ratios and profitability ratios. They help judge a firm's short-term position, long-term stability, efficiency and earning capacity.

Liquidity and solvency ratios

Current ratio = current assets ÷ current liabilities; a ratio of about 2:1 is considered safe.
Quick (liquid) ratio = quick assets ÷ current liabilities, where quick assets = current assets − inventories − prepaid expenses; about 1:1 is considered safe.
Debt-equity ratio = long-term debt ÷ shareholders' funds; proprietary ratio = shareholders' funds ÷ total assets; total assets to debt ratio; interest coverage ratio = net profit before interest and tax ÷ interest on long-term debt.

Activity ratios

Inventory turnover ratio = cost of revenue from operations ÷ average inventory.
Trade receivables turnover ratio = net credit revenue from operations ÷ average trade receivables; trade payables turnover ratio = net credit purchases ÷ average trade payables.
Working capital turnover ratio = revenue from operations ÷ working capital.

Profitability ratios

Gross profit ratio = gross profit ÷ net revenue from operations × 100; net profit ratio = net profit ÷ revenue from operations × 100.
Operating ratio = (cost of revenue from operations + operating expenses) ÷ revenue from operations × 100; operating profit ratio = 100 − operating ratio.
Return on investment (return on capital employed) = net profit before interest and tax ÷ capital employed × 100.

Key terms

Accounting ratio: a mathematical relationship between two related accounting figures
Current ratio: current assets divided by current liabilities
Quick ratio: quick assets divided by current liabilities
Debt-equity ratio: long-term debt divided by shareholders' funds
Inventory turnover ratio: cost of revenue from operations divided by average inventory

Important questions with answers

What is the quick ratio? Why is it considered a better test of liquidity than the current ratio?2 marks

The quick ratio is the ratio of quick assets to current liabilities, where quick assets are current assets minus inventories and prepaid expenses. It is a stricter test of liquidity because inventories may take time to sell and prepaid expenses cannot be converted into cash, so it shows the firm's ability to meet current liabilities immediately.

Explain the classification of accounting ratios.3 marks

Accounting ratios are classified into liquidity ratios, such as the current ratio and quick ratio, which measure the ability to meet short-term obligations; solvency ratios, such as the debt-equity ratio, proprietary ratio and interest coverage ratio, which measure long-term financial stability; activity or turnover ratios, such as inventory, trade receivables and working capital turnover, which measure efficiency in using resources; and profitability ratios, such as gross profit, net profit, operating ratio and return on investment, which measure earning capacity.

From the following, calculate the current ratio, quick ratio and debt-equity ratio and comment: current assets ₹2,00,000 including inventory ₹50,000 and prepaid expenses ₹10,000; current liabilities ₹1,00,000; long-term debt ₹3,00,000; shareholders' funds ₹2,00,000.5 marks

The current ratio is current assets ÷ current liabilities = ₹2,00,000 ÷ ₹1,00,000 = 2:1. This matches the generally accepted norm of 2:1, showing that the firm has enough current assets to meet its short-term obligations. Quick assets are current assets minus inventory and prepaid expenses = ₹2,00,000 − ₹50,000 − ₹10,000 = ₹1,40,000. The quick ratio is quick assets ÷ current liabilities = ₹1,40,000 ÷ ₹1,00,000 = 1.4:1. This is above the norm of 1:1, indicating good immediate liquidity even without selling inventory. The debt-equity ratio is long-term debt ÷ shareholders' funds = ₹3,00,000 ÷ ₹2,00,000 = 1.5:1. This is within the commonly accepted limit of 2:1, which means the firm relies more on borrowed funds than owners' funds but is not excessively risky. Overall, the firm's liquidity is sound and its long-term financial structure is reasonable, though a lower debt-equity ratio would give greater safety to lenders.

Quick revision

Liquidity: current 2:1, quick 1:1.
Solvency: debt-equity, proprietary, interest coverage.
Activity: inventory, receivables, payables, working capital turnover.
Profitability: GP, NP, operating, ROI.

Exam tips

Write each formula, substitute values and state the result in its correct form (ratio, per cent or times).
Remember the safe norms: current ratio 2:1, quick ratio 1:1, debt-equity 2:1.

Practice MCQs

Current assets divided by current liabilities is the
1. current ratio
2. quick ratio
3. debt-equity ratio
4. net profit ratio
Show answer
Answer: (a) current ratio. It measures short-term liquidity.
The current ratio generally considered safe is about
1. 1:2
2. 1:5
3. 5:1
4. 2:1
Show answer
Answer: (d) 2:1. Current assets should be about twice current liabilities.
Debt-equity ratio is a
1. liquidity ratio
2. activity ratio
3. solvency ratio
4. profitability ratio
Show answer
Answer: (c) solvency ratio. It shows long-term financial structure.
Quick assets exclude
1. inventories and prepaid expenses
2. trade receivables
3. cash
4. marketable securities
Show answer
Answer: (a) inventories and prepaid expenses. These cannot be quickly converted to cash.
Inventory turnover ratio is calculated as cost of revenue from operations divided by
1. closing inventory only
2. average inventory
3. total assets
4. net profit
Show answer
Answer: (b) average inventory. It shows how fast stock is sold.
Return on investment is calculated using
1. net profit after tax ÷ share capital
2. revenue ÷ assets
3. gross profit ÷ sales
4. net profit before interest and tax ÷ capital employed
Show answer
Answer: (d) net profit before interest and tax ÷ capital employed. It measures overall efficiency.
Current assets ₹2,00,000 (including inventory ₹50,000 and prepaid expenses ₹10,000); current liabilities ₹1,00,000. The quick ratio is
1. 2:1
2. 1.5:1
3. 1:1
4. 1.4:1
Show answer
Answer: (d) 1.4:1. Quick assets ₹1,40,000 ÷ ₹1,00,000.
Cost of revenue from operations ₹6,00,000; average inventory ₹1,00,000. Inventory turnover ratio is
1. 16 times
2. 60 times
3. 0.6 times
4. 6 times
Show answer
Answer: (d) 6 times. 6,00,000 ÷ 1,00,000.

All chapters of Class 12 Accountancy

Written by Kundali IQ from standard, well-established facts to help with revision. This is not an official NCERT publication; always read your textbook too.