Ratio Analysis | | PAPER III – ACCOUNTING & FINANCIAL MANAGEMENT FOR BANKERS | MODULE C: FINANCIAL MANAGEMENT

Ratio Analysis - Notes and MCQs

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Meaning of Accounting Ratios

Accounting ratios are numerical expressions that represent relationships between various items in the financial statements. They are used to assess the financial health and performance of a business.

Classification of Ratios

• Liquidity Ratios: Measure the firm's ability to meet short-term obligations (e.g., Current Ratio, Quick Ratio).
• Solvency Ratios: Measure long-term financial stability (e.g., Debt-Equity Ratio).
• Profitability Ratios: Measure the firm's ability to generate profit (e.g., Net Profit Ratio, Return on Capital Employed).
• Efficiency Ratios: Indicate how efficiently the business uses its resources (e.g., Inventory Turnover Ratio).

Uses of Accounting Ratios

• Assess operational efficiency
• Analyze financial performance over time
• Assist in decision-making for investors, lenders, and management
• Compare performance with industry standards

Limitations of Accounting Ratios

• Based on historical data
• May be influenced by accounting policies
• Do not consider non-financial factors
• May vary across industries

Calculation and Interpretation of Various Ratios

Example 1:
Current Ratio = Current Assets / Current Liabilities
If Current Assets = ₹50,000 and Current Liabilities = ₹25,000
Current Ratio = 50000 / 25000 = 2
Interpretation: The firm has ₹2 in current assets for every ₹1 in liabilities.

Example 2:
Debt-Equity Ratio = Total Debt / Shareholder's Equity
Total Debt = ₹1,00,000 and Equity = ₹2,00,000
Debt-Equity Ratio = 100000 / 200000 = 0.5
Interpretation: The company uses ₹0.50 debt for every ₹1 of equity.

Different Users and Their Use of Ratios

• Investors: Evaluate profitability and return on investment.
• Lenders: Assess liquidity and creditworthiness.
• Management: Analyze operational efficiency.
• Creditors: Examine the short-term financial position.

Multiple Choice Questions (MCQs)

1. Which of the following is a liquidity ratio?
   A. Debt-Equity Ratio
   B. Net Profit Ratio
   C. Current Ratio
   D. Inventory Turnover Ratio
2. Debt-Equity Ratio assesses:
   A. Profitability
   B. Solvency
   C. Liquidity
   D. Efficiency
3. Net Profit Ratio is a:
   A. Liquidity Ratio
   B. Profitability Ratio
   C. Solvency Ratio
   D. Turnover Ratio
4. Which of the following is a limitation of accounting ratios?
   A. Aid in decision-making
   B. Easy to understand
   C. Based on historical data
   D. Useful for comparison
5. Return on Capital Employed measures:
   A. Profitability
   B. Liquidity
   C. Solvency
   D. Gearing
6. Inventory Turnover Ratio is calculated as:
   A. Inventory / Cost of Goods Sold
   B. Cost of Goods Sold / Average Inventory
   C. Sales / Inventory
   D. Gross Profit / Inventory
7. Quick Ratio excludes which item from current assets?
   A. Cash
   B. Debtors
   C. Inventory
   D. Bills Receivable
8. Which user group is most interested in the Return on Investment (ROI)?
   A. Creditors
   B. Government
   C. Investors
   D. Employees
9. A company with a current ratio of less than 1 indicates:
   A. Good short-term solvency
   B. Potential liquidity issues
   C. High profitability
   D. High equity
10. Which of the following best describes ratio analysis?
    A. It replaces financial statements
    B. It is only useful for auditors
    C. It simplifies financial information for analysis
    D. It is not used in investment decisions

Key Points:

Meaning of Accounting Ratios, Classification of Ratios, Uses of Accounting Ratios, Limitations of Accounting Ratios, Calculation and Interpretation of Various Ratios, Different Users and Their Use of Ratios