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NCERT Class 12 Accountancy Textbook Chapter 5 With Answer PDF Free Download
Chapter 5: Accounting Ratios
5.1 Meaning of Accounting Ratios
As stated earlier, accounting ratios are an important tool for financial statement analysis. A ratio is a mathematical number calculated as a reference to the relationship of two or more numbers and can be expressed as a fraction, proportion, percentage, and a number of times.
When the number is calculated by referring to two accounting numbers derived from the financial statements, it is termed an accounting ratio.
5.2 Objectives of Ratio Analysis
Ratio analysis is an indispensable part of the interpretation of results revealed by the financial statements.
It provides users with crucial financial information and points out the areas which require investigation.
Ratio analysis is a technique that involves regrouping data by application of arithmetical relationships, though its interpretation is a complex matter.
It requires a fine understanding of the way and the rules used for preparing financial statements. Once done effectively, it provides a lot of information that helps the analyst:
- To know the areas of the business which need more attention;
- To know about the potential areas which can be improved with the effort in the desired direction;
- To provide a deeper analysis of the profitability, liquidity, solvency and efficiency levels in the business;
- To provide information for making cross-sectional analysis by comparing the performance with the best industry standards; and
- To provide information derived from financial statements useful for making projections and estimates for the future.
5.3 Advantages of Ratio Analysis
The ratio analysis if properly done improves the user’s understanding of the efficiency with which the business is being conducted.
The numerical relationships throw light on many latent aspects of the business. If properly analyzed, the ratios make us understand various problem areas as well as the bright spots of the business.
The knowledge of problem areas helps management take care of them in the future. The knowledge of areas that are working better helps you improve the situation further.
It must be emphasized that ratios are means to an end rather than the end in themselves. Their role is essentially indicative and that of a whistleblower.
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NCERT Solutions Class 12 Accountancy Chapter 5 Accounting Ratios
1. What do you mean by Ratio Analysis?
It is a quantitative analysis of data present in a financial statement. It shows the relationship between items present in the Balance sheet and the Income Statement.
It helps in calculating operational efficiency, solvency and determining the profitability of a firm.
Ratio is a statistical measure that helps in comparing relationships between two or more figures. Analyzing ratios presents vital pieces of information to accounting users about the firm’s financial position, performance, and viability.
It also helps in setting up new policies and frameworks by the management.
2. What are the various types of ratios?
Ratios can be classified into two types:
1. Traditional Classification
2. Functional Classification
Traditional Classification: Traditional classification is based on financial statements such as Balance Sheet and P & L accounts. The ratios are divided on the basis of accounts of financial statements and are as follows:
i. Income Statement Ratios such as Gross Profit Ratios
ii. Balance Sheet Ratios such as Debt Equity Ratio, Current Ratio
iii. Composite Ratio: Ratios that contain elements from both Trading and P & L Account.
Functional Classification: These ratios are based on the functional need of calculating ratios.
These ratio help calculate the solvency, liquidity, profitability and financial performance of a business. Such ratios are:
i. Liquidity Ratio: Ratios used to determine the solvency of short term
ii. Solvency Ratio: Ratios used to determine the solvency of long term
iii. Activity Ratio: Ratios used for determining the operating efficiency of the business. These ratios are related to sales and the cost of goods sold.
iv. Probability Ratio: Ratios used to determine the financial performance and viability of the firm.
3. What are important profitability ratios? How are these worked out?
Profitability ratios are calculated on the basis of profit earned by a business. This ratio gives a percentage that is used to assess the financial condition of a business
1. Return on Assets: This ratio measures the earnings per rupee from assets that are invested in the company. A higher profit ratio is good for the company.
Return on Assets = Net Profit ÷ Total Assets
2. Return on Equity: This ratio deals with measuring the profitability of the equity fund that is invested by the company. It also measures how owners’ funds are utilized profitably to generate company revenues. A high ratio represents the better position of a company.
Return on Equity = Profit after Tax ÷ Net worth
Where Net worth = Equity share capital, and Reserve and Surplus
3. Earnings per share: This ratio helps in measuring profitability from an ordinary shareholder’s viewpoint. A high ratio represents a well off company.
Earnings per share = Net Profit ÷ Total no of shares outstanding
4. Dividend per share: This ratio measures the amount of dividend that is distributed by the company to its shareholders at the end of an accounting period. A high ratio represents that the company is having surplus cash.
Dividend per share= Amount Distributed to Shareholders ÷ No of Shares outstanding
5. Price Earnings Ratio: A profitability ratio that is used by an investor to check for the share price of the company which can be undervalued or overvalued. It also indicates an expectation about the company’s earning and payback period for the investors.
Price Earnings Ratio = Market Price of Share ÷ Earnings per share
6. Return on capital employed: This ratio is all about the returns earned by the company from the funds invested in the business by its owners. A high ratio is indicative of a better position for the company.
Return on capital employed = Net Operating Profit ÷ Capital Employed × 100
7. Gross Profit: Gross profit ratio or GP ratio is a profitability ratio that deals with the relationship between gross profit and the total net sales revenue. This ratio is used to evaluate the operational performance of the business.
8. Net Profit: This is a profitability ratio that deals with relationship between net profit after tax and net sales. It is calculated by dividing the net profit (after tax) by net sales.
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