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3.2 Analysis of Financial Statements—CBSE XII

CHAPTER SUMMARY

• Accounting Ratio is a mathematical expression of the relationship between two related or interdependent
items or group of items shown in the financial statements.

• Ratio Analysis is the process of computing, determining and presenting the relationship of related or
interdependent items or group of items in the financial statements. It is an important technique of financial
analysis.
• Objectives of Ratio Analysis
1. To assess the earning capacity, financial soundness and operating efficiency of an enterprise.
2. To simplify the accounting information.
3. To help in comparative analysis.
• Uses of Ratio Analysis: Ratio Analysis is useful in:
1. Analysis of financial statements.
2. Assessing the profitability of the business.
3. Assessing the liquidity or short-term solvency of the business.
4. Assessing the long-term solvency of the business.
5. Assessing the operating efficiency of the business.
6. Intra-firm and inter-firm comparison.
7. Locating the weak areas of the business.

• Limitations of Ratio Analysis
1. Qualitative Factors are Ignored: Ratio analysis is a technique of quantitative analysis and thus, ignores
qualitative factors, which may be important in decision-making.
2. Lack of Standard Ratio: There is almost no single standard ratio against which the actual ratio may be
measured and compared.
3. False Results if Based on Incorrect Information: Conclusions drawn may be misleading if ratios are based
on incorrect accounting information.

4. May not be Comparable: Ratios may not be comparable if different firms follow different accounting
policies and procedures.

• Classification of Accounting Ratios
1. Liquidity Ratios: (i) Current Ratio; and (ii) Quick Ratio.
2. Solvency Ratios: (i) Debt to Equity Ratio; (ii) Proprietary Ratio; (iii) Total Assets to Debt Ratio;

(iv) Interest Coverage Ratio; and (v) Debt to Capital Employed Ratio.
3. Activity Ratios: (i) Inventory Turnover Ratio; (ii) Trade Receivables Turnover Ratio; (iii) Trade Payables
Turnover Ratio; (iv) Working Capital Turnover Ratio; (v) Fixed Assets Turnover
Ratio and (vi) Net Assets Turnover Ratio.
4. Profitability Ratios: (i) Gross Profit Ratio; (ii) Operating Ratio; (iii) Operating Profit Ratio; (iv) Net Profit
Ratio; and (v) Return on Investment.