Class 12 Accountancy Chapter 9 Accounting Ratios

Key Concept: Conceptual Understanding

c) The company likely uses funds efficiently.

[Solution Description] A company with a consistently higher Return on Shareholders’ Funds than the industry average generally implies that it is utilizing its shareholders’ funds more efficiently than its peers, potentially reflecting strong management performance and solid financial health.

Key Concept: Intra-firm Comparison

c) Assessing internal departmental performance

[Solution Description] Intra-firm comparison via ratios involves analyzing various departments or time periods within the same company to assess consistency and efficiency over time.

Key Concept: Comparative Analysis, Impact Analysis

b) Company Y due to higher revenue generation per asset

[Solution Description]

The Net Assets Turnover Ratio measures how efficiently a company uses its assets to generate revenue. A higher ratio typically suggests better asset utilization.

For Company X:

$$\text{Net Assets Turnover Ratio}_X = 3 \Rightarrow \text{Revenue from Operations}_X = 3 \times \text{Capital Employed}.$$

For Company Y:

$$\text{Net Assets Turnover Ratio}_Y = 5 \Rightarrow \text{Revenue from Operations}_Y = 5 \times \text{Capital Employed}.$$

Since Company Y generates more revenue per unit of capital employed, it suggests that Company Y’s strategy reflects greater operational efficiency.

Key Concept: Ratio Implication

a) High reliance on shareholder’s equity

[Solution Description] The Proprietary Ratio indicates the proportion of shareholders’ funds to net assets. A ratio of 0.60:1 implies that 60% of the company’s net assets are financed by shareholders’ equity, while the remaining 40% may be financed through debt or other liabilities.

Key Concept: SWOT Analysis

b) Highlighting internal strengths and weaknesses.

[Solution Description] Financial ratios are effective in identifying internal strengths and weaknesses by analyzing factors like profitability, leverage, and operational efficiency. They show how well a company utilizes its resources compared to competitors.

Key Concept: Judgment and Integrity, Accounting Policy Variations

b) Distorted views of profitability and difficulty in comparison

[Solution Description] Accounting judgments involve selecting certain principles or estimates that best reflect a company’s financial situation. However, these selections can vary significantly based on the accountant’s integrity and the applied accounting policies, causing different profit calculations. While some judgments may present more favorable results, they could mislead stakeholders regarding true profitability if not grounded in integrity. Additionally, varying policies between firms make cross-company comparisons challenging, often resulting in skewed assessments of financial health. Thus, these factors critically shape perceived profitability, highlighting the need for ethical standards and transparent reporting practices.

Key Concept: Efficiency Evaluation

b) This indicates efficient fund utilization.

[Solution Description] Since the ROCE (18%) is higher than the cost of borrowing (12%), it indicates that the company is using its capital efficiently as it earns more return on every rupee invested compared to what it pays in interest.

Key Concept: Complex Calculation, Advanced Interpretation

c) 18.75%

[Solution Description]

The Operating Profit is calculated as:

$$\text{Operating Profit} = \text{Revenue from Operations} – \text{Operating Cost} – \text{Additional Administrative Expenses}$$

Substituting the given values:

$$\text{Operating Profit} = 800,000 – 600,000 – 50,000 = 150,000$$

Now, calculate the Operating Profit Ratio using:

$$\text{Operating Profit Ratio} = \left(\frac{\text{Operating Profit}}{\text{Revenue from Operations}}\right) \times 100$$

$$\text{Operating Profit Ratio} = \left(\frac{150,000}{800,000}\right) \times 100 = 18.75\%$$

Key Concept: Strategic Decision Making, Cross-Sectional Analysis

c) Reduce current liabilities through debt repayment

[Solution Description] To achieve a higher current ratio comparable to the industry average, the firm could consider several strategies:

1. Reducing current liabilities without decreasing current assets. This could involve paying off some short-term debt.

2. Increasing current assets while keeping current liabilities constant or reducing them. This might include improving accounts receivable collections or increasing inventories responsibly.

3. Raising additional equity or long-term financing to pay off short-term obligations.

Given the options, the most immediate strategy to increase the current ratio involves focusing on reducing current liabilities by promptly managing and clearing short-term debts.

Key Concept: Application of Formula

d) 0.4

[Solution Description]

To find the Dividend Payout Ratio, use the formula:

$$\text{Dividend Payout Ratio} = \frac{\text{Dividend per share}}{\text{Earnings per share}}$$. Here,

$$\text{Dividend Payout Ratio} = \frac{4}{10} = 0.4$$

So, the Dividend Payout Ratio is 0.4.

Key Concept: Interpretative Complexity, Complex Scenario Analysis, Integration of Concepts

b) Ensure consistent use of related figures and definitions

[Solution Description] To improve ROE analysis, it’s vital to adopt standardized definitions and consistently utilize related financial figures. This ensures clarity and comparability across periods. Addressing these issues involves reviewing the calculation methodology, aligning it with established standards, and ensuring figures used are directly related to the specific context of the analysis.

Key Concept: Comparative Analysis

b) Company Y

[Solution Description] The P/E ratio reflects investor expectations regarding a company’s future growth. A higher P/E ratio suggests that investors expect higher growth from the company. Thus, with a P/E ratio of 24 compared to 18, investors expect Company Y to have higher growth potential than Company X.

Key Concept: Real-World Application, Critical Evaluation

c) Complicates the ability to perform accurate benchmarking

[Solution Description] Without industry averages available in India, the company lacks a baseline to assess its standing against peers internationally. This complicates benchmarking efforts as they cannot gauge their position relative to both domestic and international competitors accurately, leading to potential misinterpretations.

Key Concept: Intermediate Calculation

c) 10

[Solution Description]

To find the Inventory Turnover Ratio, we need to calculate both the Average Inventory and the Cost of Revenue from Operations.

First, the Cost of Revenue from Operations is:

$$\text{Cost of Revenue from Operations} = \text{Revenue from Operations} – \text{Gross Profit}$$

Given that Gross Profit is 20% of Revenue from Operations:

$$\text{Gross Profit} = 0.20 \times 5,00,000 = 1,00,000$$

Thus, the Cost of Revenue from Operations becomes:

$$\text{Cost of Revenue from Operations} = 5,00,000 – 1,00,000 = 4,00,000$$

Next, we calculate the Average Inventory:

$$\text{Average Inventory} = \frac{\text{Opening Inventory} + \text{Closing Inventory}}{2} = \frac{30,000 + 50,000}{2} = 40,000$$

Finally, the Inventory Turnover Ratio is:

$$\text{Inventory Turnover Ratio} = \frac{\text{Cost of Revenue from Operations}}{\text{Average Inventory}} = \frac{4,00,000}{40,000} = 10$$

Key Concept: Strategic Decision Making, Critical Thinking, Non-Straightforward Path

c) Balance both by integrating qualitative benefits into decision criteria.

[Solution Description] Management should recognize that while technology investments may immediately boost financial metrics, neglecting employee development could harm long-term productivity and morale. Balancing both investments necessitates looking beyond immediate financial returns to include qualitative benefits such as enhanced skills and job satisfaction.

Key Concept: Ratio Interpretation

c) The company increased its external borrowings or liabilities.

[Solution Description] A decrease in the Proprietary Ratio indicates that the proportion of shareholders’ funds in financing total assets has reduced. This implies an increase in debt or liabilities relative to equity, suggesting higher borrowing or less reliance on owners’ funds.

Key Concept: Functional Classification

d) Current ratio

[Solution Description]

A liquidity ratio measures a company’s ability to meet its short-term obligations using its most liquid assets. The current ratio, also known as the working capital ratio, is a primary example of a liquidity ratio and is calculated as $$\text{Current Assets} / \text{Current Liabilities}$$.

Key Concept: In-depth Analysis, Critical Evaluation

d) Firm B appears more efficient because of higher cash flows.

[Solution Description] Operating Cash Flow is a critical metric in assessing liquidity and operational performance. By including interest payments, Firm A’s cash flow from operations appears reduced, as interest paid is considered a cash outflow. Conversely, Firm B’s exclusion of interest payments gives a higher operating cash flow figure. This disparity could lead analysts to view Firm B as having better liquidity and operational efficiency compared to Firm A, even if the actual business conditions are similar.

Key Concept: Complex Problem Solving, Multi-step Calculation

c) 1.57:1

[Solution Description]

To calculate the quick ratio, we first need to determine the quick assets by excluding inventories from current assets.

Quick Assets = Current Assets – Inventories

$$\text{Quick Assets} = 150000 – 40000 = 110000$$

Now, compute the quick ratio using the formula:

$$\text{Quick Ratio} = \frac{\text{Quick Assets}}{\text{Current Liabilities}}$$

Substitute the values:

$$\text{Quick Ratio} = \frac{110000}{70000} \approx 1.57:1$$

Therefore, the quick ratio is approximately 1.57:1.

Key Concept: Complex Problem Solving, Advanced Reasoning

c) 13.61%

[Solution Description]

To find the Net Profit Ratio, we first need to calculate the net profit after tax.

Step 1: Calculate Net Profit before tax:

$$\text{Net Profit before tax} = \text{Gross Profit} – \text{Indirect Expenses} = 5,00,000 – 1,50,000 = 3,50,000$$

Step 2: Calculate Tax payable:

$$\text{Tax} = 0.30 \times 3,50,000 = 1,05,000$$

Step 3: Calculate Net Profit after tax:

$$\text{Net Profit after tax} = 3,50,000 – 1,05,000 = 2,45,000$$

Step 4: Calculate Net Profit Ratio:

$$\text{Net Profit Ratio} = \left(\frac{2,45,000}{18,00,000}\right) \times 100 = 13.61\%$$

Key Concept: Integration of Limitations, Advanced Forecasting

c) They increase uncertainty in forecasts.

[Solution Description] These limitations make forecasting complex because relying heavily on historical data assumes that past trends will continue into the future without accounting for potential changes. Moreover, variations in accounting practices can cause discrepancies in financial reporting across companies, leading to inconsistent data for analysis.

Key Concept: Problem Identification

b) They act as indicative tools for potential issues.

[Solution Description] Ratios serve as indicative tools by simplifying complex figures, thus highlighting potential issues within various segments of a business. This simplification allows managers to identify which areas require more attention and address them promptly.

Key Concept: Critical Thinking, Advanced Error Analysis

c) Because it fails to consider coherent relationships.

[Solution Description] Travel expenses and machinery maintenance represent distinct operational activities: one pertains to employee movement or logistics, and the other is about ensuring equipment functionality. Analyzing a ratio between such disconnected elements doesn’t offer credible insights into operational effectiveness because they don’t share a logical connection that can be assessed proportionally. This can lead to confusing assessments and incorrect conclusions regarding the operational strategy.

Key Concept: Second-order Thinking, Real-world Application

b) It fosters a reactive rather than proactive stance

[Solution Description] Relying on historical data often leads firms to base their strategies on past performance metrics, which may hinder proactive investment in new technologies or innovative processes. The firm may struggle to anticipate future trends and miss out on early mover advantages.

Key Concept: Ratio Analysis

b) Decrease

[Solution Description]

Given that the Total Assets remain constant and long-term debts increase by 20%, let us define:

– Initial long-term debts = $D$

– Increased long-term debts = $1.20D$

First, calculate the initial Total Assets to Debt Ratio:

$$\text{Initial Ratio} = \frac{\text{Total Assets}}{D}$$

After increasing the debts by 20%, new ratio becomes:

$$\text{New Ratio} = \frac{\text{Total Assets}}{1.20D}$$

Since the numerator (Total Assets) stays the same and the denominator increases from $D$ to $1.20D$, the Total Assets to Debt Ratio will decrease.

Thus, the correct option is “Decrease”.

Key Concept: Complex Calculation, Scenario Analysis

d) 0.154:1

[Solution Description]

To find the original Debt-Equity Ratio, we calculate it using the formula:

$$\text{Original Debt-Equity Ratio} = \frac{\text{Long-term Debts}}{\text{Shareholders’ Funds}} = \frac{500,000 + 200,000}{800,000} = \frac{700,000}{800,000} = 0.875$$

When \$500,000 is converted from debt to equity, the new long-term debts become \$200,000 and shareholders’ funds increase to \$1,300,000.

The new Debt-Equity Ratio becomes:

$$\text{New Debt-Equity Ratio} = \frac{200,000}{1,300,000} = \frac{2}{13} \approx 0.154$$

Hence, the new Debt-Equity Ratio is approximately 0.154:1.

Key Concept: Interpretation of Results

b) Strong Liquidity

[Solution Description]

A Quick Ratio greater than 1 indicates that a company has more quick assets than its short-term liabilities, suggesting it is financially healthy with good liquidity. Specifically, a Quick Ratio of 1.5:1 means the company has 1.50 in quick assets for every 1 of current liabilities.

Key Concept: SWOT Analysis

c) It assists in understanding both strengths and weaknesses, as well as opportunities and threats.

[Solution Description] Ratio analysis helps in identifying strengths and weaknesses by measuring efficiency, such as profitability ratios indicating strong operational performance and liquidity ratios highlighting potential cash flow issues. Opportunities and threats can be identified through market comparisons and trend analysis.

Key Concept: Ratio Impact

a) Increase

[Solution Description]

The Operating Ratio is given by:

$$\text{Operating Ratio} = \frac{\text{Cost of Revenue from Operations} + \text{Operating Expenses}}{\text{Net Revenue from Operations}} \times 100$$

If Operating Expenses increase and other components remain constant, the numerator of the ratio increases, which leads to an increase in the Operating Ratio.

Key Concept: Simple Calculation

b) 2 times

[Solution Description] Using the formula:

$$\text{Interest Coverage Ratio} = \frac{\text{Net Profit before Interest and Tax}}{\text{Interest on long-term debts}}$$

Substitute values:

$$\text{Interest Coverage Ratio} = \frac{3,00,000}{1,50,000} = 2$$

Therefore, the Interest Coverage Ratio is 2 times.

Key Concept: Scenario-Based Calculation

c) 7.5:1

[Solution Description]

Solution: We begin by calculating the initial Total Assets to Debt Ratio using the formula:

$$\text{Initial Total Assets to Debt Ratio} = \frac{10,00,000}{2,00,000} = 5:1$$

After acquiring additional assets worth Rs. 5,00,000, the new total assets become Rs. 15,00,000 while long-term debts remain unchanged at Rs. 2,00,000.

Therefore, the new Total Assets to Debt Ratio becomes:

$$\text{New Total Assets to Debt Ratio} = \frac{15,00,000}{2,00,000} = 7.5:1$$

The new Total Assets to Debt Ratio is 7.5:1.

Key Concept: Calculation with Variations

b) 0.4:1

[Solution Description] To find the new ratio:

$$\text{Debt to Capital Employed Ratio} = \frac{\text{Long-term Debt}}{\text{Capital Employed}} = \frac{500,000}{1,250,000} = 0.4:1$$

Therefore, the new ratio is 0.4:1.

Key Concept: Application Understanding

b) It highlights performance areas exceeding industry norms.

[Solution Description] Ratio analysis helps businesses identify areas with potential for growth by analyzing financial ratios such as profitability, liquidity, and efficiency. By examining these ratios, companies can pinpoint where they have competitive advantages or superior performance compared to industry averages, which could indicate untapped market opportunities.

Key Concept: Average Collection Period

c) 40.56 days

[Solution Description]

To calculate the average collection period, divide the number of days in a year by the Trade Receivables Turnover Ratio:

$$\text{Average Collection Period} = \frac{365}{\text{Trade Receivables Turnover Ratio}}$$

Given that the turnover ratio is 9 times:

$$= \frac{365}{9} \approx 40.56 \text{ days}$$

Therefore, the average collection period is approximately 40.56 days.

Key Concept: Complex Calculation, Multi-step Solutions

c) 200,000

[Solution Description]

First, calculate the Earnings Per Share (EPS) using the given P/E Ratio:

$$\text{P/E Ratio} = \frac{\text{Market Price per Share}}{\text{Earnings per Share}}$$

Rearrange to find EPS:

$$\text{Earnings per Share} = \frac{\text{Market Price per Share}}{\text{P/E Ratio}}$$

Substitute values:

$$\text{EPS} = \frac{45}{15} = 3$$

Now, find the number of equity shares using total earnings:

$$\text{Total Earnings} = \text{EPS} \times \text{Number of Shares}$$

Rearrange to find Number of Shares:

$$\text{Number of Shares} = \frac{\text{Total Earnings}}{\text{EPS}} = \frac{600,000}{3} = 200,000$$

Key Concept: Price-Level Changes

d) Price-level changes

[Solution Description] Ratio analysis commonly ignores price-level changes because it assumes that currency maintains a stable value over time, which is not always true due to inflation or deflation.

Key Concept: Simple Calculation

c) 60%

[Solution Description] To find the Operating Ratio, use the formula:

$$\text{Operating Ratio} = \left( \frac{\text{Operating Cost}}{\text{Net Revenue from Operations}} \right) \times 100$$

Substituting the given values:

$$\text{Operating Ratio} = \left( \frac{180,000}{300,000} \right) \times 100 = 60\%$$

Therefore, the Operating Ratio is 60%.

Key Concept: Application of Ratios

b) Current Ratio

[Solution Description] The Current Ratio is most suitable to assess a firm’s short-term liquidity or creditworthiness as it measures the company’s ability to cover its current liabilities with its current assets.

Key Concept: Basic Concept

b) Intra-firm Comparison

[Solution Description] Intra-firm Comparison, also known as Time Series Analysis, involves analyzing a firm’s performance over different accounting periods. This helps in identifying trends and evaluating the growth or decline of the firm.

Key Concept: Comparative Analysis

c) By providing benchmarks against similar industries

[Solution Description] Ratio analysis enables cross-sectional analysis by allowing a company to compare its financial performance with industry standards or competitors. This helps in understanding where the business stands relative to its peers.

Key Concept: Application of Formula

c) 5.71

[Solution Description] To calculate the Trade Payables Turnover Ratio, we first need to find the Average Trade Payables using the formula:

$$\text{Average Trade Payables} = \frac{\text{Opening Creditors and Bills Payable} + \text{Closing Creditors and Bills Payable}}{2}$$

Substituting in the given values:

$$\text{Average Trade Payables} = \frac{60,000 + 80,000}{2} = 70,000$$

Now, use the formula for Trade Payables Turnover Ratio:

$$\text{Trade Payables Turnover Ratio} = \frac{\text{Net Credit Purchases}}{\text{Average Trade Payables}}$$

Substitute the known values:

$$\text{Trade Payables Turnover Ratio} = \frac{400,000}{70,000} = 5.71$$

Hence, the Trade Payables Turnover Ratio is approximately 5.71 times.

Key Concept: Ratio Types

c) Debt Equity Ratio

[Solution Description] Solvency ratios are used to measure a company’s ability to meet its long-term obligations. An example of a solvency ratio is the debt equity ratio, which assesses the proportion of a company’s debt compared to its shareholders’ equity.

Key Concept: Interpretation of Ratios

b) Delayed payments

[Solution Description] The Trade Payable Turnover Ratio indicates how quickly a company pays off its trade payables. A ratio of 1.8 times suggests that the company takes longer to settle its debts with suppliers since it turns over its payables less frequently within a year.

Key Concept: Real-World Application

c) Increasing equity through issuing shares

[Solution Description] Solvency ratios determine a business’s ability to meet long-term debts. Increasing equity improves financial stability by reducing reliance on external debt, thereby positively affecting solvency ratios like the Debt Equity Ratio.

Key Concept: Real-World Application, Advanced Interpretation

d) Improve credit terms with suppliers to extend payment time.

[Solution Description]

Given the company’s current ratio of 0.9:1, it indicates a shortage of liquid assets relative to its liabilities. Investing in a project requiring immediate cash may exacerbate this situation. To maintain liquidity, the company should look for strategies to boost liquid assets or delay expenses.

Key Concept: Application of Formula

c) Rs. 20

[Solution Description] Using the formula for Book Value per Share:

$$\text{Book Value per Share} = \frac{\text{Equity Shareholders’ Funds}}{\text{Number of Equity Shares}}$$

With Equity Shareholders’ Funds = Rs. 9,60,000 and Number of Equity Shares = 48,000:

$$\text{Book Value per Share} = \frac{9,60,000}{48,000} = 20$$

Hence, the Book Value per Share is Rs. 20.

Key Concept: Complex Calculations, Multi-step Solutions

c) 17.5%

[Solution Description]

To calculate ROI, we first need to determine the Profit before Interest and Tax, which is given by:

$$\text{Profit before Interest and Tax} = \text{Gross Profit} – \text{Operating Expenses} = 150,000 – 80,000 = 70,000$$

Then, apply the formula for ROI:

$$\text{ROI} = \frac{\text{Profit before Interest and Tax}}{\text{Capital Employed}} \times 100 = \frac{70,000}{400,000} \times 100 = 17.5\%$$

Key Concept: Total Assets to Debt Ratio Calculation

c) 3:1

[Solution Description] The Total Assets to Debt Ratio is determined as follows:

$$\text{Total Assets to Debt Ratio} = \frac{\text{Total Assets}}{\text{Long-term Debts}}$$

Plugging in the numbers:

$$\text{Total Assets to Debt Ratio} = \frac{1,200,000}{400,000} = 3:1$$

Key Concept: EPS and Book Value

b) Rs. 8.00

[Solution Description]

Book value per share is calculated by dividing the total equity shareholders’ funds by the number of shares issued.

$$\text{Book Value per Share} = \frac{\text{Equity Shareholders’ Funds}}{\text{Number of Issued Shares}} = \frac{10,00,000}{1,25,000}$$

Simplifying this equation:

$$\text{Book Value per Share} = 8.00$$

Key Concept: Complex Scenario Analysis, Real-World Application

d) Approximately 53.64%

[Solution Description]

To solve this, we need to understand how the changes in cost of revenue and selling price will affect the Gross Profit and subsequently the Gross Profit Ratio.

Initial Gross Profit Ratio = 40%

Let initial Net Revenue from Operations be $R$ Rs., and let Cost of Revenue be $C$ Rs.

We know:

$$\text{Gross Profit} = R – C$$

$$\text{Initial Gross Profit Ratio} = \frac{R – C}{R} \times 100\% = 40\%$$

Simplifying, we get:

$$R – C = 0.4R \Rightarrow C = 0.6R$$

New Cost of Revenue after reduction by 15%:

$$C_{\text{new}} = 0.85 \times C = 0.85 \times 0.6R = 0.51R$$

New Net Revenue after a 10% increase in selling price:

$$R_{\text{new}} = 1.10 \times R = 1.10R$$

New Gross Profit:

$$\text{New Gross Profit} = R_{\text{new}} – C_{\text{new}} = 1.10R – 0.51R = 0.59R$$

New Gross Profit Ratio:

$$\text{New Gross Profit Ratio} = \frac{0.59R}{1.10R} \times 100\% = \frac{0.59}{1.10} \times 100\%$$

Calculating further:

$$\text{New Gross Profit Ratio} = 53.64\%$$

Therefore, the new Gross Profit Ratio is approximately 53.64%.

Key Concept: Application of Formula

b) 1.5

[Solution Description] To find the Net Assets Turnover Ratio, use the formula:

$$\text{Net Assets Turnover Ratio} = \frac{\text{Revenue from Operations}}{\text{Capital Employed}}$$

$$= \frac{45,00,000}{30,00,000}$$

$$= 1.5$$

Thus, the Net Assets Turnover Ratio is 1.5.

Key Concept: Synthesis and Evaluation, Advanced Reasoning

c) It necessitates extensive due diligence to align varying definitions.

[Solution Description] International investors rely on comparable financial metrics to make informed decisions. The absence of standardized definitions can obscure true financial performance, leading to potential misinterpretations. Investors may face challenges in assessing risk and return accurately across borders. This situation demands meticulous due diligence and adjustments for consistency to mitigate risks associated with non-standardized data, which otherwise could lead investors to make suboptimal investment choices.