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Accounting 3% exam weight

Ratio Analysis

Part of the CA Foundation study roadmap. Accounting topic accoun-014 of Accounting.

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Ratio Analysis

🟢 Lite — Quick Review (1h–1d)

Rapid summary for last-minute revision before your exam.

Ratio Analysis expresses the relationship between two accounting figures (numerator / denominator) drawn from the Balance Sheet and Statement of Profit and Loss to judge a firm’s liquidity, solvency, activity and profitability. A standalone ratio carries no meaning — comparison is compulsory, against prior-year trend, an inter-firm industry average, or a pre-set ideal.

Must-know formulas:

  • Current Ratio = Current Assets ÷ Current Liabilities (ideal 2 : 1)
  • Quick (Acid-Test) Ratio = (Current Assets − Inventory − Prepaid Expenses) ÷ Current Liabilities (ideal 1 : 1)
  • Debt-Equity Ratio = Long-term Debt ÷ Shareholders’ Funds
  • Gross Profit Ratio = (Gross Profit ÷ Net Sales) × 100
  • Net Profit Ratio = (Net Profit after Tax ÷ Net Sales) × 100
  • Return on Investment = (NP before Interest & Tax ÷ Capital Employed) × 100

High-yield pointers: (i) Quick Ratio excludes stock and prepaid items — useful when inventory is slow-moving. (ii) Always include Preference Share Capital inside Shareholders’ Funds for Debt-Equity. (iii) Two marks per ratio computation, three marks for interpretation — the verb matters.

🟡 Standard — Regular Study (2d–2mo)

Standard content for students with a few days to months.

Purpose and Classification

Ratios condense bulky financial statements into comparable indicators. The ICAI study material groups them into four families: Liquidity (short-term paying capacity), Solvency / Leverage (long-term debt servicing), Activity / Turnover (efficiency of asset use), and Profitability (margin and return). Every ratio is a pure number or percentage — dimensionless — which is why cross-firm comparison is feasible after size adjustment.

Liquidity Ratios

Current Ratio uses all current assets. A reading of 2 : 1 is the textbook ideal, but for a retail grocer with daily cash turnover 1.2 : 1 may be healthy, while an electronics dealer needs more. Quick Ratio strips Inventory and Prepaid Expenses out because they are least liquid; the remaining Quick Assets are Cash, Bank, Debtors and Marketable Securities.

Solvency and Profitability Ratios

Debt-Equity Ratio measures the margin of safety for lenders; lower is safer. Long-term debt means debentures and long-term loans, not bank overdraft. Gross Profit Ratio is the gross margin before operating expenses; Net Profit Ratio is what finally belongs to owners per rupee of sale. Both depend on Net Sales, i.e., Sales minus Sales Returns and Trade Discount.

Standard Exam Question Patterns

CA Foundation routinely asks: (a) compute four to six ratios from a given trial balance (6–8 marks), (b) comment on the trend given two years’ data (2 marks), (c) state the ideal ratio with formula (1 mark). Marks are awarded for the correct denominator, the right format (e.g., “2.05 : 1”, not “2.05”), and a one-line interpretation in business language.

🔴 Extended — Deep Study (3mo+)

Comprehensive coverage for students on a longer study timeline.

Edge Cases and Interpretation Traps

Current Ratio can mislead. Adding a long-term loan to the bank and parking it as idle cash lifts the ratio without improving real liquidity. Conversely, paying a long-term creditor with cash depresses the current ratio sharply even though long-term solvency improved. Hence ratio composition (quality of current assets, ageing of debtors) matters more than the headline number.

Debt-Equity nuances. Preference Share Capital is part of Shareholders’ Funds but is not equity in the ordinary-share sense — some analysts present a separate Debt-Total Funds Ratio = Total External Liabilities ÷ Total Funds. Interest Coverage Ratio (Times Interest Earned) complements Debt-Equity by showing whether profits cover interest obligations.

Limits of the Technique

Ratios are historical; they ignore price-level changes unless the statements are inflation-adjusted. They reflect one accounting policy — change the depreciation method and every profitability ratio shifts. Window dressing (window-dressing of closing balances on the last day of the year) can inflate liquidity ratios. Two firms of unequal size must be compared using common-size statements before ratios are computed.

Connection to Adjacent Topics

Ratio Analysis feeds directly into Cash Flow Analysis (liquidity ratios predict cash stress) and Fund Flow (solvency ratios explain long-term financing). In Auditing, ratio comparison is a mandatory analytical procedure under SA 520. In Strategic Financial Management, the DuPont decomposition (Net Profit Margin × Asset Turnover × Equity Multiplier) extends these ratios into ROE drivers.

Worked Micro-Example

Given: Current Assets ₹5,00,000; Inventory ₹1,80,000; Prepaid Expenses ₹20,000; Current Liabilities ₹2,50,000. Quick Assets = 5,00,000 − 1,80,000 − 20,000 = ₹3,00,000. Quick Ratio = 3,00,000 ÷ 2,50,000 = 1.2 : 1 — adequate, signalling that even without selling stock, current obligations are covered 1.2 times.

Common Mistakes

  • Treating Provision for Doubtful Debts as a Current Liability (it is a deduction from debtors).
  • Using Total Sales instead of Net Sales in profit ratios.
  • Forgetting to multiply by 100 in percentage ratios.
  • Comparing a manufacturing firm with a service firm without adjustment.

Practice Prompts

  1. From the given Balance Sheet and P&L, compute Current Ratio, Quick Ratio, Debt-Equity Ratio and Net Profit Ratio for FY 2024-25 and comment on the change from FY 2023-24.
  2. The Current Ratio is 2.8 : 1 and the Quick Ratio is 0.6 : 1. Diagnose the liquidity position and suggest one corrective action.

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