Chapter 9 — Ratio Analysis: Exercise Solutions Guide
How to Use This Page
Read the Samacheer Kalvi textbook chapter first and attempt every exercise question on your own. Then come here to verify your method, calculations, and presentation. Pay close attention to the format of ratio calculations — examiners award marks for correct formulas, proper substitutions, and clear final answers with units (times, %, or ratio).
Key Concepts (Quick Recap)
- Ratio Analysis — quantitative analysis of financial statements using standard ratios
- Liquidity Ratios — measure short-term paying capacity
- Current Ratio = Current Assets ÷ Current Liabilities (ideal: 2:1)
- Quick Ratio (Liquid Ratio) = Liquid Assets ÷ Current Liabilities (ideal: 1:1)
- Liquid Assets = Current Assets − Inventory − Prepaid Expenses
- Solvency Ratios — measure long-term financial stability
- Debt-Equity Ratio = Long-term Debts ÷ Shareholders' Funds (ideal: 2:1)
- Proprietary Ratio = Shareholders' Funds ÷ Total Assets
- Interest Coverage Ratio = Net Profit before Interest & Tax ÷ Interest on Long-term Debt
- Activity (Turnover) Ratios — measure operational efficiency
- Inventory Turnover Ratio = Cost of Revenue from Operations ÷ Average Inventory
- Trade Receivables Turnover Ratio = Net Credit Revenue from Operations ÷ Average Trade Receivables
- Trade Payables Turnover Ratio = Net Credit Purchases ÷ Average Trade Payables
- Working Capital Turnover Ratio = Revenue from Operations ÷ Net Working Capital
- Profitability Ratios — measure earning capacity
- Gross Profit Ratio = Gross Profit ÷ Revenue from Operations × 100
- Operating Ratio = (Cost of Revenue from Operations + Operating Expenses) ÷ Revenue from Operations × 100
- Operating Profit Ratio = Operating Profit ÷ Revenue from Operations × 100
- Net Profit Ratio = Net Profit ÷ Revenue from Operations × 100
- Return on Investment (ROI) = Net Profit before Interest & Tax ÷ Total Capital Employed × 100
I. Choose the Best Answer (MCQs)
1. The ideal current ratio is: (a) 1:1   (b) 2:1   (c) 1:2   (d) 3:1
Answer(b) 2:1 Explanation: A current ratio of 2:1 means current assets are twice the current liabilities, providing a comfortable safety margin for short-term obligations.
2. Which of the following is excluded from liquid assets? (a) Cash   (b) Debtors   (c) Inventory   (d) Bank balance
Answer(c) Inventory Explanation: Inventory is the least liquid current asset and may not be quickly convertible to cash. Hence it is excluded from liquid assets when computing the quick ratio.
3. Debt-equity ratio is a measure of: (a) Liquidity   (b) Solvency   (c) Profitability   (d) Activity
Answer(b) Solvency Explanation: The debt-equity ratio compares long-term debt with shareholders' funds, indicating whether the firm relies more on borrowed funds or owned funds — a solvency (long-term stability) measure.
4. If current assets are ₹3,00,000 and current liabilities are ₹1,50,000, the current ratio is: (a) 1:1   (b) 1.5:1   (c) 2:1   (d) 3:1
Answer(c) 2:1 Explanation: Current Ratio = Current Assets ÷ Current Liabilities = 3,00,000 ÷ 1,50,000 = 2:1.
5. Gross profit ratio is classified under: (a) Liquidity ratios   (b) Solvency ratios   (c) Profitability ratios   (d) Turnover ratios
Answer(c) Profitability ratios Explanation: Gross profit ratio expresses gross profit as a percentage of revenue from operations, measuring the profitability of core operations.
6. Which ratio indicates the efficiency of inventory management? (a) Current ratio   (b) Inventory turnover ratio   (c) Net profit ratio   (d) Debt-equity ratio
Answer(b) Inventory turnover ratio Explanation: A higher inventory turnover ratio means stock is sold quickly, indicating efficient inventory management.
7. Operating ratio + Operating profit ratio = ? (a) 50   (b) 100   (c) 0   (d) 1
Answer(b) 100 Explanation: Operating ratio and operating profit ratio are complementary. Since operating profit = revenue from operations − operating cost, their percentages always add up to 100.
8. A higher proprietary ratio indicates: (a) More debt dependence   (b) Greater financial stability   (c) Poor liquidity   (d) Low profitability
Answer(b) Greater financial stability Explanation: A higher proprietary ratio means a larger proportion of total assets is financed by shareholders' funds, reducing financial risk.
9. The formula for the quick ratio is: (a) Current Assets ÷ Current Liabilities   (b) Liquid Assets ÷ Current Liabilities   (c) Liquid Assets ÷ Liquid Liabilities   (d) Current Assets ÷ Liquid Liabilities
Answer(b) Liquid Assets ÷ Current Liabilities Explanation: Quick ratio = Liquid Assets ÷ Current Liabilities, where Liquid Assets = Current Assets − Inventory − Prepaid Expenses.
10. Interest coverage ratio is calculated as: (a) Net Profit ÷ Interest   (b) EBIT ÷ Interest on Long-term Debt   (c) EBIT ÷ Total Debt   (d) Net Profit after Tax ÷ Interest
Answer(b) EBIT ÷ Interest on Long-term Debt Explanation: Interest coverage ratio measures how many times the profit covers interest obligations. It uses Net Profit before Interest and Tax (EBIT) divided by interest on long-term debt.
II. Fill in the Blanks
1. The two liquidity ratios are Current Ratio and Quick Ratio.
2. Liquid Assets = Current Assets − Inventory − Prepaid Expenses.
3. The ideal quick ratio is 1:1.
4. Debt-equity ratio = Long-term Debts ÷ Shareholders' Funds.
5. Inventory turnover ratio is also called Stock turnover ratio.
6. When the current ratio is 2:1, for every ₹2 of current assets there is ₹1 of current liabilities.
7. Net profit ratio = Net Profit ÷ Revenue from Operations × 100.
8. Working capital turnover ratio measures the efficiency of working capital utilisation.
9. Return on investment is also known as Return on Capital Employed (ROCE).
10. Proprietary ratio = Shareholders' Funds ÷ Total Assets.
III. True or False
1. A current ratio of 4:1 is always better than 2:1. False. Correction: An excessively high current ratio may indicate idle current assets (excessive inventory or unused cash), which is not efficient.
2. Quick ratio excludes inventory from current assets. True. Inventory and prepaid expenses are excluded from liquid assets when computing the quick ratio.
3. Debt-equity ratio is a liquidity ratio. False. Correction: It is a solvency (leverage) ratio that measures long-term financial stability.
4. A higher inventory turnover ratio indicates efficient stock management. True. It means inventory is sold quickly and does not remain idle.
5. Proprietary ratio and debt-equity ratio convey the same information. False. Correction: They are related but distinct. Proprietary ratio compares shareholders' funds to total assets, while debt-equity ratio compares long-term debt to shareholders' funds.
6. Operating ratio + Operating profit ratio = 100. True. Since operating cost + operating profit = revenue from operations, their percentage ratios are complementary and always sum to 100.
7. Prepaid expenses are included in liquid assets. False. Correction: Prepaid expenses are excluded from liquid assets because they cannot be quickly converted into cash.
8. Ratio analysis ignores price-level changes. True. One limitation of ratio analysis is that it does not account for inflation or deflation, making comparisons across periods unreliable if price levels have changed significantly.
IV. Match the Following
1.
| Column A | Column B |
|---|
| Current Ratio | Liquidity |
| Debt-Equity Ratio | Solvency |
| Inventory Turnover Ratio | Activity |
| Gross Profit Ratio | Profitability |
| Proprietary Ratio | Long-term stability |
2.
| Column A | Column B |
|---|
| Liquid Assets | Current Assets − Inventory − Prepaid Expenses |
| Current Liabilities | Short-term obligations due within a year |
| EBIT | Net Profit before Interest and Tax |
| Average Inventory | (Opening Inventory + Closing Inventory) ÷ 2 |
| Net Working Capital | Current Assets − Current Liabilities |
V. Answer Briefly
1. Define ratio analysis. State its objectives.
Answer
Ratio analysis is the process of determining and interpreting the relationship between various items or groups of items in the financial statements. Its objectives include: (i) assessing liquidity and solvency, (ii) evaluating profitability, (iii) measuring operational efficiency, (iv) comparing performance across periods and with other firms, and (v) helping stakeholders make informed decisions.
2. Distinguish between current ratio and quick ratio.
Answer
| Basis | Current Ratio | Quick Ratio | |---|---|---| | Formula | Current Assets ÷ Current Liabilities | Liquid Assets ÷ Current Liabilities | | Includes inventory | Yes | No | | Includes prepaid expenses | Yes | No | | Ideal | 2:1 | 1:1 | | Measures | Overall short-term liquidity | Immediate or acid-test liquidity |
3. What is the significance of the debt-equity ratio?
Answer
The debt-equity ratio measures the proportion of long-term debt to shareholders' funds. A high ratio means greater reliance on borrowed funds, increasing financial risk and fixed interest burden. A low ratio indicates conservative financing. The ideal ratio is 2:1, meaning for every ₹2 of debt there is ₹1 of shareholders' funds as a cushion.
4. State the formula for inventory turnover ratio. What does it indicate?
Answer
Inventory Turnover Ratio = Cost of Revenue from Operations ÷ Average Inventory. It indicates how many times inventory is sold and replaced during a period. A higher ratio means faster stock movement and efficient inventory management. A very high ratio may also indicate understocking.
5. What are the limitations of ratio analysis?
Answer
(i) Ratios are based on historical cost and ignore price-level changes. (ii) Different firms use different accounting policies, making inter-firm comparison unreliable. (iii) Ratios are only indicators — they do not reveal causes. (iv) Window-dressing can distort ratios. (v) A single ratio by itself has limited meaning — it must be compared with standards, past ratios, or industry norms.
6. What is the operating ratio? State its formula.
Answer
Operating Ratio = (Cost of Revenue from Operations + Operating Expenses) ÷ Revenue from Operations × 100. It shows the percentage of revenue consumed by operating costs. A lower ratio is better — it means more revenue is available as operating profit. The sum of operating ratio and operating profit ratio is always 100.
7. How is the interest coverage ratio computed? What does it indicate?
Answer
Interest Coverage Ratio = Net Profit before Interest and Tax ÷ Interest on Long-term Debt. It indicates how many times the profit covers interest obligations. A higher ratio gives lenders confidence that interest will be paid. A ratio below 1 means the firm cannot meet its interest obligations from operating profit.
8. Differentiate between solvency ratios and liquidity ratios.
Answer
| Basis | Liquidity Ratios | Solvency Ratios | |---|---|---| | Purpose | Short-term paying capacity | Long-term financial stability | | Examples | Current ratio, Quick ratio | Debt-equity ratio, Proprietary ratio | | Focus | Current assets vs current liabilities | Total debt vs shareholders' funds | | Time horizon | Within one year | Beyond one year |
VI. Answer in Detail
1. Explain the classification of ratios with formulas and ideal standards.
Answer
Ratios are classified into four broad categories: I. Liquidity Ratios — measure the firm's ability to meet short-term obligations: - Current Ratio = Current Assets ÷ Current Liabilities (ideal: 2:1) - Quick Ratio = Liquid Assets ÷ Current Liabilities (ideal: 1:1) II. Solvency Ratios — measure long-term financial stability: - Debt-Equity Ratio = Long-term Debts ÷ Shareholders' Funds (ideal: 2:1) - Proprietary Ratio = Shareholders' Funds ÷ Total Assets - Interest Coverage Ratio = EBIT ÷ Interest on Long-term Debt (higher is better) III. Activity (Turnover) Ratios — measure efficiency of asset utilisation: - Inventory Turnover Ratio = Cost of Revenue from Operations ÷ Average Inventory - Trade Receivables Turnover Ratio = Net Credit Revenue from Operations ÷ Average Trade Receivables - Trade Payables Turnover Ratio = Net Credit Purchases ÷ Average Trade Payables - Working Capital Turnover Ratio = Revenue from Operations ÷ Net Working Capital IV. Profitability Ratios — measure earning capacity: - Gross Profit Ratio = Gross Profit ÷ Revenue from Operations × 100 - Operating Ratio = (Cost of Revenue from Operations + Operating Expenses) ÷ Revenue from Operations × 100 - Operating Profit Ratio = Operating Profit ÷ Revenue from Operations × 100 - Net Profit Ratio = Net Profit ÷ Revenue from Operations × 100 - Return on Investment = Net Profit before Interest & Tax ÷ Total Capital Employed × 100
2. From the following information, calculate (a) Current Ratio, (b) Quick Ratio, (c) Debt-Equity Ratio, and (d) Proprietary Ratio.
Answer
| Particulars | ₹ |
|---|
| Cash at Bank | 40,000 |
| Debtors | 60,000 |
| Inventory | 50,000 |
| Prepaid Expenses | 10,000 |
| Bills Receivable | 20,000 |
| Creditors | 40,000 |
| Bills Payable | 20,000 |
| Long-term Loans | 1,00,000 |
| Share Capital | 2,00,000 |
| Reserves & Surplus | 50,000 |
| Fixed Assets | 2,50,000 |
(a) Current Ratio Current Assets = Cash (40,000) + Debtors (60,000) + Inventory (50,000) + Prepaid Expenses (10,000) + Bills Receivable (20,000) = ₹1,80,000 Current Liabilities = Creditors (40,000) + Bills Payable (20,000) = ₹60,000 Current Ratio = 1,80,000 ÷ 60,000 = 3:1 (b) Quick Ratio Liquid Assets = Current Assets − Inventory − Prepaid Expenses = 1,80,000 − 50,000 − 10,000 = ₹1,20,000 Quick Ratio = 1,20,000 ÷ 60,000 = 2:1 (c) Debt-Equity Ratio Long-term Debts = ₹1,00,000 Shareholders' Funds = Share Capital (2,00,000) + Reserves & Surplus (50,000) = ₹2,50,000 Debt-Equity Ratio = 1,00,000 ÷ 2,50,000 = 0.4:1 Interpretation: For every ₹1 of shareholders' funds, there is only ₹0.40 of debt — the firm is conservatively financed. (d) Proprietary Ratio Total Assets = Fixed Assets (2,50,000) + Current Assets (1,80,000) = ₹4,30,000 Proprietary Ratio = Shareholders' Funds ÷ Total Assets = 2,50,000 ÷ 4,30,000 = 0.58:1 or 58.14%
3. From the following data, calculate (a) Gross Profit Ratio, (b) Net Profit Ratio, (c) Operating Ratio, and (d) Operating Profit Ratio.
Answer
| Particulars | ₹ |
|---|
| Revenue from Operations | 5,00,000 |
| Cost of Revenue from Operations | 3,00,000 |
| Administration Expenses | 40,000 |
| Selling & Distribution Expenses | 30,000 |
| Interest on Debentures | 10,000 |
| Income from Investments | 5,000 |
(a) Gross Profit Ratio Gross Profit = Revenue from Operations − Cost of Revenue from Operations = 5,00,000 − 3,00,000 = ₹2,00,000 Gross Profit Ratio = (2,00,000 ÷ 5,00,000) × 100 = 40% (b) Net Profit Ratio Operating Expenses = Administration Expenses (40,000) + Selling & Distribution Expenses (30,000) = ₹70,000 Net Profit before Tax = Gross Profit − Operating Expenses − Interest on Debentures + Income from Investments = 2,00,000 − 70,000 − 10,000 + 5,000 = ₹1,25,000 Net Profit Ratio = (1,25,000 ÷ 5,00,000) × 100 = 25% (c) Operating Ratio Operating Cost = Cost of Revenue from Operations + Operating Expenses = 3,00,000 + 70,000 = ₹3,70,000 Operating Ratio = (3,70,000 ÷ 5,00,000) × 100 = 74% (d) Operating Profit Ratio Operating Profit = Revenue from Operations − Operating Cost = 5,00,000 − 3,70,000 = ₹1,30,000 Operating Profit Ratio = (1,30,000 ÷ 5,00,000) × 100 = 26% Verification: Operating Ratio (74%) + Operating Profit Ratio (26%) = 100% ✓
4. Calculate (a) Inventory Turnover Ratio, (b) Trade Receivables Turnover Ratio, and (c) Working Capital Turnover Ratio from the following:
Answer
| Particulars | ₹ |
|---|
| Revenue from Operations (Credit) | 4,00,000 |
| Cost of Revenue from Operations | 2,40,000 |
| Opening Inventory | 40,000 |
| Closing Inventory | 60,000 |
| Debtors (Opening) | 30,000 |
| Debtors (Closing) | 50,000 |
| Current Assets | 1,20,000 |
| Current Liabilities | 60,000 |
(a) Inventory Turnover Ratio Average Inventory = (Opening Inventory + Closing Inventory) ÷ 2 = (40,000 + 60,000) ÷ 2 = ₹50,000 Inventory Turnover Ratio = Cost of Revenue from Operations ÷ Average Inventory = 2,40,000 ÷ 50,000 = 4.8 times (b) Trade Receivables Turnover Ratio Average Trade Receivables = (Opening Debtors + Closing Debtors) ÷ 2 = (30,000 + 50,000) ÷ 2 = ₹40,000 Trade Receivables Turnover Ratio = Net Credit Revenue from Operations ÷ Average Trade Receivables = 4,00,000 ÷ 40,000 = 10 times (c) Working Capital Turnover Ratio Net Working Capital = Current Assets − Current Liabilities = 1,20,000 − 60,000 = ₹60,000 Working Capital Turnover Ratio = Revenue from Operations ÷ Net Working Capital = 4,00,000 ÷ 60,000 = 6.67 times
5. Explain the importance and limitations of ratio analysis.
Answer
Importance of Ratio Analysis: 1. Simplified Financial Data — Ratios convert complex financial data into simple, understandable figures. 2. Liquidity Assessment — Current and quick ratios help assess whether the firm can meet short-term obligations. 3. Solvency Evaluation — Debt-equity and proprietary ratios reveal long-term financial stability. 4. Profitability Measurement — Gross profit, net profit, and ROI ratios help evaluate earning capacity. 5. Efficiency Analysis — Turnover ratios indicate how efficiently assets and working capital are used. 6. Trend Analysis — Comparing ratios over time reveals positive or negative trends. 7. Inter-firm Comparison — Ratios enable comparison with industry averages and competitors. 8. Decision Making — Lenders, investors, and managers use ratios for credit, investment, and operational decisions. Limitations of Ratio Analysis: 1. Ignores Price-Level Changes — Ratios use historical cost figures, making comparisons unreliable during inflation. 2. Accounting Policy Differences — Different depreciation methods, inventory valuation, etc., make inter-firm comparison difficult. 3. Not a Substitute for Statements — Ratios supplement but cannot replace detailed financial statements. 4. Window Dressing — Firms may manipulate accounts to present favourable ratios. 5. Lack of Standard Ratios — Ideal ratios vary by industry; a "good" ratio in one sector may be poor in another. 6. Qualitative Factors Ignored — Ratios ignore factors like management quality, employee morale, and market conditions. 7. Single Ratio Is Misleading — A ratio must be interpreted in context with other ratios and industry norms.
6. From the following Balance Sheet of XYZ Ltd., calculate all solvency ratios:
Answer
Balance Sheet of XYZ Ltd. as at 31st March 2025
| Liabilities | ₹ | Assets | ₹ |
|---|
| Share Capital | 3,00,000 | Fixed Assets | 4,00,000 |
| Reserves & Surplus | 1,00,000 | Inventory | 1,00,000 |
| Long-term Borrowings | 2,00,000 | Debtors | 80,000 |
| Creditors | 60,000 | Cash at Bank | 1,20,000 |
| Bills Payable | 40,000 | | |
| Total | 7,00,000 | Total | 7,00,000 |
1. Debt-Equity Ratio Long-term Debts = ₹2,00,000 Shareholders' Funds = Share Capital + Reserves & Surplus = 3,00,000 + 1,00,000 = ₹4,00,000 Debt-Equity Ratio = 2,00,000 ÷ 4,00,000 = 0.5:1 Interpretation: The firm has ₹0.50 of debt for every ₹1 of shareholders' funds, which is a conservative and safe position. 2. Proprietary Ratio Total Assets = ₹7,00,000 Proprietary Ratio = Shareholders' Funds ÷ Total Assets = 4,00,000 ÷ 7,00,000 = 0.571:1 or 57.14% Interpretation: 57.14% of total assets are financed by shareholders' funds. 3. Interest Coverage Ratio (assuming interest on long-term debt = ₹20,000 and EBIT = ₹1,20,000) Interest Coverage Ratio = EBIT ÷ Interest on Long-term Debt = 1,20,000 ÷ 20,000 = 6 times Interpretation: The firm's profit covers interest obligations 6 times, indicating strong debt servicing capacity.
Common Mistakes to Avoid
1. Including inventory in liquid assets — Always subtract inventory AND prepaid expenses from current assets to get liquid assets for the quick ratio.
2. Using total debt instead of long-term debt — The debt-equity ratio uses only long-term debts (excluding current liabilities), not total external liabilities.
3. Forgetting to compute average values — Turnover ratios (inventory, receivables, payables) require average figures: (Opening + Closing) ÷ 2.
4. Confusing gross profit and net profit ratios — Gross profit uses only cost of goods sold; net profit deducts ALL expenses including interest and tax.
5. Not expressing ratios in the correct unit — Liquidity and solvency ratios are expressed as "x:1" (times), profitability ratios as percentages (%). Do not mix them up.
6. Omitting the "× 100" in percentage ratios — Gross profit ratio, net profit ratio, and operating ratio must be multiplied by 100 to express as a percentage.
Exam Checklist
- [ ] I can classify ratios into liquidity, solvency, activity, and profitability categories
- [ ] I know the formula, ideal standard, and interpretation for each ratio
- [ ] I can compute all four categories of ratios from a given Balance Sheet and P&L
- [ ] I can distinguish between current assets, liquid assets, and current liabilities
- [ ] I remember to use average figures for turnover ratios
- [ ] I can interpret ratio results (higher/lower, favourable/unfavourable)
- [ ] I can state the limitations of ratio analysis
- [ ] I always show the formula, substitution, and final answer with correct units
