Analysis of Financial Statements: Ratio Analysis
This section covers Analysis of Financial Statements: Ratio Analysis. BSEB tests formulas, classification and interpretation of liquidity, solvency, activity and profitability ratios.
Core rules
- Liquidity: current ratio = current assets/current liabilities; quick ratio = quick assets/current liabilities. Quick assets exclude inventory and prepaid expenses.
- Solvency: debt-equity ratio = long-term debt/shareholders’ funds (or external/internal as per question); interest coverage = profit before interest and tax/interest.
- Activity: inventory turnover = cost of goods sold/average inventory; trade receivables turnover = credit sales/average receivables.
- Profitability: gross profit ratio = gross profit/revenue from operations × 100; net profit ratio; return on capital employed = profit before interest and tax/capital employed × 100.
Worked example
Current assets ₹4,00,000; inventory ₹1,00,000; current liabilities ₹2,00,000. Current ratio = 4,00,000/2,00,000 = 2:1. Quick ratio = (4,00,000 − 1,00,000)/2,00,000 = 1.5:1. If long-term debt is ₹3,00,000 and shareholders’ funds ₹2,00,000, debt-equity = 3,00,000/2,00,000 = 1.5:1. A high current ratio is not automatically good if inventory is slow-moving.
Traps
Use average balances when opening balances are given; use closing balances only if the question says so. Do not include prepaid expenses in quick assets. Do not include current liabilities in debt for debt-equity if the formula specifies long-term debt. Express ratios consistently and state the base.