Accounting Ratios
What the exam tests
Accounting Ratios tests liquidity, solvency, activity and profitability ratios, their formulas and interpretation. Current ratio = current assets / current liabilities. Quick ratio = quick assets / current liabilities, where quick assets exclude inventory and prepaid expenses. Debt-equity ratio = debt / equity. Inventory turnover = cost of goods sold / average inventory. Gross profit ratio = gross profit / revenue from operations x 100. A ratio is meaningful only with its components and comparison base.
Worked example
Current assets are Rs. 3,00,000, including inventory Rs. 1,00,000 and prepaid expenses Rs. 20,000. Current liabilities are Rs. 1,50,000. Current ratio = 3,00,000 / 1,50,000 = 2:1. Quick assets = 3,00,000 - 1,00,000 - 20,000 = 1,80,000. Quick ratio = 1,80,000 / 1,50,000 = 1.2:1. The firm appears liquid, but the quick ratio is lower because inventory and prepaid expenses are not readily convertible into cash.
Traps
Do not include inventory or prepaid expenses in quick assets. Bank overdraft is usually a current liability, but treatment depends on the terms. Use average inventory, not closing inventory, when opening inventory is available. Do not compare ratios across industries without context. A high current ratio can also reflect idle inventory or slow debtors.