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Ch 13 · Financial Analysis · T.S. Grewal — Analysis of Financial Statements

Accounting
Ratios

75 MCQs 50 Flashcards T.S. Grewal Class 12 Updated May 2026
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Chapter Overview

Chapter 13 is the numerical heavyweight of the Analysis of Financial Statements book. It teaches you how to express the arithmetical relationship between two related items in the financial statements — and how to interpret those relationships to judge the firm's liquidity, solvency, efficiency and profitability. Ratios are not new figures; they are a compass that translates the numbers in the Balance Sheet and Statement of Profit & Loss into actionable signals about the business.

The chapter follows the standard four-fold functional classification: Liquidity Ratios (Current Ratio with the 2:1 benchmark, Quick / Acid-Test Ratio with 1:1), Solvency Ratios (Debt-Equity, Total Assets to Debt, Proprietary Ratio, Interest Coverage Ratio), Activity / Turnover Ratios (Inventory Turnover, Trade Receivables Turnover with its companion Average Collection Period, Trade Payables Turnover, Working Capital Turnover), and Profitability Ratios (Gross Profit Ratio, Operating Ratio with the 100 − rule for Operating Profit Ratio, Net Profit Ratio, and Return on Investment / Capital Employed).

The hard part is composition discipline: knowing exactly what goes into each numerator and denominator. Liquid Assets = Current Assets − Inventory − Prepaid Expenses. Long-term Debt EXCLUDES current liabilities. EBIT = PAT + Tax + Interest. Capital Employed = Shareholders' Funds + Long-term Borrowings. Operating Expenses EXCLUDE finance costs and non-operating items like loss-by-fire. The 75 MCQs in this set drill these definitions, then push you through every standard calculation pattern — including reverse-engineered numericals where the ratio is given and you must back-solve a missing figure.

What You'll Learn
Key Concepts
Group 1
Liquidity Ratios
Measure short-term solvency — the firm's ability to meet obligations falling due within 12 months.
Formula
Current Ratio
Current Assets ÷ Current Liabilities. Ideal = 2:1. Higher means comfortable liquidity but possibly idle CA.
Formula
Quick Ratio
(CA − Inventory − Prepaid) ÷ CL. Ideal = 1:1. The strict acid-test of immediate liquidity.
Group 2
Solvency Ratios
Measure long-term solvency — the firm's ability to meet long-term obligations and the safety of its capital structure.
Formula
Debt-Equity Ratio
Long-term Debt ÷ Shareholders' Funds. Ideal ≤ 2:1. Higher = more financial risk.
Formula
Interest Coverage
EBIT ÷ Interest on Long-term Debt. Higher = lender safety. EBIT = PAT + Tax + Interest.
Group 3
Activity Ratios
Measure efficiency — how well the firm uses its assets and working capital to generate revenue.
Formula
Inventory Turnover
Cost of Revenue from Operations ÷ Average Inventory. Numerator is COGS, NOT sales.
Formula
Receivables Turnover
Net Credit Sales ÷ Average Trade Receivables. Average Collection Period = 365 ÷ Turnover.
Group 4
Profitability Ratios
Measure earning capacity — margin per rupee of sales (GP, Op, NP) and return per rupee of capital (ROI).
Formula
Operating Ratio
((COGS + Op Exp) ÷ Revenue) × 100. Lower is better. Operating Profit Ratio = 100 − Operating Ratio.
Formula
Return on Investment
(EBIT ÷ Capital Employed) × 100. Capital Employed = SHF + Long-term Borrowings.
Sample MCQs
Q1. Current Assets ₹6,00,000; Inventory ₹1,50,000; Prepaid Expenses ₹10,000; Current Liabilities ₹3,00,000. The Current Ratio is:
A. 1.50 : 1
B. 2.00 : 1
C. 2.50 : 1
D. 1.47 : 1
Current Ratio = Current Assets ÷ Current Liabilities = 6,00,000 ÷ 3,00,000 = 2.00 : 1. Inventory and Prepaid Expenses are NOT removed for the Current Ratio (they are removed only for the Quick Ratio).
Q2. Cost of Revenue from Operations ₹12,00,000; Opening Inventory ₹1,50,000; Closing Inventory ₹2,50,000. Inventory Turnover Ratio is:
A. 4 times
B. 6 times
C. 8 times
D. 5 times
Average Inventory = (1,50,000 + 2,50,000) ÷ 2 = ₹2,00,000. Inventory Turnover = 12,00,000 ÷ 2,00,000 = 6 times.
Q3. Revenue from Operations ₹30,00,000; Gross Profit Ratio 40%; Operating Ratio 78%; Tax 25% of profit before tax; Interest on long-term debt ₹20,000. Net Profit after Tax is:
A. ₹4,80,000
B. ₹6,30,000
C. ₹6,40,000
D. ₹4,60,000
Operating Profit = (100 − 78)% × 30,00,000 = 22% × 30,00,000 = ₹6,60,000. Net Profit before Tax = 6,60,000 − 20,000 = ₹6,40,000. Tax = 25% × 6,40,000 = ₹1,60,000. Net Profit after Tax = 6,40,000 − 1,60,000 = ₹4,80,000.
Frequently Asked Questions
What is ratio analysis?
Ratio analysis is a technique that expresses the arithmetical relationship between two related figures drawn from the financial statements (Balance Sheet and Statement of Profit & Loss) so as to assess the firm's liquidity, solvency, operational efficiency and profitability. Ratios are grouped into four categories: Liquidity, Solvency, Activity / Turnover and Profitability. Ratios do NOT replace the financial statements — they only interpret them.
What is the ideal Current Ratio and why?
The conventionally accepted ideal Current Ratio is 2:1 — i.e., Current Assets should be twice the Current Liabilities. The reasoning is that even if half the current assets cannot be realised quickly (slow-moving inventory, doubtful debtors), the remaining half is still enough to meet the firm's short-term obligations. A ratio significantly higher than 2:1 may indicate idle working capital, while a ratio below 2:1 signals liquidity stress.
How is the Quick Ratio different from the Current Ratio?
The Current Ratio (= Current Assets ÷ Current Liabilities) covers ALL current assets including inventory and prepaid expenses. The Quick Ratio (= Liquid Assets ÷ Current Liabilities) is a STRICTER liquidity test that excludes inventory and prepaid expenses from the numerator, since these cannot be converted to cash quickly. Ideal Current Ratio is 2:1; ideal Quick Ratio is 1:1.
What does the Inventory Turnover Ratio measure?
Inventory Turnover = Cost of Revenue from Operations ÷ Average Inventory. It measures how many times the firm has sold and replaced its inventory during the year. A higher turnover usually indicates efficient inventory management and faster movement of stock. However, an excessively high ratio may indicate stock-outs or under-investment in inventory. The numerator is COGS — NOT sales — because inventory is carried at cost.
What does Return on Investment indicate?
Return on Investment (also called Return on Capital Employed) = (Net Profit before Interest and Tax ÷ Capital Employed) × 100. Capital Employed = Shareholders' Funds + Long-term Borrowings. ROI measures the overall return generated on the long-term funds invested in the business. EBIT is used in the numerator because Capital Employed includes both equity AND debt — ROI is the pre-allocation profitability that is later split between interest (to lenders) and PAT (to shareholders).
What are the limitations of ratio analysis?
Key limitations: (i) Ratios are based on financial statements which may be window-dressed; (ii) inter-firm comparison is misleading when firms follow different accounting policies (depreciation, inventory valuation, revenue recognition); (iii) ratios ignore price-level changes since the underlying figures are at historical cost; (iv) ratios do not capture qualitative factors like quality of management, brand strength or employee morale; (v) a single ratio is meaningless without an industry benchmark, a trend over years and the context of related ratios.