AccountancyRatio analysis: formulas and a fully worked example
A profit of one lakh is splendid for a tea stall and poor for a factory. Ratios turn raw figures into comparisons that mean something.
What a ratio is
An accounting ratio is a relationship between two figures of the financial statements, expressed as a proportion (2 : 1), a number of times (4 times), or a percentage (30%). Ratios are useful only in comparison: with the same firm's earlier years, with other firms in the industry, or with a standard.
The four groups
| Group | Question it answers |
|---|---|
| Liquidity ratios | Can the business pay its short-term debts? |
| Solvency ratios | Can it meet its long-term obligations? |
| Activity (turnover) ratios | How efficiently does it use its resources? |
| Profitability ratios | How much does it earn on sales and on capital? |
The figures used on this page
Malabar Ltd., year ended 31 March 2026.
| Particulars | ₹ | ₹ |
|---|---|---|
| Revenue from operations (all on credit) | 12,00,000 | |
| Less: Cost of revenue from operations | 8,40,000 | |
| Gross profit | 3,60,000 | |
| Less: Operating expenses | 1,80,000 | |
| Operating profit (profit before interest and tax) | 1,80,000 | |
| Less: Interest on long-term borrowings | 30,000 | |
| Profit before tax | 1,50,000 | |
| Less: Tax | 37,500 | |
| Profit after tax | 1,12,500 |
| Equity and liabilities | ₹ | Assets | ₹ |
|---|---|---|---|
| Share capital | 5,00,000 | Fixed assets (net) | 7,00,000 |
| Reserves and surplus | 1,50,000 | Inventories | 2,00,000 |
| Long-term borrowings | 3,00,000 | Trade receivables | 1,50,000 |
| Current liabilities | 2,50,000 | Cash and cash equivalents | 1,00,000 |
| Prepaid expenses | 50,000 | ||
| 12,00,000 | 12,00,000 |
Opening inventories were ₹2,20,000 and opening trade receivables ₹1,50,000. Shareholders' funds = ₹6,50,000. Current assets = ₹5,00,000. Capital employed = shareholders' funds + long-term borrowings = ₹9,50,000.
Liquidity ratios
| Ratio | Formula | Malabar Ltd. |
|---|---|---|
| Current ratio | Current assets ÷ Current liabilities | 5,00,000 ÷ 2,50,000 = 2 : 1 |
| Quick (liquid, acid-test) ratio | Quick assets ÷ Current liabilities, where quick assets = current assets − inventories − prepaid expenses | (5,00,000 − 2,00,000 − 50,000) ÷ 2,50,000 = 1 : 1 |
A current ratio of about 2 : 1 and a quick ratio of about 1 : 1 are the traditional rules of thumb. Too low a ratio signals difficulty in paying bills; too high a ratio means money lying idle in stock, debtors or the bank.
Solvency ratios
| Ratio | Formula | Malabar Ltd. |
|---|---|---|
| Debt to equity ratio | Long-term debt ÷ Shareholders' funds | 3,00,000 ÷ 6,50,000 = 0.46 : 1 |
| Total assets to debt ratio | Total assets ÷ Long-term debt | 12,00,000 ÷ 3,00,000 = 4 : 1 |
| Proprietary ratio | Shareholders' funds ÷ Total assets | 6,50,000 ÷ 12,00,000 = 0.54 : 1 |
| Interest coverage ratio | Profit before interest and tax ÷ Interest on long-term debt | 1,80,000 ÷ 30,000 = 6 times |
A lower debt to equity ratio means more safety for lenders. An interest coverage of 6 times means the profit could fall to a sixth before interest became unpayable.
Activity (turnover) ratios
| Ratio | Formula | Malabar Ltd. |
|---|---|---|
| Inventory turnover ratio | Cost of revenue from operations ÷ Average inventory | 8,40,000 ÷ 2,10,000 = 4 times |
| Trade receivables turnover ratio | Net credit revenue from operations ÷ Average trade receivables | 12,00,000 ÷ 1,50,000 = 8 times |
| Average collection period | 365 ÷ Trade receivables turnover | 365 ÷ 8 = about 46 days |
| Trade payables turnover ratio | Net credit purchases ÷ Average trade payables | Needs purchases and payables figures |
| Working capital turnover ratio | Revenue from operations ÷ Working capital | 12,00,000 ÷ (5,00,000 − 2,50,000) = 4.8 times |
Average inventory = (opening + closing) ÷ 2 = (2,20,000 + 2,00,000) ÷ 2 = ₹2,10,000. A higher turnover means stock is sold, and debtors pay, more quickly.
Profitability ratios
| Ratio | Formula | Malabar Ltd. |
|---|---|---|
| Gross profit ratio | Gross profit ÷ Revenue from operations × 100 | 3,60,000 ÷ 12,00,000 × 100 = 30% |
| Operating ratio | (Cost of revenue from operations + Operating expenses) ÷ Revenue from operations × 100 | (8,40,000 + 1,80,000) ÷ 12,00,000 × 100 = 85% |
| Operating profit ratio | Operating profit ÷ Revenue from operations × 100 | 1,80,000 ÷ 12,00,000 × 100 = 15% |
| Net profit ratio | Profit after tax ÷ Revenue from operations × 100 | 1,12,500 ÷ 12,00,000 × 100 = 9.375% |
| Return on investment (return on capital employed) | Profit before interest and tax ÷ Capital employed × 100 | 1,80,000 ÷ 9,50,000 × 100 = 18.95% |
Operating ratio and operating profit ratio always add up to 100%: here 85% + 15%. Return on investment is the best single test of overall efficiency, because it relates profit to all the long-term money used to earn it.
Reading the result
Malabar Ltd. is comfortably liquid (2 : 1 and 1 : 1), lightly borrowed (0.46 : 1) with interest covered six times, turns its stock four times a year and collects from customers in about a month and a half, and earns nearly 19% on the capital employed. On these figures it is a sound business. The same ratios for last year and for a competitor would tell us whether it is improving and how it compares.
How a transaction changes a ratio
A favourite examination question. Suppose the current ratio is 2 : 1 (current assets ₹5,00,000, current liabilities ₹2,50,000).
| Transaction | Effect on CA and CL | Current ratio |
|---|---|---|
| Paid creditors ₹50,000 | CA 4,50,000; CL 2,00,000 | 2.25 : 1 (improves) |
| Bought goods on credit ₹50,000 | CA 5,50,000; CL 3,00,000 | 1.83 : 1 (falls) |
| Collected ₹40,000 from debtors | CA unchanged; CL unchanged | 2 : 1 (no change) |
| Sold a fixed asset for cash ₹1,00,000 | CA 6,00,000; CL 2,50,000 | 2.4 : 1 (improves) |
| Issued shares for cash ₹1,00,000 | CA 6,00,000; CL 2,50,000 | 2.4 : 1 (improves) |
Rule: when the ratio is above 1, an equal decrease in both current assets and current liabilities improves it, and an equal increase lowers it.
Limitations of ratio analysis
- Ratios are only as good as the figures behind them; window dressing of accounts distorts them.
- They ignore price-level changes and qualitative factors such as staff quality.
- Different firms use different accounting policies, so comparisons can mislead.
- A single ratio means little; ratios must be read together and over time.
All the formulas are collected on the formula sheet.
Questions students ask
What is the ideal current ratio?
The traditional rule of thumb is 2 : 1, and 1 : 1 for the quick ratio. The right level differs by industry.
Which items are excluded from quick assets?
Inventories and prepaid expenses, because they cannot be turned into cash at once.
What is the difference between operating ratio and operating profit ratio?
Operating ratio is operating cost as a percentage of revenue from operations; operating profit ratio is operating profit as a percentage of the same. Together they total 100%.
More Class 12 topics
For study, and independent. These pages explain accountancy as it is generally taught in Class 11, Class 12 and B.Com courses in India, in our own words with our own examples, reviewed in November 2026. This site is not connected with NCERT, CBSE, ICAI or any board or university. Syllabuses change: follow your own board's or university's current syllabus and textbook. Nothing here is professional accounting, tax or legal advice.