Accounting Ratios

Absolute figures expressed in monetary terms in the financial statements of any entity are meaningless. Such figures don’t pass on the required meaning or useful information unless these are illustrated as a relative value to some other financial variables. This is the reason why the concept of accounting ratio is used.

Accounting ratios are nothing but the relationship among various items or groups of items in financial statements. In other words, it is used as a measure to compare the two or more financial variables of the given financial data which is helpful to interpret the performance of the entity.

Multiple Choice Questions (MCQs)

1. The current ratio can be numerically expressed in the form of the following equation:-

1. 1. Current ratio = Current assets – current liabilities

   2. Current ratio = Current assets + current liabilities

   3. Current ratio = Current assets / current liabilities

   4. Current ratio = Current assets * current liabilities

Ans. C) Current ratio = Current assets / current liabilities

Explanation: Current ratio tells (a number of times) whether a current asset is sufficient enough to be used to pay off the current liabilities of the entity concerned.

2. From the following data, calculate the liquid ratio:-

Current Assets = 50,000 ; Current Liabilities = 20,000 ; Inventory = 13,000 ; Prepaid Expenses = 1,000.

1. 1. 1 : 1

   2. 1.8 : 1

   3. 1 : 1.8

   4. 1.5 : 1

Ans. B) 1.8 : 1

Explanation:   Liquid assets = Current assets – inventory – prepaid expenses

 Liquid assets = 50,000 – 13,000 – 1,000 = 36,000

 Liquid Ratio = Liquid AssetsCurrent Liabilities = 36,00020,000 

 Liquid Ratio =  1.8 : 1

3. Operating Margin can be numerically expressed in the form of following equation:-

1. 1. [(Net profits – operating expenses) / Revenue]

   2. [(Gross profits – operating expenses) / Revenue]

   3. [(Net profits – operating revenue) / Revenue]

   4. [(Gross profits – non-operating expenses) / Revenue]

Ans. B) [(Gross profits – operating expenses) / Revenue from operations]

Explanation: Operating Margin determines the relationship between the profit of a company after paying its variable cost except interest and tax and the sales of an entity.

4. Which of the following is not a part of liquidity ratios?

1. 1. Current ratio

   2. Solvency ratio

   3. Liquid ratio

   4. Quick ratio

Ans. B) Solvency ratio

Explanation:  Liquidity ratios has been sub-classified into two ratios as stated below:-

• Current Ratio

• Liquid Ratio (or Quick Ratio)

5. Interest coverage ratio can be numerically expressed in the form of the following equation:-

1. 1. (Gross profit / interest on total debts)

   2. (Interest on long-term debts / Net profit before interest and tax)

   3. (Net profit after interest / interest on long-term debts)

   4. (Net profit before interest and tax/interest on long-term debts)

Ans. D) (Net profit before interest and tax/interest on long-term debts)

Explanation: The interest coverage ratio tells whether the PBIT (Profit Before Interest and Tax) is sufficient enough to pay off the interest expenses on long-term debts (like debentures) of the concerned entity.

6. What is the ideal liquid ratio of any entity?

1. 1. 1: 1

   2. 2: 1

   3. 1: 2

   4. None

Ans. A) 1 : 1

Explanation: Ideally, the liquid assets should be equal to the current liabilities of an entity. Hence the ideal liquid ratio is 1: 1.

7. Accounting Ratios provide a _________ measure of a company’s performance and condition.

1. 1. Definitive

   2. Gross

   3. Relative

   4. Qualitative

Ans. C) Relative

Explanation:  Accounting ratios are a relative measure of a company’s performance and condition as they are calculated by determining the relationship between two or more financial variables or values taken from the financial data or financial statements of an entity.

8. _________ analysis involves the comparison of different firm’s financial ratios at the same point in time.

1. 1. Time-series

   2. Cross-sectional

   3. Marginal

   4. Quantitative

Ans. B) Cross-sectional

Explanation: Cross-sectional analysis involves the comparison of a firm’s ratios with that of some other selected firms in the same industry or the industry average at the same point of time. Such a comparison is very helpful in assessing the relative financial position and performance of the firm.

9.  __________ analysis involves the comparison between the current and historical financial performance and the evaluation of developing trends.

1. 1. Time-series

   2. Cross-sectional

   3. Marginal

   4. Quantitative

Ans. A) Time series

Explanation: When the ratios of the same firm over a period of time are compared, it is known as the time series analysis (or trend analysis). Such an analysis gives an indication of the direction of change or developing trends and reflects whether a firm’s financial performance has improved, deteriorated, or remained constant over a period of time.

10. Time-series analysis is often used to

1. 1. Assess developing trends

   2. Correct errors of judgement

   3. Reflect performance relative to some norms

   4. Standardize

Ans. A) Assess developing trends

Explanation: In order to derive meaningful conclusions from time-series analysis, we require quality data over a period of time so that it gives an indication of the direction of variation or developing trends and depicts whether a firm’s financial performance has improved, deteriorated, or remained constant over a period of time.

11. Which of the following ratios are basically the measures of yield or return. 

1. 1. Liquidity

   2. Activity

   3. Debt

   4. Profitability

Ans. D) Profitability

Explanation: Profitability ratios are used to measure the various aspects of profitability of a company, such as what is the rate of profit on revenue from operations and whether the profits are decreasing or increasing and if declining, the cause of such decline.

12. An analysis in which the firm’s ratio values are compared to those of a key competitor or group of competitors, primarily to identify areas for improvement is called:-

1. 1. Time-series analysis

   2. Combined analysis

   3. Benchmarking

   4. None of the above

Ans. C) Benchmarking

Explanation: Benchmarking refers to the process of evaluating the firm’s accounting ratios and its financial performance with that of the competitor or a group of competitors in order to know where the entity needs to improve.

13. The _________ of a business firm is measured by its ability to satisfy its short-term obligations as they become due.

1. 1. Activity

   2. Liquidity

   3. Debt

   4. Profitability

Ans. B) Liquidity

Explanation: Liquidity refers to the ability of the firm to pay off its current liabilities (or short term obligations) as and when they fall due.

14.  ____________ ratios are a measure of the speed with which various accounts are converted into sales or cash. 

1. 1. Activity

   2. Liquidity

   3. Debt

   4. Profitability

Ans. A) Activity

Explanation: Activity ratios (or Turnover ratios) are calculated on the basis of either cost of revenue from operations or revenue from operations. It indicates the speed or the number of times the capital employed has been rotated in the process of doing business.

15. The __________ is useful in evaluating credit and collection policies.

1. 1. Average payment period

   2. Current ratio

   3. Average collection period

   4. Inventory turnover ratio

Ans. C) Average collection period

Explanation: The average collection period is used as an accounting measure to symbolize the avg. No. of days among a credit score sale date and the date whilst the customer remits payment. An entity’s average collection period indicates the effectiveness of its Accounts Receivable (or Trade Receivables) Management.

16. Net working capital is defined as

1. 1. Total assets less current assets

   2. The excess of current assets over current liabilities

   3. Current liabilities less current assets

   4. Marketable securities and cash

Ans. B) The excess of current assets over current liabilities

Explanation: Net working capital of a firm depicts the difference between its current assets and current liabilities.

Net working capital = Current assets – current liabilities

17. The two basic measures of liquidity are

1. 1. Inventory turnover and current ratio

   2. Current ratio and liquid ratio

   3. Gross profit margin and operating ratios

   4. Current ratio and average collection period

Ans. B) Current ratio and liquid ratio

Explanation: Liquidity ratios has been sub-classified into two ratios as stated below:-

• Current Ratio

• Liquid Ratio (or Quick Ratio)

18. ABC Company extends credit terms of 45 days to its customers. Its credit collection would be considered poor if its average collection period was

1. 1. 30 days

   2. 36 days

   3. 40 days

   4. 57 days

Ans. D) 57 days

Explanation:  Avg.collection period =365Avg.receivables turnover ratios

Higher the avg. Collection period, the poorer is its credit collection and lower the avg. Collection period, the stronger is its credit collection.

19. The __________ indicates the percentage of each sales rupee remaining after the firm has paid for its goods.

1. 1. Net profit margin

   2. Operating profit margin

   3. Gross profit margin

   4. Earnings available to equity shareholders

Ans. C) Gross profit margin

Explanation: Gross profit margin establishes the relationship between the gross profit and revenue from operation of the concerned entity.

20.  If the inventory turnover is divided by 365, it becomes a measure of

1. 1. Revenue from operations efficiency

   2. The average age of the inventory

   3. Revenue from operations turnover

   4. The average collection period

Ans. B) The average age of the inventory

Explanation: The average age of the inventory is the average number of days it takes for an entity to completely sell off its stock or inventory. It is a measure that is used to determine the performance of the revenue from operations or sales. The average age of inventory can also be termed as DSI (Day’s Sale in Inventory).