## CBSE Class 12 Commerce Accountancy Accounting Ratios Complete Notes

CBSE Class 12 Commerce Accountancy Accounting Ratios : CBSE is a renowned educational Board, which comes under the Union Government of India. This eminent board was formed in 1952 and associated with the Board of High School and Intermediate Education, Rajputana. Ajmer, Gwalior, Merwara and Central India were included in the administrative territory of this board along with the other places including Bhopal, Ajmer and Vindhya Pradesh. From 1952 onwards, it has been providing a standard education and robust learning environment to all. The Central Board of Secondary Education or CBSE is a prestigious board of education and it provides affiliation to public and private schools. Apart from this, all Jawahar Navodaya Vidyalayas and kendriya vidyalayas are affiliated to this board.

### CBSE Class 12 Commerce Accountancy Accounting Ratios Complete Notes

CBSE Class 12 Commerce Accountancy Accounting Ratios : Accounting ratios assist in measuring the efficiency and profitability of a company based on its financial reports. Also called financial ratios, accounting ratios provide a way of expressing the relationship between one accounting data point and another, which is intended to provide a useful comparison. Accounting ratios form the basis of fundamental analysis.

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#### BREAKING DOWN ‘Accounting Ratio’

CBSE Class 12 Commerce Accountancy Accounting Ratios : An accounting ratio compares two aspects of a financial statement, such as the relationship (or ratio) of current assets to current liabilities. The ratios can be used to evaluate the financial condition of a company, including the company’s strengths and weaknesses. Examples of financial ratios include the gross margin ratio, operating margin ratio, the debt-to-equity ratio and the payout ratio. Each of these ratios requires the most recent data in order to be relevant.

#### Financial Statement Ratios

CBSE Class 12 Commerce Accountancy Accounting Ratios : Every year companies publish an annual report. The annual report contains three financial statements: the income statement, balance sheet and cash flow statement. Each statement provides the investor with information about the performance of the company over the most recent fiscal year. Analysts rely on the financial statements to provide the data needed to update accounting ratios.

#### Gross Margin and Operating Margin

CBSE Class 12 Commerce Accountancy Accounting Ratios : The income statement contains information about company sales, expenses and net income. It also provides an overview of earnings per share and the number of shares outstanding used to calculate it. These are some of the most popular data points for analysts to use when computing accounting ratios dealing with profitability. For example, gross profit as a percent of sales is an accounting ratio referred to as gross margin. It is calculated by dividing gross profit by sales. For example, if gross profit is $80,000 and sales are $100,000, the gross profit margin is 80%. Operating profit as a percentage of sales is referred to as operating profit margin. It is calculated by dividing operating profit by sales. For example, if operating profit is $60,000 and sales are $100,000, the operating profit margin is 60%. Both accounting ratios provide information about company profitability.

#### Debt-to-Equity Ratio

CBSE Class 12 Commerce Accountancy Accounting Ratios : The balance sheet is a snapshot in time and provides accountants with data for calculating credit and debt ratios. The most popular debt ratio is debt-to-equity. It is calculated by dividing debt by equity. For example, if a company has debt equal to $100,000 and equity equal to $50,000, the debt-to-equity ratio is 2 to 1.

#### Payout Ratio

CBSE Class 12 Commerce Accountancy Accounting Ratios : The cash flow statement provides data for ratios dealing with cash. For example, the payout ratio is the percentage of net income paid out to investors. Both dividends and share repurchases are considered outlays of cash and can be found on the cash flow statement. For example, if dividends are $100,000, share repurchases are $100,000, and income is $400,000, the payout ratio is calculated by dividing $200,000 by $400,000, which is 50%.

### CBSE Class 12 Commerce Accountancy Accounting Ratios Complete Notes

CBSE Class 12 Commerce Accountancy Accounting Ratios : Accounting ratios (also known as financial ratios) are considered to be part of financial statement analysis. Accounting ratios usually relate one financial statement amount to another. For example, the inventory turnover ratio divides a company’s cost of goods sold for a recent year by the cost of its inventory on hand during that year. For a company with current assets of $300,000 and current liabilities of $150,000 its *current ratio* is $300,000 to $150,000, or 2 to 1, or 2:1. This ratio of 2:1 can then be compared to other companies in its industry regardless of size or it can be compared to the company’s ratio from an earlier year.

Other examples of accounting ratios include:

- Quick ratio
- Current ratio
- Debt to equity ratio
- Acid-test ratio
- Contribution margin ratio
- Interest coverage ratio
- Debt to total assets ratio
- Gross margin ratio
- Return on assets ratio
- Profit margin (after tax) ratio
- Total assets turnover ratio
- Fixed asset turnover ratio
- Times interest earned ratio
- Liquidity ratio
- Working capital ratio
- Dividend payout ratio
- Free cash flow ratio

### CBSE Class 12 Commerce Accountancy Accounting Ratios Complete Notes

CBSE Class 12 Commerce Accountancy Accounting Ratios : **Ratio analysis** is used to evaluate relationships among financial statement items. The ratios are used to identify trends over time for one company or to compare two or more companies at one point in time. Financial statement ratio analysis focuses on three key aspects of a business: liquidity, profitability, and solvency.

**Liquidity ratios**

**CBSE Class 12 Commerce Accountancy Accounting Ratios-Liquidity ratios** measure the ability of a company to repay its short‐term debts and meet unexpected cash needs.

**Current ratio.** The **current ratio** is also called the working capital ratio, as working capital is the difference between current assets and current liabilities. This ratio measures the ability of a company to pay its current obligations using current assets. The current ratio is calculated by dividing current assets by current liabilities.

This ratio indicates the company has more current assets than current liabilities. Different industries have different levels of expected liquidity. Whether the ratio is considered adequate coverage depends on the type of business, the components of its current assets, and the ability of the company to generate cash from its receivables and by selling inventory.

**Acid‐test ratio.** The **acid‐test ratio** is also called the **quick ratio**. **Quick assets** are defined as cash, marketable (or short‐term) securities, and accounts receivable and notes receivable, net of the allowances for doubtful accounts. These assets are considered to be very liquid (easy to obtain cash from the assets) and therefore, available for immediate use to pay obligations. The acid‐test ratio is calculated by dividing quick assets by current liabilities.

The traditional rule of thumb for this ratio has been 1:1. Anything below this level requires further analysis of receivables to understand how often the company turns them into cash. It may also indicate the company needs to establish a line of credit with a financial institution to ensure the company has access to cash when it needs to pay its obligations.

**Receivables turnover**. The **receivable turnover ratio** calculates the number of times in an operating cycle (normally one year) the company collects its receivable balance. It is calculated by dividing net credit sales by the average net receivables. Net credit sales is net sales less cash sales. If cash sales are unknown, use net sales. Average net receivables is usually the balance of net receivables at the beginning of the year plus the balance of net receivables at the end of the year divided by two. If the company is cyclical, an average calculated on a reasonable basis for the company’s operations should be used such as monthly or quarterly.

**Average collection period.** The **average collection period** (also known as **day’s sales****outstanding**) is a variation of receivables turnover. It calculates the number of days it will take to collect the average receivables balance. It is often used to evaluate the effectiveness of a company’s credit and collection policies. A rule of thumb is the average collection period should not be significantly greater than a company’s credit term period. The average collection period is calculated by dividing 365 by the receivables turnover ratio.

The decrease in the average collection period is favorable. If the credit period is 60 days, the 20X1 average is very good. However, if the credit period is 30 days, the company needs to review its collection efforts.

**Inventory turnover.** The **inventory turnover ratio** measures the number of times the company sells its inventory during the period. It is calculated by dividing the cost of goods sold by average inventory. Average inventory is calculated by adding beginning inventory and ending inventory and dividing by 2. If the company is cyclical, an average calculated on a reasonable basis for the company’s operations should be used such as monthly or quarterly.

**Day’s sales on hand.** Day’s sales on hand is a variation of the inventory turnover. It calculates the number of day’s sales being carried in inventory. It is calculated by dividing 365 days by the inventory turnover ratio.

**Profitability ratios**

Profitability ratios measure a company’s operating efficiency, including its ability to generate income and therefore, cash flow. Cash flow affects the company’s ability to obtain debt and equity financing.

**Profit margin.** The **profit margin ratio**, also known as the operating performance ratio, measures the company’s ability to turn its sales into net income. To evaluate the profit margin, it must be compared to competitors and industry statistics. It is calculated by dividing net income by net sales.

**Asset turnover.** The **asset turnover ratio** measures how efficiently a company is using its assets. The turnover value varies by industry. It is calculated by dividing net sales by average total assets.

**Return on assets.** The **return on assets ratio (ROA)** is considered an overall measure of profitability. It measures how much net income was generated for each $1 of assets the company has. ROA is a combination of the profit margin ratio and the asset turnover ratio. It can be calculated separately by dividing net income by average total assets or by multiplying the profit margin ratio times the asset turnover ratio.

The information shown in equation format can also be shown as follows:

**Return on common stockholders’ equity.** The **return on common stockholders’ equity** (ROE) measures how much net income was earned relative to each dollar of common stockholders’ equity. It is calculated by dividing net income by average common stockholders’ equity. In a simple capital structure (only common stock outstanding), average common stockholders’ equity is the average of the beginning and ending stockholders’ equity.

In a complex capital structure, net income is adjusted by subtracting the preferred dividend requirement, and common stockholders’ equity is calculated by subtracting the par value (or call price, if applicable) of the preferred stock from total stockholders’ equity.

**Earnings per share.** Earnings per share (EPS) represents the net income earned for each share of outstanding common stock. In a simple capital structure, it is calculated by dividing net income by the number of weighted average common shares outstanding.

Assuming The Home Project Company has 50,000,000 shares of common stock outstanding, EPS is calculated as follows:

Calculation notes:

- If the number of shares of common stock outstanding changes during the year, the weighted average stock outstanding must be calculated based on shares actually outstanding during the year. Assuming The Home Project Company had 40,000,000 shares outstanding at the end of 20X0 and issued an additional 10,000,000 shares on July 1, 20X1, the earnings per share using weighted average shares for 20X1 would be $0.18. The weighted average shares was calculated by 2 because the new shares were issued half way through the year.
- If preferred stock is outstanding, preferred dividends declared should be subtracted from net income before calculating EPS.

**Price‐earnings ratio.** The **price‐earnings ratio (P/E)** is quoted in the financial press daily. It represents the investors’ expectations for the stock. A P/E ratio greater than 15 has historically been considered high.

If the market price for The Home Project Company was $6.25 at the end of 20X1 and $5.75 at the end of 20X0, the P/E ratio for 20X1 is 39.1.

**Payout ratio.**The payout ratio identifies the percent of net income paid to common stockholders in the form of cash dividends. It is calculated by dividing cash dividends by net income.

Cash dividends for The Home Project Company for 20X1 and 20X0 were $1,922,000 and $1,295,000, respectively, resulting in a payout ratio for 20X1 of 23.6%.

A more stable and mature company is likely to pay out a higher portion of its earnings as dividends. Many startup companies and companies in some industries do not pay out dividends. It is important to understand the company and its strategy when analyzing the payout ratio.

**Dividend yield.** Another indicator of how a corporation performed is the **dividend yield**. It measures the return in cash dividends earned by an investor on one share of the company’s stock. It is calculated by dividing dividends paid per share by the market price of one common share at the end of the period.

A low dividend yield could be a sign of a high growth company that pays little or no dividends and reinvests earnings in the business or it could be the sign of a downturn in the business. It should be investigated so the investor knows the reason it is low.

**Solvency ratios**

**Solvency ratios** are used to measure long‐term risk and are of interest to long‐term creditors and stockholders.

**Debt to total assets ratio.** The **debt to total assets ratio** calculates the percent of assets provided by creditors. It is calculated by dividing total debt by total assets. Total debt is the same as total liabilities.

The 20X1 ratio of 37.5% means that creditors have provided 37.5% of the company’s financing for its assets and the stockholders have provided 62.5%.

**Times interest earned ratio.** The **times interest earned ratio** is an indicator of the company’s ability to pay interest as it comes due. It is calculated by dividing earnings before interest and taxes (EBIT) by interest expense.

A times interest earned ratio of 2–3 or more indicates that interest expense should reasonably be covered. If the times interest earned ratio is less than two it will be difficult to find a bank to loan money to the business.

### CBSE Class 12 Commerce Accountancy Accounting Ratios Complete Notes

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