State whether the following statement is true or false. 'Inventory Turnover Ratio measures the level of financ

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Q. State whether the following statement is true or false. 'Inventory Turnover Ratio measures the level of financial leverage.'

CBSECBSE Class XII Board 2020Subjective· 1mImportance★★★★★

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Concept understanding — Financial Ratio Analysis

Financial Ratio Analysis — A First Look

Think of a friend who runs a small shop. You want to know: Is the shop doing well? You could ask, "How much profit did you make?" But that single number doesn't tell you much. A profit of ₹50,000 sounds good — but what if the shop owner invested ₹10,00,000 of their own money? Suddenly that profit looks small. What if the shop owes ₹8,00,000 to suppliers? That changes the picture too.

This is where ratio analysis comes in. It takes two numbers from the financial statements and compares them. A ratio is simply one number divided by another. That comparison gives you a relative measure — not just "how much profit" but "profit relative to investment" or "profit relative to sales."

What Exactly Is Financial Ratio Analysis?

Financial ratio analysis is the process of calculating and interpreting ratios using data from the Balance Sheet and Statement of Profit and Loss (the P&L). These ratios help you evaluate a business's performance, financial health, and efficiency.

The NCERT Class 12 Accountancy textbook (Part II, Chapter 5) defines it as: "the process of establishing meaningful relationship between items of the financial statements."

There are four main categories of ratios you will study:

Category	What it measures	Example
Liquidity ratios	Ability to pay short-term debts	Current ratio
Solvency ratios	Ability to pay long-term debts	Debt-equity ratio
Activity ratios	How efficiently assets are used	Inventory turnover ratio
Profitability ratios	How much profit relative to sales/investment	Gross profit ratio

Why Does It Matter?

A single absolute number — say, Net Profit of ₹2,00,000 — is almost meaningless without context. Ratio analysis gives you that context. It lets you:

Compare performance across years (trend analysis)
Compare one company with another in the same industry
Judge whether the business can meet its obligations
Identify strengths and weaknesses before they become crises

For example, if Current Assets are ₹5,00,000 and Current Liabilities are ₹2,50,000, the Current Ratio is 2:1. That is considered healthy. But if Current Liabilities were ₹5,00,000, the ratio would be 1:1 — a warning sign.

Accounting Treatment — What Gets Debited and Credited?

Here is a critical point: Ratio analysis itself does not involve any journal entry. You are not recording a transaction. You are analysing existing data. No account is debited or credited when you calculate a ratio.

However, the data used in ratio analysis comes from accounts that were debited and credited when transactions occurred. For instance:

Gross Profit Ratio uses Gross Profit (from the P&L) and Revenue from Operations (Net Sales). Gross Profit itself is the result of closing entries — debit Trading Account, credit P&L.
Current Ratio uses Current Assets (like Cash, Debtors) and Current Liabilities (like Creditors, Bills Payable). These balances exist because of past journal entries.

So while ratio analysis has no direct debit/credit, it draws entirely from the ledger balances that do.

Formats and Proformas You Need to Know

The NCERT textbook provides specific formats for the financial statements from which ratios are calculated. Here is the Statement of Profit and Loss format (as per Schedule III of the Companies Act, 2013) that you will use:

Particulars	Note No.	Amount (₹)
I. Revenue from Operations		xxx
II. Other Income		xxx
III. Total Revenue (I + II)		xxx
IV. Expenses:
Cost of Materials Consumed		xxx
Purchases of Stock-in-Trade		xxx
Changes in Inventories		xxx
Employee Benefit Expenses		xxx
Finance Costs		xxx
Depreciation and Amortisation		xxx
Other Expenses		xxx
Total Expenses		xxx
V. Profit before Tax (III – IV)		xxx
VI. Tax Expense		xxx
VII. Profit for the Period (V – VI)		xxx

And the Balance Sheet format (abbreviated):

Particulars	Note No.	Amount (₹)
EQUITY AND LIABILITIES
1. Shareholders' Funds
(a) Share Capital		xxx
(b) Reserves and Surplus		xxx
2. Non-Current Liabilities		xxx
3. Current Liabilities		xxx
Total		xxx
ASSETS

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The statement is false. Inventory Turnover Ratio measures operational efficiency in managing inventory, while financial leverage measures the extent of debt financing and associated risk.

Let's understand what each of these terms represents in the context of financial analysis.

The Inventory Turnover Ratio is an activity ratio. Its primary purpose is to assess how efficiently a company is managing its inventory. It tells us how many times, on average, a company sells and replaces its inventory during a specific period (usually a year). A higher ratio generally indicates efficient inventory management, meaning inventory is not sitting idle for too long, reducing storage costs and the risk of obsolescence.

\frac{\text{Cost of Revenue from Operations}}{\text{Average Inventory}}

On the other hand, Financial Leverage is a measure of a company's capital structure. It indicates the extent to which a company uses borrowed funds (debt) to finance its assets. Companies with high financial leverage rely heavily on debt, which can amplify returns for shareholders when the company performs well, but also significantly increases financial risk if the company's earnings decline or interest rates rise. Common ratios used to measure financial leverage include the Debt-to-Equity Ratio, Debt-to-Asset Ratio, and Interest Coverage Ratio. These ratios focus on the relationship between debt and equity, or debt and total assets, to gauge the company's solvency and risk profile. …

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Same / Similar Concept — real previous-year questions on the same or a closely similar concept, not this exact question.

Showing the 12 most recent of 33 on this concept.

CBSE 2026Set 67/4/11 markMCQ
$Q. The Debt-Equity Ratio of a company is 2 : 1. Which of the following transactions will increase the Debt-Equity Ratio ? (A) Issue of Shares ₹ 2,00,000 (B) Issue of 8% Debentures ₹ 5,00,000 (C) Issue of Bonus shares ₹ 4,00,000 (D) Payment to Creditors ₹ 1,00,000$
›Reveal solutionSolution
Option (B) — Issue of 8% Debentures ₹5,00,000 — will increase the Debt-Equity Ratio from 2:1.

Concept: Debt-Equity Ratio

The Debt-Equity Ratio measures the relationship between a company's external liabilities (debt) and shareholders' funds (equity):
$\text{Debt-Equity Ratio} = \frac{\text{Total Debt (External Liabilities)}}{\text{Shareholders' Funds (Equity)}}$
A ratio of 2:1 means for every ₹1 of equity, the company has ₹2 of debt.

To increase this ratio, we need a transaction that either:

Increases debt while keeping equity constant, or

Decreases equity while keeping debt constant, or

Increases debt proportionately more than equity increases.

Let us assume the company currently has Debt = ₹2,00,000 and Equity = ₹1,00,000 (giving the 2:1 ratio). We will test each option.

Analysis of Each Transaction

(A) Issue of Shares ₹2,00,000

Accounting Treatment:

When shares are issued, Bank/Cash A/c is debited and Share Capital A/c (part of equity) is credited.

Effect:

Debt remains ₹2,00,000

Equity increases to ₹1,00,000 + ₹2,00,000 = ₹3,00,000

New Ratio:
$\frac{2,00,000}{3,00,000} = \frac{2}{3} = 0.67:1$
The ratio decreases from 2:1 to 0.67:1.

(B) Issue of 8% Debentures ₹5,00,000

Accounting Treatment:

When debentures are issued, Bank/Cash A/c is debited and Debentures A/c (a long-term liability, part of debt) is credited.

Effect:

Debt increases to ₹2,00,000 + ₹5,00,000 = ₹7,00,000

Equity remains ₹1,00,000

New Ratio:
$\frac{7,00,000}{1,00,000} = 7:1$
The ratio increases from 2:1 to 7:1.

Tip

Any issue of debentures, bonds, or long-term loans increases debt without affecting equity, thereby raising the Debt-Equity Ratio.

(C) Issue of Bonus Shares ₹4,00,000

Accounting Treatment:

Bonus shares are issued by capitalising reserves. General Reserve/Profit & Loss A/c is debited and Share Capital A/c is credited. Both accounts are part of shareholders' funds (equity).

Effect:

Debt remains ₹2,00,000

Equity remains ₹1,00,000 (internal transfer within equity — reserves decrease, share capital increases by the same amount)

New Ratio:
$\frac{2,00,000}{1,00,000} = 2:1$
The ratio remains unchanged at 2:1.

Watch out

Bonus shares do NOT bring in fresh capital. They merely convert one component of equity (reserves) into another (share capital). Total equity is unaffected, so the Debt-Equity Ratio does not change.

--- …
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CBSE 2026Set ANNUAL1 markMCQ
$Q. Profit before Interest and Tax is ₹ 3,00,000 and Interest ₹ 75,000. The Interest coverage Ratio is _______.$
(a) 4 : 1
(b) 3 : 1
(c) 2 : 1
(d) 1 : 1
(a) 4 : 1
(b) 3 : 1
(c) 2 : 1
(d) 1 : 1
›Reveal solutionSolution

Interest Coverage Ratio = 4 : 1 (Option A).

Interest Coverage Ratio = Profit before Interest and Tax (PBIT) ÷ Interest on Long-term Debt

= 3,00,000 / 75,000 = 4 times, i.e. 4 : 1

…

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CBSE 2025Set ANNUAL1 markMCQ
$Q. Creditors turnover ratio includes (A) Total credit purchase (B) Total credit sales (C) Total cash sales (D) Total cash purchase$
›Reveal solutionSolution
Creditors (payables) turnover ratio uses total credit purchases, so the answer is (A).

Creditors Turnover Ratio = Net Credit Purchases / Average Accounts Payable (creditors plus bills payable). It tells us how many times, on average, the firm pays off its trade creditors during the year.

Credit sales (B) belong to the debtors/trade receivables turnover ratio, not creditors.

Cash sales (C) and cash purchases (D) create no creditors at all, so they are irrelevant to this ratio. …
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CBSE 2025Set ANNUAL1 markMCQ
$Q. Total sales and cash sales of a concern are Rs. 6,00,000 and Rs. 40,000 respectively. Amount of average debtors is Rs. 1,40,000. Debtors turnover ratio will be (A) 3 times (B) 5 times (C) 4 times (D) None of these.$
›Reveal solutionSolution

The debtors turnover ratio is 4 times — option (C).

Debtors (Receivables) Turnover Ratio = Net Credit Sales / Average Debtors.

Step 1 - Net Credit Sales: …

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CBSE 2025Set ANNUAL1 mark
$Q. Write the formula of creditors turnover ratio.$
(OR)
$Give one example of solvency ratio.$
›Reveal solutionSolution

Creditors Turnover Ratio = Net Credit Purchases / Average Creditors; a solvency ratio example is the Debt-Equity Ratio.

Formula of Creditors Turnover Ratio:

Creditors (Accounts Payable) Turnover Ratio = Net Credit Purchases / Average Creditors,

where Average Creditors = (Opening Creditors + Closing Creditors) / 2, and creditors include bills payable. It measures how many times, on average, a firm pays off its trade payables during the year.

OR - One example of a solvency ratio: …

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CBSE 2025Set ANNUAL1 markMCQ
$Q. Satisfactory Ratio between Long-term Debts and Shareholder's Fund is ________. (A) 1 : 1 (B) 1 : 2 (C) 2 : 1 (D) 3 : 1$
›Reveal solutionSolution

A Debt-Equity Ratio of 2:1 is conventionally regarded as safe/satisfactory, meaning debt should not exceed twice the shareholders' funds, giving lenders an adequate margin of safety.

The Debt-Equity Ratio measures the relationship between a company's long-term debts (borrowed funds) and its Shareholders' Funds (owners' funds), and indicates the long-term solvency/financial stability of the firm. A 2:1 ratio is generally considered satisfactory because it means that for every Rs. 2 of debt, the company has Rs. 1 of owners' funds backing it — i.e., debt is …

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CBSE 2025Set ANNUAL1 markMCQ
$Q. Solvency of the business can be measured by -$
(a) Comparing fixed assets and liabilities
(b) Comparing current assets with current liabilities
(c) Comparing liquid assets with current assets
(d) All of these
›Reveal solutionSolution

Solvency (long-term financial soundness) is judged by comparing fixed assets with liabilities; liquidity (short-term paying ability) is judged by current-asset/current-liability or quick-asset comparisons — these are two different questions.

'Solvency' refers to a firm's ability to meet its LONG-TERM debts and obligations as they fall due, i.e., whether the business has enough resources overall to survive and discharge its liabilities over time — distinct from 'liquidity', which asks whether the firm can pay its IMMEDIATE, short-term bills.

…

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CBSE 2024Set MARCH1 mark
$Q. Expand EPS.$
›Reveal solutionSolution

EPS = Earnings Per Share.

Earnings Per Share (EPS) is a profitability ratio that shows the amount of net profit (after tax and preference dividend) earned on each equity share. It is calculated as: EPS = (Net profit after tax − Preference dividend) ÷ Number of equity shares. It is …

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CBSE 2024Set ANNUAL1 markMCQ
$Q. Either attempt question numbers (xix) to (xxiv) Or (xxv) to (xxx). Only one series of questions to be answered from above mentioned series of questions. If cash sales ₹ 50,000, credit sales ₹ 4,50,000, cost of goods sold ₹ 4,40,000, then Gross Profit Ratio will be$
(a) 12.5%.
(b) 13%.
(c) 15%.
(d) 12%.
›Reveal solutionSolution

Gross Profit Ratio is 12% — option (d).

Item Working Amount (₹)
Total Sales 50,000 (cash) + 4,50,000 (credit) 5,00,000
Less: Cost of Goods Sold 4,40,000
Gross Profit 5,00,000 − 4,40,000 60,000
…

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CBSE 2024Set ANNUAL1 mark
$Q. What is Proprietary Ratio?$
›Reveal solutionSolution

Proprietary Ratio = Proprietors'/Shareholders' Funds ÷ Total Assets — it measures the share of total assets funded by owners.

The Proprietary Ratio (also called Net Worth to Total Assets Ratio) is a solvency ratio that establishes the relationship between proprietors' (shareholders') funds and the total assets of the business.

Proprietary Ratio = Shareholders' Funds ÷ Total Assets

…

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CBSE 2024Set ANNUAL1 markMCQ
$Q. An ideal debt-Equity ratio is considered safe :- A) 1 : 1 B) 2 : 1 C) 0.5 : 1 D) 1 : 2$
›Reveal solutionSolution

The conventionally accepted safe Debt–Equity ratio is 2 : 1. Correct option: (B).

Debt–Equity Ratio = Long-term Debt ÷ Shareholders' Funds. A ratio of 2 : 1 is traditionally regarded as satisfactory/safe: it indicates that for every ₹1 of owners' funds, long-term debt is ₹2, which lenders …

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CBSE 2024Set ANNUAL1 mark
$Q. Give the formula for calculating receivable turnover ratio.$
›Reveal solutionSolution
Receivable Turnover Ratio = Net Credit Revenue from Operations ÷ Average Trade Receivables.

The Receivable (Trade Receivables / Debtors) Turnover Ratio is an activity/efficiency ratio that measures how efficiently a firm manages and collects the credit it extends to its customers. It is calculated as:

Receivable Turnover Ratio = Net Credit Revenue from Operations / Average Trade Receivables

where:

Net Credit Revenue from Operations = Total credit sales/revenue less sales returns (cash sales are excluded, since receivables arise only from credit sales).

Average Trade Receivables = (Opening Trade Receivables + Closing Trade Receivables) / 2 (debtors + bills receivable, generally taken before deducting any provision for doubtful debts). …
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Item	Working	Amount (₹)
Total Sales	50,000 (cash) + 4,50,000 (credit)	5,00,000
Less: Cost of Goods Sold		4,40,000
Gross Profit	5,00,000 − 4,40,000	60,000
…

Q.State whether the following statement is true or false. 'Inventory Turnover Ratio measures the level of financial leverage.'

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