Q.What does a low Debt Equity ratio indicate?
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🔒 Start your 14-day free trial to unlock the full solution →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 |
A low Debt-Equity ratio shows the company relies mostly on its own (owners') funds rather than borrowed funds. …
Debt-Equity Ratio = Debt / Shareholders' Funds (Equity). A low ratio means debt forms a small part of the capital structure compared to owners' funds.
A low Debt-Equity ratio indicates:
- The company is financed mainly through owners'/shareholders' funds rather than borrowed (debt) capital.
- Lower financial risk — the company has fewer fixed interest obligations, so it is less vulnerable during periods of low profit.
- Greater safety for lenders/creditors, since there is a larger cushion of owners' funds available to absorb losses before creditors are affected. …
Showing the 12 most recent of 33 on this concept.
- CBSE 2026Set 67/4/11 markMCQQ.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):
Debt-Equity Ratio=Shareholders’ Funds (Equity)Total Debt (External Liabilities)
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:
3,00,0002,00,000=32=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:
1,00,0007,00,000=7:1
The ratio increases from 2:1 to 7:1.
TipAny 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:
1,00,0002,00,000=2:1
The ratio remains unchanged at 2:1.
Watch outBonus 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 markMCQQ.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
…
- CBSE 2025Set ANNUAL1 markMCQQ.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. …
- CBSE 2025Set ANNUAL1 markMCQQ.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: …
- CBSE 2025Set ANNUAL1 markQ.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: …
- CBSE 2025Set ANNUAL1 markMCQQ.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 …
- CBSE 2025Set ANNUAL1 markMCQQ.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.
…
- CBSE 2024Set MARCH1 markQ.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 …
- CBSE 2024Set ANNUAL1 markMCQQ.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 … - CBSE 2024Set ANNUAL1 markQ.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
…
- CBSE 2024Set ANNUAL1 markMCQQ.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 …
- CBSE 2024Set ANNUAL1 markQ.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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