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:

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:

And the Balance Sheet format (abbreviated):