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 | | |
| 1. Non-Current Assets | | xxx |
| 2. Current Assets | | xxx |
| Total | | xxx |
Key Formulas You Must Memorise
Here are the most important ratios from the NCERT syllabus, stated in plain text:
Current Ratio = Current Assets / Current Liabilities
(Ideal: 2:1)
Liquid Ratio = Liquid Assets / Current Liabilities
(Ideal: 1:1)
Liquid Assets = Current Assets – Inventories – Prepaid Expenses
Debt-Equity Ratio = Long-term Debts / Shareholders' Funds
(Ideal: 2:1 for a safe company)
Gross Profit Ratio = (Gross Profit / Revenue from Operations) × 100
Net Profit Ratio = (Net Profit / Revenue from Operations) × 100
Return on Investment (ROI) = (Net Profit before Interest, Tax and Dividend / Capital Employed) × 100
Inventory Turnover Ratio = Cost of Revenue from Operations / Average Inventory
Trade Receivables Turnover Ratio = Revenue from Operations / Average Trade Receivables
A Common Mistake to Avoid
Do not mix up the numerator and denominator. For example, the Current Ratio is always Current Assets divided by Current Liabilities — never the reverse. Also, remember that ratios are expressed either as a pure number (like 2:1) or as a percentage (like 25%). The textbook specifies which form to use for each ratio.
The Big Picture
Ratio analysis is a tool — not the final answer. A single ratio can be misleading. For example, a high Current Ratio might mean the company has too much idle cash or unsold inventory, which is inefficient. Always interpret ratios in combination, and compare them with industry averages or past years' data.
Start by memorising the formulas and the standard formats. Then practise extracting the right numbers from the Balance Sheet and P&L. That is the skill the board exam tests.