What relationships will be established to study: (a) Inventory turnover (b) Trade receivables turnover (c) Tra

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Q. What relationships will be established to study:

(a) Inventory turnover

(b) Trade receivables turnover

(d) Working capital turnover.

Yanam CbseNCERTSubjective· 3mImportance★★★★★

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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 four turnover ratios measure how efficiently a business uses its inventory, collects receivables, pays suppliers, and deploys working capital — each is a relationship between a turnover figure (Cost of Revenue from Operations, Revenue from Operations, Net Credit Purchases, or Revenue from Operations) and the corresponding average balance (Inventory, Trade Receivables, Trade Payables, or Working Capital).

The Concept: Why Turnover Ratios Matter

Turnover ratios are efficiency ratios. They tell you how many times in a year a particular asset or liability is "turned over" or converted into cash. Think of them as speedometers for different parts of the business cycle.

The logic is simple: a company invests money in inventory, sells it on credit (creating receivables), collects cash, and then pays its suppliers. Each of these steps has a speed. Faster turnover generally means better liquidity and profitability — but not always. Too fast might mean lost sales (stockouts) or overly strict credit policies.

Every turnover ratio follows the same skeleton:

Turnover Ratio = (Related Annual Figure) / (Average Balance of the Item)

The "related annual figure" is always the flow (income statement item), and the denominator is the stock (balance sheet average). Let's apply this to each of the four ratios.

(a) Inventory Turnover Ratio

Relationship: Cost of Revenue from Operations (or Cost of Goods Sold) divided by Average Inventory.

Inventory Turnover Ratio = Cost of Revenue from Operations / Average Inventory

Why this relationship? Inventory is held to be sold. The numerator captures the total cost of inventory that was actually sold during the year. The denominator is the average stock held. The ratio tells you how many times the average inventory was sold and replaced.

Key points:

Cost of Revenue from Operations = Opening Inventory + Net Purchases + Direct Expenses – Closing Inventory. If not given directly, it can be derived from Revenue from Operations minus Gross Profit.
Average Inventory = (Opening Inventory + Closing Inventory) / 2. If only closing inventory is available, use that as a proxy (though the question usually provides both).
A higher ratio indicates faster moving inventory and lower holding costs. A very high ratio may signal stockouts.

Watch out

Never use Revenue from Operations (sales) in the numerator unless Cost of Revenue from Operations is unavailable. Using sales inflates the ratio because sales includes profit margin. If you must use sales, state it clearly as a limitation.

(b) Trade Receivables Turnover Ratio

Relationship: Net Credit Revenue from Operations divided by Average Trade Receivables.

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

Why this relationship? Trade receivables arise from credit sales. The numerator is the total credit sales (net of returns) that generated those receivables. The denominator is the average amount owed by customers. The ratio shows how many times the receivables are collected in a year.

Key points:

Net Credit Revenue from Operations = Credit Sales – Sales Returns. If credit sales are not separately given, assume all sales are credit unless stated otherwise.
Average Trade Receivables = (Opening Trade Receivables + Closing Trade Receivables) / 2. Trade Receivables = Debtors + Bills Receivable (net of provision for doubtful debts, though many textbooks use gross figure).
A higher ratio means faster collection. A lower ratio may indicate poor credit policy or collection efforts.

Tip

To convert this ratio into the average collection period (in days), divide 365 by the turnover ratio. That gives you the average number of days it takes to collect from customers.

(c) Trade Payables Turnover Ratio

Relationship: Net Credit Purchases divided by Average Trade Payables.

Trade Payables Turnover Ratio = Net Credit Purchases / Average Trade Payables

Why this relationship? Trade payables arise from credit purchases. The numerator is the total credit purchases (net of returns). The denominator is the average amount owed to suppliers. The ratio tells you how many times the company pays off its suppliers in a year.

Key points:

Net Credit Purchases = Credit Purchases – Purchase Returns. If credit purchases are not separately given, assume all purchases are credit unless stated otherwise.
Average Trade Payables = (Opening Trade Payables + Closing Trade Payables) / 2. Trade Payables = Creditors + Bills Payable.
A lower ratio (slower payment) may indicate better cash management, but can also signal strained supplier relationships.

Watch out

Do not confuse this with the "creditors turnover ratio" — they are the same thing. Also, if Cost of Revenue from Operations is used as a proxy for purchases (common in trading firms), state the assumption clearly.

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Q.What relationships will be established to study:

The Concept: Why Turnover Ratios Matter

(a) Inventory Turnover Ratio

(b) Trade Receivables Turnover Ratio

(c) Trade Payables Turnover Ratio

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