Accounting Ratios Explained: What They Are & How to Master L

Accounting Ratios Explained: What They Are & How to Master Liquidity Ratios — CBSE Class 12

Accounting ratios carry 10–12 marks in CBSE Class 12 board exams and form the backbone of financial analysis in CA Foundation. Unlike most accountancy topics, ratios reward understanding over memorisation — once you know what a ratio measures and why, the formula becomes easy to recall.

This post covers the foundation: what ratios are, the four-category framework, and the two liquidity ratios you must know cold.

The CASA Framework: Four Categories of Ratios

Use the mnemonic CASA to organise every ratio you study:

Letter	Category	What It Measures
C	Current / Quick (Liquidity)	Ability to meet short-term obligations
A	Activity (Turnover)	Efficiency of asset utilisation
S	Solvency	Long-term financial health and stability
A	And Profitability	Earning capacity and return on investment

Every ratio in the syllabus fits into one of these four buckets. When a question asks you to identify a ratio's category, use CASA to locate it immediately.

Liquidity Ratios

Liquidity ratios answer the question: "Can the company pay what it owes in the short term?"

They compare current assets — things that can be converted to cash within a year — against current liabilities — obligations due within a year.

Ratio 1: Current Ratio

\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}

Ideal value: 2:1

Components

Current Assets include:
Cash, bank balances, debtors (trade receivables), stock (inventory), short-term investments, prepaid expenses, advance payments

Current Liabilities include:
Creditors (trade payables), bills payable, outstanding expenses, bank overdraft, short-term loans

Worked Example

Current Assets = ₹2,00,000 | Current Liabilities = ₹1,00,000

\text{Current Ratio} = \frac{2{,}00{,}000}{1{,}00{,}000} = \mathbf{2:1}

Interpretation: The company has ₹2 of current assets for every ₹1 of current liability. This matches the ideal ratio — the company is in a good liquidity position.

What the Ratio Tells You

Current Ratio	Interpretation
> 2:1	Strong liquidity; may indicate excess idle assets
= 2:1	Ideal — comfortable short-term position
1–2:1	Adequate but watch closely
< 1:1	Danger zone — current liabilities exceed current assets

Ratio 2: Quick Ratio (Acid Test Ratio)

\text{Quick Ratio} = \frac{\text{Quick Assets}}{\text{Current Liabilities}}

\text{Quick Assets} = \text{Current Assets} - \text{Stock} - \text{Prepaid Expenses}

Ideal value: 1:1

Why Are Stock and Prepaid Excluded?

Stock takes time to sell and convert to cash — and in a crisis, it may not fetch its book value
Prepaid expenses cannot be converted to cash at all — they represent services already paid for

The Quick Ratio strips out these less liquid items to give a more conservative picture of short-term solvency.

Worked Example

Current Assets = ₹80,000 | Stock = ₹20,000 | Prepaid Expenses = ₹5,000 | Current Liabilities = ₹50,000

\text{Quick Assets} = 80{,}000 - 20{,}000 - 5{,}000 = ₹55{,}000

\text{Quick Ratio} = \frac{55{,}000}{50{,}000} = \mathbf{1.1:1}

Interpretation: Even without selling any stock, the company can cover all its current liabilities — excellent short-term position.

Current Ratio vs Quick Ratio: Side by Side

Feature	Current Ratio	Quick Ratio
Numerator	All current assets	Current assets − Stock − Prepaid
Ideal value	2:1	1:1
What it tests	Broad short-term liquidity	Immediate, liquid-asset coverage
More conservative?	No	Yes

A company can have a healthy Current Ratio but a weak Quick Ratio — which would indicate it is heavily dependent on stock to meet its short-term obligations. Both ratios together give a fuller picture.

Common Mistakes in Liquidity Ratios

Mistake	Fix
Including long-term investments in current assets	Only short-term investments belong here
Excluding bank overdraft from current liabilities	Bank overdraft is always a current liability
Forgetting to subtract prepaid expenses from Quick Assets	Quick Assets = CA − Stock − Prepaid
Treating advance payments as current liabilities	Advance payments received are current liabilities; advance payments made are current assets

What's Next?

In Part 2, we cover Solvency Ratios — Debt-Equity Ratio, Proprietary Ratio, and Interest Coverage Ratio — the ratios that tell long-term lenders and investors whether the company is built on solid financial foundations.

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