Effect of Transaction on Accounting Ratio

Students often get this question in their exams as to ‘What is the effect of a transaction on the given ratio?’

Generally, this question is asked in case of Current Ratio, Quick Ratio and Debt Equity Ratio. They get confused. Moreover, they have to manage time also.

Here are the short cut tricks to judge the effect of a transaction on the given ratio:

Ratio = Numerator/ Denominator               R =N/D

 

Case 1: There is change in only numerator or denominator (N or D).

Change in Numerator →Ratio moves in same direction (N→R).

Change in Denominator →Ratio moves in opposite direction {D→(-R)}

 

Case 2: There is equal amount of change in both (N and D).

There are further three situations:

Situation 1: When Numerator < Denominator (N<D)

If both increase/decrease by the same amount, Ratio changes in the same direction.

Situation 2: When Numerator = Denominator(N=D)

If both increase/decrease by the same amount, Ratio does not change.

Situation 3: When Numerator > Denominator(N>D)

If both increase/decrease by the same amount, Ratio changes in the opposite direction.

 

Case 3: When there is unequal change in both (N and D).

First, check in which Numerator or Denominator, the change is more.

If change in Numerator is more than change in Denominator, Ratio will follow the same direction.

If change in Denominator is more than change in Numerator, Ratio will follow the opposite direction.

Try using this mathematical trick and you will learn to save time, doing this question correctly.

 

Effect of Transaction on Accounting Ratio

Illustration

The current ratio of ABC Ltd is 2 : 1. State with reason, which of the following transactions would (a) increase, (b) decrease or (c) not change the ratio:
(a) Trade receivables included debtors of ₹20,000 which were received.
(b) Company purchased furniture of ₹25,000. The vendor was paid by issue of 9% Debentures of ₹1,000 each at par.
Answer:
(a) No change in ratio

Reason: Debtors decreased, and cash increased by the same amount, keeping the Trade Receivables same. So, there is no effect on the current ratio.
(ii) No Change the ratio

Reason: Shares issued, and furniture purchased are non-current assets, they do not affect either current assets or current liabilities.

 

Effect of Transaction on Accounting Ratio

 

Effect on Current Ratio

Given Current Ratio = 2:1

Current Ratio = Current Assets/Current Liabilities

Transaction - Effect

  1. Purchased goods for cash - No Change
  2. Cash paid to Trade Payables - Increase
  3. Bills Payable discharged - Increase
  4. Bills Receivable endorsed to a creditor - Increase
  5. Payment of final Dividend already declared - Increase
  6. Purchase of Goods for Cash - No Change
  7. Purchase of Stock-in-Trade on credit - Decrease
  8. Sale of old machine for cash - Increase
  9. Bills Receivable endorsed to a Creditor dishonoured - Decrease
  10. Purchases of Stock-in-Trade for cash - No Change
  11. Sale of Old Furniture (Book Value of ₹5,000) for ₹7,000 - Increase
  12. Sale of Old Machine for ₹4,000 (Book Value of ₹3,000) - Increase
  13. Issue of Equity Shares - Increase
  14. Redemption of 9% Debentures at 10% Premium, ₹1,00,000 - Decrease
  15. Purchased Furniture and issued 1,000 Shares of ₹100 each to the vendor - No Change
  16. Received from Debtors ₹7,000 - No Change
  17. Payment of Dividend already declared - Increase
  18. Purchase of Loose Tools for cash - Decrease
  19. Payment of Dividend Payable - Increase
  20. Accepted Bills of exchange drawn by creditors ₹8,000 - No Change
  21. Trade receivables included debtors of ₹40,000 which were received - No Change
  22. Cash deposited into bank ₹6,000 - No Change
  23. Paid cash ₹3,000 to the creditors - Increase

 

Effect of Transaction on Accounting Ratio

Effect on Quick Ratio

Given Quick ratio = 1 : 1

Quick Ratio = Quick Assets/Current Liabilities

  1. Included in the trade payables was a bills payable of ₹2,000 which was met on maturity - No Change
  2. Purchased Goods for cash/ paid by cheque - Decrease
  3. Purchased Goods on credit- Decrease
  4. Issued Equity Shares ₹1,00,000 - Increase
  5. Debentures of ₹40,000 were converted into equity shares - No Change
  6. Paid rent ₹3,000 in advance - Decrease
  7. Trade receivables included a debtor who paid his entire amount due ₹2,500 - No Change
  8. Paid insurance premium in advance ₹8,000 - Decrease
  9. Purchased goods on credit ₹6,000 - Decrease
  10. Cash collected from Debtors - No Change
  11. Issued fully paid equity shares of ₹2,00,000 - Increase
  12. Issued 9% debentures of ₹3,00,000 to the vendor for machinery purchased - No change

Given Quick ratio of a company is 0.8 : 1.

  1. Purchase of loose tools ₹1,000 - Decrease
  2. Insurance premium paid in advance ₹1,700 - Decrease
  3. Sale of goods on credit ₹5,000 - Increase
  4. Sale of goods costing ₹5,000 for ₹4,000 - decrease

 

Effect of Transaction on Accounting Ratio

Effect on Inventory Turnover Ratio

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

  1. Sale of goods for ₹2,000 (Cost 1,600) - Increase
  2. Increase in the value of Closing Inventory by 20,000 - Decrease
  3. Goods purchased for ₹4,000 - Decrease
  4. Purchases return ₹1,000 - Increase
  5. Goods costing ₹500 withdrawn for personal use - Increase
  6. Goods costing ₹1000 distributed as samples - Increase

 

Effect of Transaction on Accounting Ratio

Effect on Gross Profit Ratio

Given G.P. Ratio = 20%

Gross Profit Ratio = (Gross Profit/ Revenue from Operations) X 100

  1. Purchase of Stock-in-Trade₹ 50,000 - No Change
  2. Purchases Return₹15,000 - No Change
  3. Sale of Stock-in-Trade costing ₹5,000 - No Change
  4. Goods costing ₹2,000 withdrawn for personal use - No Change
  5. Goods costing ₹1,000 distributed as samples - No Change

 

Effect on Operating Ratio

Given Operating Ratio = 80%

Operating Ratio = (Cost of Revenue from Operations + Operating Expenses) / Revenue from Operations

  1. Purchases of Stock-in-Trade ₹40,000 - No Change
  2. Purchase Return ₹3,000 - No Change
  3. Goods costing ₹4,000 drawn for personal use - No Change
  4. Office Expenses paid ₹40,000 - Increase
  5. Goods costing ₹20,000 distributed as samples - Increase
  6. Payment to Creditors ₹30,000 - No Change
  7. Building sold for ₹4,00,000 - No Change
  8. Income Tax Paid ₹50,000 - No Change
  9. Purchase of goods costing ₹16,000 - No Change
  10. Purchased goods on credit ₹24,000 - No Change
  11. Paid wages ₹4,000 - Increase
  12. Redeemed ₹20,000, 9% debentures - No Change
  13. Sold goods ₹30,000 for cash - Decrease

 

Effect of Transaction on Accounting Ratio

Operating Profit Ratio

Given Operating Profit Ratio = 20%.

Operating Profit Ratio = (Operating Profit/ Revenue from Operations) X 100

  1. Purchase of Stock-in-Trade ₹20,000 - No Change
  2. Purchases Return ₹7,000 - No Change
  3. Sale of Stock-in-Trade of ₹12,000 Costing ₹10,000 - No Change
  4. Stock-in-Trade costing ₹3,000 withdrawn for personal use - No Change

 

Effect on Debt Equity Ratio

Given Debt Equity ratio -= 2:1

Debt Equity Ratio = Debt/Equity

  1. Borrowed Loan from bank for 4 years - Increase
  2. Repayment of long-term loan - Decrease
  3. Payment to Creditors - No Change
  4. Redemption of Debentures in Cash - No Change
  5. Issue of Equity Shares - Decrease
  6. Issue of shares to vendor for furniture purchased - Decrease
  7. Issue of 9% Debentures to vendor for machinery purchased - Increase
  8. Issue of bonus shares - No Change
  9. Purchase of a fixed assets by taking loan - Increase
  10. (Purchase of Fixed Assets on credit or on deferred payment basis would also mean the same)
  11. Purchase of fixed assets on 3 months credit/ cash / cheque - No Change
  12. Sale of fixed assets (book value ₹4,000) at loss of ₹1,500 - Increase
  13. Sale of Machinery (book value ₹9,000) for ₹10,000 - Decrease
  14. Conversion of Debentures into Equity Shares - Decrease
  15. Declaration of final dividend - Increase

 

Effect of Transaction on Accounting Ratio 

Effect on Proprietary Ratio

Given Proprietary ratio = 0.80 : 1.

Proprietary Ratio = Proprietor’s Funds/Total Assets

  1. Borrowed a loan from bank ₹1,00,000 payable after 3 years - Decrease
  2. Purchased furniture for cash ₹25,000 - No Change
  3. Purchased Office Equipment by cheque - No Change
  4. Redeemed 6% redeemable preference shares ₹1,00,000 - Decrease
  5. Redeemed 9% Debentures ₹2,00,000 - Increase
  6. Issued equity shares to the vendors of machinery purchased for ₹2,00,000 - Increase

 

Debt to Capital Employed Ratio

Given Debt to Capital Employed Ratio = 0.4:1

Debt to Capital Employed Ratio = Debt/ Capital Employed

  1. Sale of Machinery at a loss of ₹20,000 - Increase
  2. Tax Refund of ₹10,000 during the year - Decrease
  3. Purchase of Stock-in-Trade on credit of two months for ₹20,000 - No Change
  4. Purchase of Goods on credit for ₹10,000 on 16 months credit basis, operating cycle is of 18 months - Decrease
  5. Conversion of Debentures into Equity Shares of ₹1,00,000 - Decrease
  6. Purchase of Fixed Assets for ₹3,00,000 on credit - Increase

 

Effect of Transaction on Accounting Ratio 

Effect on Return on Investment Ratio

Return on Investment = (Net Profit before Interest and Tax /Capital Employed) X 100

  1. Purchase of office Equipment of ₹2,00,000 by issue of Equity Shares - Decrease
  2. Charging depreciation of ₹12,500 on machinery - Decrease
  3. Redemption of 9% Debentures by cheque ₹2,00,000 - No Change
  4. Conversion of ₹3,00,000, 9% Debentures into Equity Shares - Decrease

 

The question of this form can also be there in MCQs, like:

Which of the following transaction will improve the quick ratio?

(a) Purchase of inventory for cash

(b) Cash collected from debtors

(c) Sale of goods (costing ₹4,000 for ₹5,000)

(d) None of the above

Answer:

(c) Sale of goods (costing ₹4,000 for ₹5,000)

 

 

Liquidity Ratios

Learning Games and Activities in Business Studies Class 12