Unit 2: Ratio analysis & budgetary control
Management Accounting notes · PTU syllabus (BCOM 301-18)
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Unit summary
Ratios condense hundreds of numbers into a few meaningful indicators, while budgets turn plans into numbers that guide control. This unit covers the nature and types of ratios — liquidity, turnover, profitability, coverage and solvency — and budgetary control: functional budgets, fixed and flexible budgets and zero-base budgeting.
After this unit you can
- Explain the nature, uses and limitations of ratio analysis
- Compute and interpret liquidity, turnover, profitability, coverage and solvency ratios
- Explain budgetary control and prepare functional budgets
- Prepare fixed and flexible budgets and explain zero-base budgeting
PTU syllabus topics
- Nature and types of ratios
- computation of liquidity
- turnover
- profitability
- coverage and solvency ratios
- concept of budget and budgetary control
- functional budgets
- fixed and flexible budgets
- zero base budgeting
Current ratio
Current assets / current liabilities
Ideal about 2:1
Quick ratio
Quick assets / current liabilities
Ideal about 1:1
Debt-equity ratio
Long-term debt / equity
Net profit ratio
Net profit / sales × 100
Inventory turnover
Cost of goods sold / average inventory
Topic 1
Nature of ratio analysis
A ratio is an arithmetical expression of the relationship between two related figures. Ratio analysis is the process of computing, comparing and interpreting ratios.
- Expressed as pure ratio (2:1), percentage (25%) or times (8 times).
- Uses: judge liquidity, solvency, efficiency and profitability; inter-firm and intra-firm comparison; trend analysis; forecasting; communication.
- Limitations: based on historical data, affected by accounting policies and window dressing, ignore price-level changes and qualitative factors, no standard ratios universally valid.
Topic 2
Liquidity and turnover ratios
Current ratio
Current assets ÷ Current liabilities (ideal 2:1)
Quick (acid-test) ratio
Quick assets ÷ Current liabilities (ideal 1:1); quick assets = current assets − inventory − prepaid expenses
Absolute liquid ratio
(Cash + Marketable securities) ÷ Current liabilities (ideal 0.5:1)
Inventory turnover
Cost of goods sold ÷ Average inventory
Debtors (receivables) turnover
Net credit sales ÷ Average debtors and bills receivable
Average collection period
365 ÷ Debtors turnover (days)
Creditors turnover
Net credit purchases ÷ Average creditors
Working capital turnover
Net sales ÷ Working capital
Fixed assets turnover
Net sales ÷ Net fixed assets
Example
Current assets ₹4,00,000 (including inventory ₹1,50,000 and prepaid ₹10,000); current liabilities ₹2,00,000. Current ratio = 2:1; quick ratio = (4,00,000 − 1,60,000) ÷ 2,00,000 = 1.2:1 — comfortable liquidity.
Topic 3
Profitability, coverage and solvency ratios
Gross profit ratio
Gross profit ÷ Net sales × 100
Net profit ratio
Net profit ÷ Net sales × 100
Operating ratio
(COGS + Operating expenses) ÷ Net sales × 100
Return on capital employed
EBIT ÷ Capital employed × 100
Return on equity
Profit after tax − preference dividend ÷ Equity shareholders' funds × 100
Earnings per share
(PAT − Preference dividend) ÷ Number of equity shares
Price-earnings ratio
Market price per share ÷ EPS
Debt-equity ratio
Long-term debt ÷ Shareholders' funds (ideal about 2:1 or lower)
Proprietary ratio
Shareholders' funds ÷ Total assets
Total assets to debt
Total assets ÷ Long-term debt
Interest coverage ratio
EBIT ÷ Interest charges
Debt service coverage ratio
(PAT + Depreciation + Interest) ÷ (Interest + Loan instalment)
Dividend coverage ratio
PAT ÷ Dividend
| Ratio group | Tells about | Who is most interested |
|---|---|---|
| Liquidity | Ability to pay short-term obligations | Short-term creditors, banks |
| Turnover | Efficiency in using assets | Management |
| Profitability | Earning capacity | Shareholders, investors |
| Solvency and coverage | Long-term stability and debt servicing | Lenders, debenture holders |
Exam tip
Interpret every ratio you compute — "the current ratio of 2:1 indicates satisfactory liquidity" — and compare with the ideal or industry average.
Topic 4
Budget and budgetary control
- Budget: a quantitative plan of action for a future period. Budgetary control: setting budgets, comparing actual performance, and taking corrective action.
- 1
Establish budget centres and committee
- 2
Prepare budget manual
- 3
Fix budget period and key factor
- 4
Prepare functional budgets
- 5
Consolidate into the master budget
- 6
Compare actual with budget
- 7
Analyse variances and take action
Functional budgets
| Budget | Content |
|---|---|
| Sales budget | Quantity and value of sales by product, area, period |
| Production budget | Units = Sales + Closing stock − Opening stock |
| Materials budget | Materials needed and purchases |
| Labour budget | Labour hours and cost |
| Overhead budgets | Factory, administration, selling overheads |
| Cash budget | Receipts, payments and balances |
| Capital expenditure budget | Purchase of fixed assets |
| Master budget | Summary — budgeted P&L and balance sheet |
Example
Budgeted sales 10,000 units; opening stock 1,500; desired closing stock 2,000. Production = 10,000 + 2,000 − 1,500 = 10,500 units. At 2 kg per unit, material needed = 21,000 kg; with opening material 3,000 kg and desired closing 4,000 kg, purchases = 21,000 + 4,000 − 3,000 = 22,000 kg.
Topic 5
Fixed and flexible budgets; zero-base budgeting
Activity level
One
Several
Nature
Rigid
Adjusts with activity
Cost classification
Not essential
Fixed, variable, semi-variable needed
Comparison
Misleading if actual activity differs
Compares actual cost with budget at actual activity
Suitable
Stable businesses
Seasonal or changing businesses
Example
Flexible budget: fixed overhead ₹60,000; variable ₹8 per unit; semi-variable ₹20,000 fixed + ₹2 per unit. At 10,000 units total = 60,000 + 80,000 + 40,000 = ₹1,80,000 (₹18/unit); at 15,000 units = 60,000 + 1,20,000 + 50,000 = ₹2,30,000 (₹15.33/unit).
Zero-base budgeting
Every activity is justified from zero each period; managers prepare decision packages describing the activity, its cost and benefits, which are ranked; funds go to top-ranked packages (Peter Pyhrr, Texas Instruments).
- Merits: eliminates waste, better allocation, questions every activity, involves managers.
- Demerits: time-consuming, costly, difficult ranking of non-financial activities.
Key terms
- Ratio analysis
- Computing and interpreting relationships between financial figures
- Quick ratio
- Quick assets divided by current liabilities
- Interest coverage ratio
- EBIT divided by interest charges
- Master budget
- Summary of all functional budgets
- Zero-base budgeting
- Budgeting each activity from scratch each period
Quick revision
- Liquidity: current 2:1, quick 1:1.
- Turnover: inventory, debtors, creditors, assets.
- Profitability: GP, NP, operating ratio, ROCE, ROE, EPS, P/E.
- Solvency: debt-equity, proprietary, interest coverage, DSCR.
- Budgets: functional → master; fixed vs flexible; ZBB.
Important exam questions
Practice questions written to the PTU exam pattern for this unit's syllabus: short answers (Section A style) and long answers (Sections B and C style).
Short-answer questions
- Q1.What is a ratio?
- Q2.Define current ratio and quick ratio.
- Q3.How is the average collection period computed?
- Q4.What is the interest coverage ratio?
- Q5.What is a functional budget?
- Q6.Distinguish fixed and flexible budgets.
Long-answer questions
- Q1.Explain the significance and limitations of ratio analysis.
- Q2.Explain liquidity, turnover, profitability and solvency ratios with formulas.
- Q3.Explain the process of budgetary control and functional budgets.
- Q4.Explain flexible budgets and zero-base budgeting with illustrations.
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