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Accounting Ratios — Part 2: Activity and Profitability Ratios, Interpretation and Limitations

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Lesson

Activity and profitability ratios

Part 2 — turnover ratios, profitability ratios, reading ratios together, and their limitations.

In this lesson you will

Compute inventory, trade receivables, trade payables, fixed asset, net asset and working capital turnover ratios
Work out capital employed in two ways and check that they agree
Compute the gross profit, operating, operating profit and net profit ratios and the return on investment
Interpret a set of ratios and state the limitations of ratio analysis

Part 2 at a glance

Concept

Activity ratios: how hard do resources work?

All are expressed in times. Average = (opening + closing) ÷ 2.
Turnover ratio	Flow of the year (numerator)	Resource (denominator)
Inventory	Cost of revenue from operations	Average inventory
Trade receivables	Credit revenue from operations	Average trade receivables
Trade payables	Net credit purchases	Average trade payables
Fixed asset	Revenue from operations	Net fixed assets
Net asset (capital employed)	Revenue from operations	Capital employed
Working capital	Revenue from operations	Working capital

Concept

Cost of revenue from operations and average inventory

Working of the cost of revenue from operations of Narmada: opening inventory plus purchases plus direct expenses less closing inventory equals 30,00,000, which is also revenue less gross profit; average inventory 3,00,000
Narmada, year ended 31 March 2026	₹
Opening inventory	2,80,000
Add: Purchases	29,20,000
Add: Direct expenses (wages, carriage inwards)	1,20,000
Less: Closing inventory	(3,20,000)
Cost of revenue from operations	30,00,000
Check: revenue − gross profit	40,00,000 − 10,00,000 = 30,00,000
Average inventory	(2,80,000 + 3,20,000) ÷ 2 = 3,00,000