Classification of Ratios
Accounting ratios are used to analyse the financial position of the firm. They are being categorised into two different types which are given as below:
A) Traditional classification – The ratios in this type are based on the financial statements.
- Balance Sheet Ratios – When both figures used to calculate a ratio form part of a Balance Sheet, then the ratio is called Balance Sheet Ratio.
- Statement of Profit & Loss Ratios – This ratio signifies the relationship between two items of profit and loss. For eg – gross profit or net profit ratio.
- Composite Ratios – Composite Ratios are the ratios which use variables from both Statement of Profit & Loss and Balance Sheet. For eg – trade receivables turnover ratio.
B) Functional Classification –
However, from the users point of view, they are interested to know about the liquidity, solvency, turnover and profitability of the organisation. This category calculates ratios on the basis of their purpose. So, the main categories of ratio from financial users perspective are:
Liquidity Ratios : Liquidity means the firm’s ability to meet its current liabilities. In other words, the ability of a business to pay its short-term debts is frequently referred to as the liquidity position of the business. Short term creditors of the firm are generally interested to know about the liquidity position of the firm. The liquidity ratio is further categorised into two parts: (i) Current Ratio & (ii) Liquid Ratio
Solvency Ratio Analysis
Solvency Ratio Analysis : It measures the ability of a business to survive for a long period of time. These ratios are very important for stockholders and creditors as these ratios assess the ability of the firm to meet its long term liabilities.
The solvency ratios are categorised into following types :a) Debt Equity Ratio b) Total Assets to Debt Ratio c) Proprietary Ratio d) Interest Coverage Ratio
Activity Ratio Analysis
Activity Ratio Analysis – Activity ratios are financial analysis tools used to measure a business’ ability to convert its assets into cash. These ratios are known as turnover ratios because they indicate the rapidity with which the resources available to the concern are being used to produce revenue from operations.
The different types of activity ratios are:
- Inventory Turnover Ratio
- Trade Receivables Turnover Ratio
- Trade Payables Turnover Ratio
- Working Capital Turnover Ratio
It is also known as income ratio. The objective of every organisation is to earn profit and hence the organisations would definitely want to keep a track on various aspects of profit like operating profit, net profit etc. Therefore, they prepare and compute the profitability ratios.
The different types of profitability ratios are:
- Gross Profit Ratio
- Operating Ratio
- Net Profit Ratio
- Operating Profit Ratio
- Earning Per Share
The classification of ratios can be done into traditional and functional classification. These are further divided in several other ratios which help in judging the efficiency of the company as a whole and conduct financial analysis.