Understanding Classification of Ratios

Ratios are essential tools for evaluating a business organization’s earning capacity, financial health, and operational efficiency. They express the relationship between two related financial items. When calculated using accounting information, they are referred to as Accounting Ratios.

Ratios can be classified in two ways:

A) Traditional Classification
B) Functional Classification

A) Traditional Classification

This classification is based on accounting statements and includes:

1. Profit and Loss Ratios
2. Balance Sheet Ratios
3. Composite Ratios

1. Profit and Loss Ratios:
These ratios are derived from two variables exclusively from the Statement of Profit and Loss. For example, the Gross Profit Ratio is calculated by dividing Gross Profit by Revenue from Operations. Both variables originate from the Profit and Loss Statement.

2. Balance Sheet Ratios:
Balance Sheet Ratios are used to assess a company’s financial position using data from the balance sheet. Examples include:

• Debt to Equity Ratio
• Liquidity Ratios (Current Ratio, Quick Ratio, Cash Ratio)
• Efficiency Ratios (Accounts Receivable Turnover, Accounts Payable Turnover, Inventory Turnover)
• Interest Coverage Ratio

The Current Ratio compares a company’s current assets to its current liabilities. A higher ratio indicates better liquidity. The Quick Ratio excludes inventory, offering a more stringent liquidity measure. The Cash Ratio (or Absolute Liquid Ratio) considers only cash and cash equivalents over current liabilities. The Inventory Turnover Ratio measures how frequently inventory is sold and replaced. The Interest Coverage Ratio evaluates a company’s ability to pay interest on its debts.

3. Composite Ratios:
Composite Ratios compare variables from different financial statements. For example, the Trade Receivable Turnover Ratio combines trade receivables from the balance sheet and revenue from operations from the Profit and Loss Statement.

B) Functional Classification

Functional Classification groups ratios based on the financial function they serve. Examples include:

1. Liquidity Ratios
2. Leverage Ratios
3. Turnover Ratios
4. Profitability Ratios

1. Liquidity Ratios:
These ratios assess a company’s ability to meet short-term obligations. Key liquidity ratios include:

• Current Ratio = Current Assets / Current Liabilities
  A ratio between 1.2 and 2 is ideal; less than 1 indicates potential liquidity issues.
• Liquidity Ratio = Liquid Assets / Current Liabilities
  A high ratio suggests strong financial stability.
• Efficiency Ratio = Expenses / Revenue
  This ratio measures how well a company controls expenses relative to revenue. In banking, it is calculated as Non-interest Expenses / Revenue, reflecting how effectively banks manage overhead costs.

2. Leverage Ratios:
Leverage Ratios evaluate a company’s ability to meet long-term liabilities by analyzing its debt usage. The Debt-to-EBITDA Ratio (Total Debt / EBITDA) indicates financial stability and risk. EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization.

3. Turnover Ratios:
These ratios measure how efficiently a company uses its assets to generate revenue. Examples include:

• Debtors’ Velocity Ratio
• Creditors’ Velocity Ratio
• Sales to Inventory Ratio
• Fixed Asset Turnover Ratio
• Capital Employed Turnover Ratio

Turnover Ratios assess how effectively resources are utilized to drive sales and profitability.

To know more read: WHAT ARE TURNOVER RATIOS?

4. Profitability Ratios:
Profitability Ratios evaluate a company’s ability to generate income relative to expenses, assets, and equity. These ratios guide management and investors in making strategic decisions. Key examples include:

• Return on Equity (ROE): Net Profit / Tangible Net Worth
• Return on Assets (ROA): Net Profit / Total Assets
• Net Profit Margin: Net Profit / Net Sales
• Gross Profit Margin: Gross Profit / Net Sales
• Cash Flow Margin Ratio
• Profit Volume Ratio

These ratios are usually expressed as percentages and help assess the efficiency and profitability of business operations. To know more read: WHAT ARE PROFITABILITY RATIOS?

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