TYPES OF RATIOS

There are a number of ratios which can be determined on the basis of financial data made available by
the company. But the financial analyst is always interested in those ratios which serve his basic purpose.
Accordingly, there are certain important ratios which are used very often for analysis and interpretation
of the various aspects of a business concern viz. solvency, credit standings, leverage, stability, structural
analysis, resource utilisation, profitability, operational efficiency, etc. In actual practice usually different
types of financial ratios are grouped together according to the different purposes they serve, for
different types of users of basic accounting data and for different methods of financial statement
analysis to be made out of the same.

A. Traditional Classification
1) Balance Sheet Ratios

Top management will probably want to view the financial structure of the company in terms of basic
ratios of assets or liability categories to total assets. These ratios attempt to express the relationship
between two Balance Sheet items, eg the ratio of stock to debtors or the ratio of Owner’s equity to total
equity.

2) Profit and Loss Account Ratios

These ratios indicate the relationship between two such variables which have been taken from the Profit
and Loss Account. Basically there are two types of such ratios viz.

i)Those showing the current year’s figure as a percentage of last year, thus facilitating comparison of the
changes in the various profit and loss items and

ii) those expressing a relationship among different items for the current year, eg the percentage of
distribution expenses to sales etc.

3) Inter-Statement Ratios

The components for computation of these ratios are drawn from both Balance Sheet and Profit and Loss
Account. These ratios deal with the relationship between operating and Balance Sheet items. The
example of such ratios are debtors turnover ratio, fixed assets turnover ratio, working capital turnover
ratio, and stock turnover ratio.

(B) Functional Classification

Ratios can broadly be classified into four groups Profitability Ratios, Liquidity Ratios Leverage Ratios and
Activity Ratios.

i)PROFITABILITY RATIOS

The profitability of a firm can be measured by the profitability ratios. Such ratios can be computed either
from sales or investments. The profitability ratios based on sales are: 1) Profit Margin (grom and net),
and i) Expenses or Operating ratios. They indicate the proportion of sales comed by operating costs, and
the proportion available to meet financial and other expenses The profitability related to investments
includes i) Return on assets, ii) Return on capital employed and iii) Return on shareholders equity,
including earning per share, dividend payout ratio, earning and dividend yield. The overall profitability
(earning power) is measured by the return on investment, which is computed as a combined product of
net profit margin and turnover it is a central measure of the earning power and operating efficiency of a
firm.

ii) LIQUIDITY RATIOS

Liquidity Ratios measure the ability of a firm to meet its short-term obligations, and reflect its short-
term financial strength or solvency. Important Liquidity Ratios are: i) Current Ratio and ii) Quick or Acid-
Test Ratio Current Ratio is the ratio of total current assets to total current liabilities. A satisfactory
current ratio would enable a firm to meet its obligations even if the value of the current assets declines.
It is however a quantitative index of liquidity as it does not differentiate between the components of
current assets, such as cash and inventory which are not equally liquid . The Quick Ratio-Acid Test Ratio
takes into consideration the different liquidity of the components of current assets. It represents the
ratio between quick current assets, and the total current liabilities. It is a rigorous measure and superior
to current ratio. However, both these ratios should be used to analyse the liquidity of a firm.

iii)LEVERAGE RATIOS

The Capital Structure or Leverage Ratios or Solvency Ratios, throw light on the long term solvency of a
firm. This is reflected in its ability to assure the long-term creditors with regard to periodic payment of
interest, and the repayment of a loan on maturity or in pre-determined installments at due date. There
are two types of such ratios: i) Debt-equity or Debt assets, and ii) The first type is computed from the
Balance Sheet and reflects the relative contribution/stake of owners and creditors in financing the assets
of the firm. In other words, such ratios reflect the safety margin to the long-term creditors. The second
category of such ratios is based on the income statement and shows the number of times the fixed
obligations are covered by earnings before interest and taxes. They indicate, in other words, the extent
to which a fall in operating profits is tolerable in that the ability to repay would not be adversely
affected.

Activity Ratios

This category of ratios comprises the activity ratios which are also known as efficiency or turnover ratios.
Such ratios are concerned with measuring the efficiency in assets management. The efficiency with
which assets are managed or used is reflected in the speed and rapidity with which they are converted
into sales. Thus, activity ratios are a test of relationship between sales/cost of goods sold and assets.
Depending upon the type of asset, activity ratios may be 1) Inventory or Stock turnover ii) Receivables or
Debtors turnover, and ui) Total assets turnover. The first of these indicates the number of times
inventory is replaced during the year or how quickly the goods are sold. It is a test of efficiency of
inventory management. The second category of turnover ratios is indicative of the efficiency of
receivables management as it shows how quickly trading goods are sold. It reveals efficiency in
managing and utilising the total assets.