Elements of Accountancy · Ch 9 — Accounting Ratios
Types of Ratios
Types of Ratios
Two-Way Classification of Ratios
Ratios are classified in two ways: traditional classification (based on which financial statement the numbers come from) and functional classification (based on the purpose for which the ratio is calculated).
Traditional Classification (Based on Financial Statements)
This classification looks at the source of the two variables used in the ratio.
-
Statement of Profit and Loss Ratios
Both variables are taken from the Statement of Profit and Loss.
Example: Gross Profit Ratio = (Gross Profit / Revenue from Operations) × 100. Both gross profit and revenue from operations appear in the Statement of Profit and Loss.
-
Balance Sheet Ratios
Both variables are taken from the Balance Sheet.
Example: Current Ratio = Current Assets / Current Liabilities. Both figures come from the Balance Sheet.
-
Composite Ratios
One variable is from the Statement of Profit and Loss and the other from the Balance Sheet.
Example: Trade Receivables Turnover Ratio = Credit Revenue from Operations / Average Trade Receivables. Credit revenue is from the Statement of Profit and Loss; trade receivables are from the Balance Sheet.
Although this classification exists, it is rarely used in practice. The functional classification (below) is far more common because it directly serves the purpose of analysis.
Functional Classification (Based on Purpose)
The basic purpose of accounting is to reveal:
- Financial performance (profitability)
- Financial position (ability to raise and invest money wisely)
- Changes in financial position (explanations for changes in activity level)
Accordingly, ratios are grouped into four functional categories:
1. Liquidity Ratios
- Purpose: To measure the business's ability to pay its short-term obligations as they fall due.
- Nature: Short-term.
- Key idea: Liquidity means having enough liquid funds to meet dues to stakeholders on time.
2. Solvency Ratios
- Purpose: To measure the business's ability to meet its long-term contractual obligations, especially to external stakeholders.
- Nature: Long-term.
- Key idea: Solvency reflects the overall financial health and ability to survive in the long run.
3. Activity (or Turnover) Ratios
- Purpose: To measure how efficiently the business uses its resources (assets) to generate revenue.
- Also called: Efficiency Ratios.
- Key idea: These ratios show the speed with which assets are converted into sales or cash. …