Q.How are accounting ratios classified? Explain briefly.

Ratios are grouped by the kind of question they help answer about a firm — some are about paying bills soon, others about paying debts far in the future, others about efficiency, and others about earnings.

Accounting ratios are classified into four broad categories: Liquidity Ratios (assess ability to meet short-term obligations), Solvency Ratios (assess ability to meet long-term obligations and how the firm is financed), Activity/Turnover Ratios (assess efficiency in using assets), and Profitability Ratios (assess overall earning capacity).

Accounting ratios are broadly classified into four categories, based on the specific aspect of financial health each is designed to reveal:

1. Liquidity Ratios — assess whether the firm has sufficient short-term (current) resources to meet its immediate obligations; examples are the Current Ratio and the Quick (Acid-Test) Ratio.
2. Solvency Ratios — assess the firm's ability to meet its long-term obligations, and reveal how much of its assets are financed by debt versus owners' funds; examples are the Debt-Equity Ratio, Total Assets to Debt Ratio, Proprietary Ratio, and Interest Coverage Ratio.
3. Activity (Turnover) Ratios — assess how efficiently the firm uses its assets (inventory, receivables, payables, working capital) to generate sales; examples are the Inventory Turnover Ratio, Trade Receivables Turnover Ratio, Trade Payables Turnover Ratio, and Working Capital Turnover Ratio.
4. Profitability Ratios — assess the firm's overall earning capacity, both as a margin on sales and as a return on capital invested; examples are the Gross Profit Ratio, Operating Ratio, Net Profit Ratio, and Return on Investment.

This four-way classification is useful precisely because a firm can be strong on one dimension and weak on another — for instance, a highly profitable firm could still face a liquidity crunch — so a complete financial analysis draws on ratios from all four categories rather than relying on just one.

Students sometimes name only two or three categories and forget Activity/Turnover Ratios, perhaps because these ratios are less familiar than liquidity or profitability measures — remember all FOUR categories (Liquidity, Solvency, Activity, Profitability) for a complete classification answer.