Accounting Ratios Meaning
Accounting ratios are an important business tool for analyzing financial statements. A ratio is defined as a mathematical number that can be calculated with respect to the relationship of two or more numbers and can be expressed as a ratio, percentage, and fraction. When a ratio is calculated by relating two accounting numbers derived from the financial statements, it is termed as an accounting ratio or financial ratio.
It should be noted that accounting ratios represent the relationship between if any, the accounting numbers derived from the financial statement. Accounting ratios are essentially derived from the financial statements and their efficiency largely depends on the original numbers from which they are calculated. Therefore, if there are any errors found in the financial statements, the derived numbers in relation to the ratio analysis would also present an incorrect imprecise situation. Therefore, the ratios must be calculated using the numbers which are meaningfully associated because a ratio calculated using the two unrelated numbers would hardly serve any purpose. For example, the office furniture is Rs. 5,00,000 and their purchase is 10,00,000. The ratio of office furniture to purchase is 2 (5,00,000/10,00,000) but it hardly served any purpose as there is no relationship between the two aspects.
What are Accounting Ratios?
Accounting ratio, also known as the financial ratio, is the comparison of two or more financial data which are used to evaluate a business condition. It is an effective business tool that is used by shareholders, creditors, and all kinds of stakeholders to understand the profitability, strength, and financial status of a business. Accounting ratios are also widely used to examine business performance and accordingly business decisions can be made.
What are the Different Types of Accounting Ratios?
Ratios are classified into two types namely traditional classification and functional classification. The traditional classification is based on the financial statement to which the determinants belong. Based on the traditional classification, ratios are classified as:
Statement of Profit and Loss Ratios:
A ratio of two variables from the profit and loss statements is termed the statement of profit and loss ratio. For example, the ratio of gross profit to revenue generated from business operations is referred to as the gross profit ratio. It is calculated using both the figures derived from the profit and loss statement.
Balance Sheet Ratios:
If both the variables of the ratios are from the balance sheet, then it is classified as the balance sheet ratios. For example, the ratio of current assets to current liabilities is termed the current ratio. It is calculated using both the figures derived from the balance sheet.
Composite Ratios:
If the ratios are calculated using one variable from the financial statement and another variable from the balance sheet, then it is termed composite ratios. For example, the ratio of credit revenue from business operations to trade receivables is termed the trade receivable turnover ratio. It is calculated using one variable from the profit and loss statement (credit revenue from business operations) and another variable (trade receivables) from the balance sheet statement.
On the Basis of Functional Classification, Ratios Are Classified as:
Liquidity Ratios: To meet business commitments, the business needs liquid funds. The ability of a business to pay the due amount to stakeholders as to when it is due is known as liquidity; the ratios calculated to measure it are known as liquidity ratios. The liquidity ratios are short-term in nature. They are calculated to measure the short-term solvency of the business i.e. the firm's ability to meet its current obligations. The most common type of liquidity ratios are:
Current Ratio
Quick or Liquid Ratio
Solvency Ratio: The business solvency is determined by its ability to meet its contractual obligations towards stakeholders, specifically towards external stakeholders, and the ratios calculated to measure the business solvency positions are known as the solvency ratio. The solvency ratios are long-term in nature. The most common type of solvency ratio for calculating the business solvency are:
Debt-Equity Ratio
Debt to Capital Employed Ratio
Proprietary ratio
Total Asset to Debt Ratio
Interest Coverage Ratio
Activity or Turnover Ratio: These are the ratios that are calculated for measuring the efficiency of business operations based on the effective utilization of resources. Hence, these are also termed efficiency ratios. A higher turnover ratio means better utilization of assets and signifies improved business efficiency and profitability. The most important types of activity ratios are:
Activity Turnover Ratio
Trade Receivable Turnover Ratio
Trade Payable Turnover Ratio
Net Asset or Capital Employed Turnover Ratio
Fixed Asset Turnover Ratio, and
Working Capital Turnover Ratio
Profitability Ratios: Profitability ratios are referred to as analysis of business profits in relation to the revenue generated from the business operations ( or funds) or assets used in the business and the ratios calculated to meet its objectives are termed as profitability ratios. The most common types of profitability ratios that are used to analyze the profitability of the business are:
Gross Profit Ratio
Operating Ratio
Operating Profit Ratio
Net Profit Ratio
Return on Investment (ROI) or Return on Capital Employed (ROCE)
Return on Net Worth (RONW)
Earnings Per Share
Book Value Per Share
Dividend Payout Ratio
Price Earning Ratio
Accounting Ratio Formulas
Here, we will list the formulas of all the accounting ratios on the basic functional classification discussed above:
FAQs on Types of Ratios: Financial Analysis Made Easy
1. What is the main purpose of calculating financial ratios?
The main purpose of calculating financial ratios is to analyse a company's financial statements to understand its performance and health. It helps in evaluating various aspects like a company's ability to pay its short-term debts (liquidity), its long-term financial stability (solvency), and its efficiency in generating profits (profitability).
2. What are the major types of ratios used in financial analysis?
Financial ratios are generally classified into four main categories, each providing a different insight into the company's operations:
- Liquidity Ratios: These measure a firm's ability to meet its short-term obligations. Examples include the Current Ratio and Quick Ratio.
- Solvency Ratios: These assess a company's ability to meet its long-term debt obligations. Examples include the Debt-to-Equity Ratio.
- Activity (or Turnover) Ratios: These show how efficiently a company is using its assets. An example is the Inventory Turnover Ratio.
- Profitability Ratios: These measure a company's ability to generate earnings. Examples include the Gross Profit Ratio and Net Profit Ratio.
3. How is the Quick Ratio different from the Current Ratio?
Both the Current Ratio and the Quick Ratio measure a company's short-term liquidity. The key difference lies in the assets considered. The Current Ratio includes all current assets, while the Quick Ratio (also called the Acid-Test Ratio) excludes inventory and prepaid expenses. This makes the Quick Ratio a more conservative or strict measure of a company's ability to pay its immediate liabilities without relying on selling its stock.
4. How can an investor use profitability ratios to compare two different companies?
An investor can use profitability ratios like the Net Profit Ratio or Return on Investment (ROI) to compare the financial performance of two companies in the same industry. By comparing these ratios, an investor can determine which company is more efficient at converting its revenue into actual profit. A consistently higher profitability ratio suggests better management, operational efficiency, and a stronger competitive position.
5. Can a very high current ratio be a negative sign for a business?
Yes, a very high current ratio can be a negative sign. While it indicates strong liquidity, it might also suggest that the company is not using its assets efficiently. For example, it could mean that a large amount of cash is sitting idle instead of being invested, or that there is too much inventory not being sold, which can lead to storage costs and potential obsolescence. A good balance is ideal.
6. What do solvency ratios tell us that liquidity ratios don't?
While liquidity ratios focus on a company's ability to cover its short-term debts (due within a year), solvency ratios focus on its ability to survive over the long term. Solvency ratios, like the Debt-to-Equity ratio, show how much the company relies on debt for its financing. They help assess whether a company can meet its long-term obligations and withstand economic downturns, providing a picture of its long-run financial stability.
7. How do different types of ratios work together to provide a full financial picture?
No single ratio can tell the whole story. They must be used together. For instance, a company might have a strong profitability ratio, suggesting it makes good profits. However, a poor liquidity ratio could reveal it doesn't have enough cash to pay its bills on time. Similarly, a high debt-to-equity ratio might show that its profits are generated using a risky amount of debt. Analysing all types of ratios together gives a balanced and comprehensive view of a company's strengths and weaknesses.
