Classification of financial ratios

Generally, financial ratios are classified on the basis of function or test, on the basis of financial statements, and on the basis of importance. These three classifications are briefly discussed below:

Classification of financial ratios on the basis of function:

On the basis of function or test, the ratios are classified as liquidity ratios, profitability ratios, activity ratios and solvency ratios.

Liquidity Ratios:

Liquidity ratios measure the adequacy of current and liquid assets and help evaluate the ability of the business to pay its short-term debts. The ability of a business to pay its short-term debts is frequently referred to as short-term solvency position or liquidity position of the business.

Generally a business with sufficient current and liquid assets to pay its current liabilities as and when they become due is considered to have a strong liquidity position and a businesses with insufficient current and liquid assets is considered to have weak liquidity position.

Short-term creditors like suppliers of goods and commercial banks use liquidity ratios to know whether the business has adequate current and liquid assets to meet its current obligations. Financial institutions hesitate to offer short-term loans to businesses with weak short-term solvency position.

Four commonly used liquidity ratios are given below:

  1. Current ratio or working capital ratio
  2. Quick ratio or acid test ratio
  3. Absolute liquid ratio
  4. Current cash debt coverage ratio

Unfortunately, liquidity ratios are not true measure of liquidity because they tell about the quantity but nothing about the quality of the current assets and, therefore, should be used carefully. For a useful analysis of liquidity, these ratios are used in conjunction with activity ratios (also known as current assets movement ratios). Examples of activity ratios are receivables turnover ratio, accounts payable turnover ratio and inventory turnover ratio etc.

Profitability ratios:

Profit is the primary objective of all businesses. All businesses need a consistent improvement in profit to survive and prosper. A business that continually suffers losses cannot survive for a long period.

Profitability ratios measure the efficiency of management in the employment of business resources to earn profits. These ratios indicate the success or failure of a business enterprise for a particular period of time.

Profitability ratios are used by almost all the parties connected with the business.

A strong profitability position ensures common stockholders a higher dividend income and appreciation in the value of the common stock in future.

Creditors, financial institutions and preferred stockholders expect a prompt payment of interest and fixed dividend income if the business has good profitability position.

Management needs higher profits to pay dividends and reinvest a portion in the business to increase the production capacity and strengthen the overall financial position of the company.

Some important profitability ratios are given below:

  1. Net profit (NP) ratio
  2. Gross profit (GP) ratio
  3. Price earnings ratio (P/E ratio)
  4. Operating ratio
  5. Expense ratio
  6. Dividend yield ratio
  7. Dividend payout ratio
  8. Return on capital employed ratio
  9. Earnings per share (EPS) ratio
  10. Return on shareholder’s investment/Return on equity
  11. Return on common stockholders’ equity ratio

Activity ratios:

Activity ratios (also known as turnover ratios) measure the efficiency of a firm or company in generating revenues by converting its production into cash or sales. Generally a fast conversion increases revenues and profits.

Activity ratios show how frequently the assets are converted into cash or sales and, therefore, are frequently used in conjunction with liquidity ratios for a deep analysis of liquidity.

Some important activity ratios are:

  1. Inventory turnover ratio
  2. Receivables turnover ratio
  3. Average collection period
  4. Accounts payable turnover ratio
  5. Average payment period
  6. Asset turnover ratio
  7. Working capital turnover ratio
  8. Fixed assets turnover ratio

Solvency ratios:

Solvency ratios (also known as long-term solvency ratios) measure the ability of a business to survive for a long period of time. These ratios are very important for stockholders and creditors.

Solvency ratios are normally used to:

  • Analyze the capital structure of the company
  • Evaluate the ability of the company to pay interest on long term borrowings
  • Evaluate the ability of the the company to repay principal amount of the long term loans (debentures, bonds, medium and long term loans etc.).
  • Evaluate whether the internal equities (stockholders’ funds) and external equities (creditors’ funds) are in right proportion.

Some frequently used long-term solvency ratios are given below:

  1. Debt to equity ratio
  2. Times interest earned (TIE) ratio
  3. Proprietary ratio
  4. Fixed assets to equity ratio
  5. Current assets to equity ratio
  6. Capital gearing ratio

Classification on the basis of financial statements:

Income statement/profit and loss ratios:

Income statement/profit and loss account ratios are those ratios that are calculated by using the items of income statement/profit and loss account of a particular period only. Examples of income statement/profit and loss account ratios are net profit ratio, gross profit ratio, operating ratio, and times interest earned ratio etc.

Balance sheet ratios:

Balance sheet ratios are those ratios that are calculated by using figures from the balance sheet only. The figures must be used from the balance sheet of the same period. Examples of balance sheet ratios are current ratio, liquid ratio, and debt to equity ratio etc.

Composite ratios:

These ratios are calculated by using the items of both income statement and balance sheet for the same period. Composite ratios are, therefore, also known as mixed ratios and inter-statement ratios. Numerous composite ratios are computed depending on the need of analyst. Some examples are inventory turnover ratio, receivables turnover ratio, accounts payable turnover ratio, and working capital turnover ratio etc.

Classification on the basis of importance:

On the basis of importance or significance, the ratios are classified as primary ratios and secondary ratios.  The most important ratios are called primary ratios and less important ratios are called secondary ratios. Secondary ratios are usually used to explain the primary ratios.

Examples of primary ratios for a commercial undertaking are return on capital employed ratio and net profit ratio because the basic purpose of these undertakings is to earn profit.

Importance of ratios significantly varies among industries therefore each industry has its own primary and secondary ratios. A ratio that is of primary importance in one industry may be of secondary importance in another industry.

Classification of ratios on the basis of importance or significance is very useful for inter-firm comparisons.

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18 Thoughts on Classification of financial ratios

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