A ratio is commonly known as a number that is calculated by comparing two or more numbers and can be expressed as a pure number, a percentage, a proportion, or even as a fraction. Accounting ratios are a way to compare different financial data so that the financial status of a company can be gauged. This is an effective tool used by shareholders, creditors, and other stakeholders who wish to understand the profitability and efficiency of a company. A two-way classification can classify these ratios.

Two-way Classification of Ratios

Accounting ratios can be classified in two ways classification of ratios:

  1. Traditional classification
  2. Functional classification

Traditional Classification

The ratios are classified based on the traditional classification the following way:

  • Statement of profit and loss ratios: When two variables are taken from the profit and loss statement, and their ratio is taken, it is known as a statement of profit and loss ratio. An example of this ratio would be the ratio between the gross profit and revenue from operations. Both the variables are taken from the statement of profit and loss.
  • Composite ratios: When a ratio is calculated by taking one variable from the statement of profit and loss and another ratio from the balance sheet, the resultant ratio is a composite ratio. An example of a composite ratio is the trade receivable turnover ratio. It is calculated between one figure from the profit and loss statement and one figure from the balance sheet.
  • Balance sheet ratios: When a financial ratio is calculated using figures from the balance sheet, it is known as a balance sheet ratio. The current ratio is an example of a balance sheet ratio. It is the ratio between current assets and current liabilities.

Functional Classification

In a two way classification of ratios, functional classification is the second-way financial ratios are classified. Following are the categories of this classification:

Liquidity Ratios 

This ratio indicates the ability of a company to pay off its short term liabilities. A good liquidity ratio shows that a company will pay off its creditors with ease in the short term. Two and above is considered a good liquidity ratio. Following are some of the commonly used liquidity ratios:

  • Current ratio: This ratio compares the current assets to the current liabilities. It indicates its ability to pay off its debts in a year. Formula: {(Current Assets)/(Current Liabilities)}
  • Quick ratio: This ratio is the acid test of a company’s ability to fulfil its liabilities. It is calculated using only those assets which are easy to liquidate. This ratio does not use inventory and prepaid assets.  Formula: {(Quick Assets)/(Current Liabilities)}
  • Cash ratio: Computed using only those assets that can be liquified immediately. Formula: {(Cash + Marketable securities )/(Current Liabilities)}

Profitability Ratios 

This ratio indicates a company’s ability to make profits. Following are the different kinds of profitability ratios:

  • Gross profit margin: This is an indicator of the efficiency of a business. Formula: {(Revenue – Cost of Goods Sold (COGS))/(Revenue)}
  • Operating margin: This ratio takes more expenses into account. Hence it is a more accurate measure of profitability. Formula: {(Gross Profits- Operating Expense)/(Revenue)}
  • Profit margin: Indicates the profit against the total revenue. Formula: {(Revenue – Operating expense + non-operating income-Interest Expense- Income taxes)/(Revenue)}
  • Earnings per share: This helps indicate the volume of return on investment. So it is helpful for investors and shareholders. Formula: {(Net Income – Preferred Dividend)/(Weighted Average Outstanding Shares)}

Leverage Ratios

This gives an idea of the company’s efficiency using borrowed money. It also indicates s firm’s ability to pay off its debts. Following are the types of leverage ratios:

  • Debt to equity ratio: This ratio is used by investors and shareholders to gauge the firm’s financial leverage. If this ratio is high, then it means that the firm is more dependent on borrowed money to operate. Formula: {(Total Debt)/(Total Equity)}
  • Debt to asset ratio: If this ratio is less than one, the company is considered a good investment. This ratio indicates if the company will have the capacity to pay off its loans if it is closed immediately. Formula: {(Total Debt)/(Total Asset)}
  • Debt ratio: This ratio indicates how many liabilities exist compared to the assets. Formula: {(Total Liabilities)/(Total Asset)}
  • Interest coverage ratio: A higher ratio indicates a good financial position. It measures a company’s ability to pay its interest-payment obligation. Formula: {(Earnings before interest and taxes (EBIT))/(Interest Expense)}

Activity or Efficiency Ratios

This ratio uses the sales, costs, and asset data to analyse the return from a particular type of asset. Below are the different activity ratios:

  • Receivable ratio: This ratio measures how quickly a company collects its receivables. Formula:{(Annual Sales Credit)/(Accounts Receivable)}
  • The inventory turnover ratio shows how quickly the inventory gets changed into cash. Formula: {(Cost of Goods Sold)/(Average Inventory)}
  • Asset turnover ratio: This ratio gauges the revenue generated percentage of the investment. Formula: {(Net Revenue)/(Assets)}

 Conclusion

Accounting ratios are a valuable tool in assessing a company’s past performance. On this basis, firms can make informed decisions to improve their performance and cut down on areas that reduce the company’s efficiency.