CLASSIFICATION OF RATIOS ON THE BASIS OF FUNCTION
On the basis of function , 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.
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.
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.
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 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.
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.
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