Ratio analysis and interpretation Conventional and Functional classification
Traditional (Conventional) Classification
Traditional Classification has three types of ratios, namely
- Balance Sheet Ratios
- Profit and Loss Ratios
- Composite Ratios
Profit and Loss Ratios
When both figures are derived from the statement of Profit and Loss A/c we will call it a Profit and Loss Ratio. It can also be known as Income Statement Ratio or Revenue Statement Ratio. One such example is the Gross Profit ratio, which is the ratio of Gross Profit to Sales or Revenue. As you will notice, both these amounts will be derived from the Profit and Loss A/c. Other examples include Operating ratio, Net Profit ratio, Stock Turnover Ratio etc.
Balance Sheet Ratios
Just as above, if both the variables are obtained from the balance sheets, it is known as a balance sheet ratio. When such a ratio expresses the relation between two accounts of the balance sheet, we also call them financial ratios (other than accounting ratios).
Take for example Current ratio that compares current assets to current liabilities, both derived from the balance sheet. Other examples include Quick Ratio, Capital Gearing Ratio, Debt-Equity ratio etc.
Composite Ratios
A composite ratio or combined ratio compares two variables from two different accounts. One is taken from the Profit and Loss A/c and the other from the Balance Sheet. For example the ratio of Return on Capital Employed. The profit (return) figure will be obtained from the Income Statement and the Capital Employed is seen in the Balance Sheet. A few other examples are Debtors Turnover Ratio, Creditors Turnover ratio, Earnings Per Share etc.
Functional Classification
Then we move onto the functional classification. These help us group the ratios according to the functions they perform in our understanding and analysis of financial statements. This is a more accurate and useful classification of ratios, and hence more commonly used as well. The types of ratios according to the functional classification are
- Liquidity Ratio
- Leverage Ratios
- Activity Ratios
- Profitability Ratios
- Coverage Ratios
Liquidity Ratios
A firm needs to keep some level of liquidity, so stakeholders can be paid when they are due. All assets of the firm cannot be tied up, a firm must look after its short-term liquidity. These ratios help determine such liquidity, so the firm may rectify any problems. The two main liquidity ratios are Current ratio and Quick Ratio (or liquid ratio).
Leverage Ratios
These ratios show how well a company can pay back its long-term debt. So, they show how the owner’s money relates to the company’s debts. They actually show how a company will be able to pay its bills in the long run. They show if the company has enough assets to pay off all of its debts and all of its stakeholders. They are also called “solvency ratios” because of this. Some examples are the Debt Ratio, the Debt-Equity Ratio, the Capital Gearing Ratio, etc.
Activity Ratios
Activity ratios help measure the efficiency of the organization. They help quantify the effectiveness of the utilization of the resources that a company has. They show the relationship between sales and assets of the company. These types of ratios are alternatively known as performance ratios or turnover ratios. Some ratios like Stock Turnover, Debtors turnover, Stock to Working Capital ratio etc measure the performance of a company.
Profitability Ratios
These ratios provide an analysis of the earnings that a business has made. They evaluate the earnings in relation to the income, the cash used, or the assets of an organisation. These ratios provide an indication of the entity’s capacity to generate acceptable returns in relation to the amount of capital that is put to use. Even the validity of the choices and regulations pertaining to investments are scrutinised. The Operating Profit Ratio, the Gross Profit Ratio, the Return on Equity Ratio, and other similar metrics are some examples.
Demonstrates the relationship that exists between the actual profit made and the claims made by outside stakeholders. Even in the event that the company is put into liquidation, the law mandates that these stakeholders be compensated. Therefore, ratios of this kind ensure that sufficient funds are available to cover payments to third parties of this kind. The Dividend Payout Ratio, the Debt Service Ratio, and other similar metrics are all examples of coverage ratios.
