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 are the 5 main types of ratios?
The five main types of ratios in financial analysis are
- Liquidity ratios
- Profitability ratios
- Activity ratios
- Solvency ratios
- Market value ratios
2. What are the 7 types of ratio analysis?
The seven types of ratio analysis include:
- Current ratio
- Quick ratio
- Debt-equity ratio
- Gross profit ratio
- Net profit ratio
- Inventory turnover ratio
- Return on equity (ROE)
3. What is the 3 type of ratio?
There are three primary types of ratios in financial statement analysis:
- Liquidity ratios
- Profitability ratios
- Solvency ratios
4. What are the six financial ratios?
The six financial ratios are:
- Current ratio
- Debt to equity ratio
- Return on assets
- Net profit margin
- Gross profit margin
- Inventory turnover
5. How do liquidity ratios help in financial analysis?
Liquidity ratios show whether a company can pay its short-term debts. These types of ratio, like the current ratio and quick ratio, compare assets to liabilities and help investors judge if a business can survive day-to-day financial demands.
6. Why are profitability ratios important?
Profitability ratios measure how efficiently a company turns sales into profits. This type of ratio examines factors like net profit margin and return on equity, which help investors and stakeholders assess how well a business generates earnings from its resources.
7. What do solvency ratios indicate in financial analysis?
Solvency ratios assess a company’s ability to pay long-term debts. This type of ratio, such as the debt-to-equity ratio, tells lenders and investors whether a business can meet its obligations even during tough economic conditions.
8. Can you explain activity ratios?
Activity ratios show how efficiently a company uses its assets to generate sales. This type of ratio, including inventory turnover and accounts receivable turnover, helps identify strengths or weaknesses in operations and asset management for a business.
9. How is the debt-to-equity ratio calculated?
The debt-to-equity ratio is a solvency ratio calculated as $$\text{Debt-to-Equity Ratio} = \frac{\text{Total Liabilities}}{\text{Shareholders' Equity}}$$. This ratio measures how much a company relies on borrowed money versus shareholders’ funds for financing its assets.
10. What is the importance of market value ratios?
Market value ratios help investors decide if a stock is overvalued or undervalued. This type of ratio, such as price-earnings ratio or book value per share, connects a company’s financial data to its share price in the stock market.
11. Which ratios help analyze a company’s short-term health?
Liquidity ratios like the current ratio and quick ratio are the main types of ratio used to check a company’s short-term health. They compare current assets to current liabilities, showing if the business can pay bills in the near future.
12. Are all types of ratio important for every industry?
No, not all types of ratio are equally important for every industry. For example, inventory turnover ratios matter more in retail, while banks focus on capital adequacy ratios. Businesses should choose financial ratios most relevant to their industry standards and operations.
