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.
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:
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 to Capital Employed 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 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 Ratio
1. What are Financial Statements?
Financial statements are written records that communicate the business activities and the financial performance of the company. Financial statements are generally audited by government agencies, accountants, firms, etc. this is done to ensure the accuracy of the statement so that it can be utilized for tax purposes, financing, or investing purposes. The financial statements include:
Cash flow statement.
2. What do financial ratios tell us about?
Financial ratios provide clues to the financial position of a business. These are the indicators of the financial strength, soundness, position, or weakness of an organization. With the help of the financial ratio, one can easily draw the financial position of a business.
3. Explain the significance of the current ratio?
The current ratio is defined as the ratio of current assets to current liabilities of a firm for a particular period. It represents the number of current assets available to firms for the repayment of current liabilities. Higher the current ratio, the greater is the short-term solvency of the firm and vice versa. However, a very high or low current ratio is a matter of concern. If the current ratio is very high, it implies that the current assets are lying idle whereas a very low current ratio implies that short-term solvency is not good for the organization.
4. How is the quick ratio different from the current ratio?
Both quick ratio and current ratio represent the firm abilities to meet the current debt obligation of the business. The difference between the current ratio and quick ratio is that while calculating the current ratio, current assets are considered whereas while calculating the quick ratio, quick asset or liquid assets are considered.
5. What do liquidity ratio, solvency ratio, and profitability ratio describe?
The liquidity ratio is the ratio that describes the firm's ability to meet its short-term obligations or liabilities, the solvency ratio describes the firm's ability to meet the long-term obligations or liabilities, and the profitability ratio is the ratio that describes the firm ability to generate profit.