Classification of financial ratios

Generally, financial ratios are classified on the basis of function or test, on the basis of financial statements, and on the basis of importance. These three classifications are briefly discussed below:

Classification of financial ratios on the basis of function:

On the basis of function or test, the ratios are classified as liquidity ratios, profitability ratios, activity ratios and solvency ratios.

Liquidity Ratios:

Liquidity ratios quantitatively measure the adequacy of current and liquid assets and help evaluate the ability of a business to meet its short-term debts. The ability of a business entity to pay its short-term debts is frequently referred to as short-term solvency position or liquidity position of the entity.

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 a weak liquidity position.

Short-term creditors like suppliers of goods and commercial banks use liquidity ratios to know whether or not 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.

Four commonly used liquidity ratios are given below:

1. Current ratio or working capital ratio
2. Quick ratio or acid test ratio
3. Absolute liquid ratio
4. Current cash debt coverage ratio

Unfortunately, liquidity ratios are not true measure of liquidity because they tell about the quantity but nothing about the quality of the current assets and, therefore, should be used with caution. For a useful analysis of liquidity, these ratios are used in conjunction with activity ratios (also known as current assets movement ratios). Examples of activity ratios are receivables turnover ratio, accounts payable turnover ratio and inventory turnover ratio etc.

Profitability ratios:

Generating profit for the owners is the primary objective to operate commercial entities. Regardless of size and industry, a business entity needs a consistent improvement in its profit making ability to survive and prosper. A business that continually suffers loss cannot survive for a longer period of time.

Profitability ratios measure the efficiency of management in the employment of business resources to earn profits and indicate the success or failure of a business enterprise for a particular period of time. Almost all the parties connected with the business use these ratios as per their analysis needs.

A strong profitability position ensures common stockholders a higher and timely dividend income and a future appreciation in the value of shares they hold. It ensures creditors a prompt payment for the goods and services delivered to the entity. The stakeholders like banks and other financial institutions that provide loan can expect a timely repayment of principal amount lent and interest earned thereon if the entity exhibits a well performance in terms of profitability. Consequently, they would not hesitate to extend loan to the entity.

Management needs higher profits to pay dividends to stockholders as well as reinvest a portion back into the business to increase the production capacity and strengthen the overall financial position of the company.

Some important profitability ratios are listed below:

1. Net profit (NP) ratio
2. Gross profit (GP) ratio
3. Price earnings ratio (P/E ratio)
4. Operating ratio
5. Expense ratio
6. Dividend yield ratio
7. Dividend payout ratio
8. Return on capital employed ratio
9. Earnings per share (EPS) ratio
10. Return on shareholder’s investment/Return on equity
11. Return on common stockholders’ equity ratio

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. A fast conversion generally increases both revenues and profits.

Activity ratios show how frequently the assets are converted into cash or sales and are, therefore, frequently used in conjunction with liquidity ratios for a deep analysis of entities’ liquidity status.

Some important activity ratios are:

1. Inventory turnover ratio
2. Receivables turnover ratio
3. Average collection period
4. Accounts payable turnover ratio
5. Average payment period
6. Asset turnover ratio
7. Working capital turnover ratio
8. Fixed assets turnover ratio

Solvency ratios:

Solvency ratios (also known as long-term solvency ratios) measure the ability of a business to survive for a longer period of time. These ratios are very important to win the trust stockholders and creditors.

Solvency ratios are normally used to:

• Analyze the capital structure of the entity.
• Evaluate the ability of the entity to pay interest on its long term borrowings.
• Evaluate the ability of the the company to repay principal amount of the long term loans obtained from any source. These include debentures, bonds, medium and long term loans taken from financial institutions etc.
• Evaluate whether the internal equities (i.e., stockholders’ funds) and external equities (i.e., creditors’ funds) are in right proportion.

Some frequently used long-term solvency ratios are given below:

1. Debt to equity ratio
2. Times interest earned (TIE) ratio
3. Proprietary ratio
4. Fixed assets to equity ratio
5. Current assets to equity ratio
6. Capital gearing ratio

Classification of ratios on the basis of financial statements:

On the basis of financial statements, the ratios are classified as income statement ratios, balance sheet ratios, and composite ratios.

Income statement/profit and loss ratios:

Income statement/profit and loss account ratios are those ratios that are calculated by using the items from income statement/profit and loss account of a particular period. Some common examples of income statement/profit and loss account ratios are net profit ratio, gross profit ratio, operating profit ratio, expense 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 used must be taken 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 from 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 the analysts or investors. Some examples composite ratios are inventory turnover ratio, receivables turnover ratio, accounts payable turnover ratio, and working capital turnover ratio etc.

Classification of ratios on the basis of importance:

On the basis of importance or significance, the financial ratios are classified as primary ratios and secondary ratios. The most important ratios for an undertaking are called its primary ratios and less important ratios are called secondary ratios. Secondary ratios are usually used to further explain the outcomes or results generated by primary ratios.

The importance of a ratio mainly depends on two factors – the core purpose of establishing an entity and the analyst’s need of analysis. For example, the return on capital employed ratio and net profit ratio are the primary ratios for a commercial undertaking because the basic purpose of these undertakings is to earn profit. Similarly, if the purpose is to test the liquidity of a business, then the liquidity ratios like current ratio and quick ratio would be among the most significant ratios for the analyst.

The importance of ratios also significantly varies among industries. Different industries have different set of primary and secondary ratios. A ratio that is of primary importance in one industry may be of secondary importance in another industry. Classification of ratios on the basis of importance or significance is much useful for inter-firm comparisons.