Classification of Ratios
Classification of Ratios
Classification of Ratios
Meaning of ratio
A ratio is only a comparison of the numerator with the denominator. The
term ratio refers to the numerical or quantitative relationship between two
figures. A ratio is the relationship between two figures, and obtained by
dividing the former by the latter. Ratios are designed to show how one
number is related to another. It is worked out by dividing one number by
another.
1.Liquidity ratios –
With the help of ratio analysis conclusions can be drawn
regarding the liquidity position of firm. The liquidity position of the firm would
be satisfactory if it is able to meet its current obligations when they become
due. A firm can be said to have the ability to meet its short term liabilities if it
has sufficient liquid funds to pay the interest on its short term maturing debt
usually within a year as well as to repay the principal. This ability is reflected
in the liquidity ratios of firm. The liquidity ratios are particularly useful in
credit analysis by banks &other supplier of short term loans.
2. Operating efficiency-
4. Overall profitability-
Unlike the outside parties which are interested in one aspect of the
financial position of a firm, the management is constantly concern about the
overall profitability of the enterprise. That is, they are concerned about the
ability of the firm to meet its short terms as well as long term obligation to its
creditors, to ensure reasonable returns to its owners and secure optimum
utilization of the assets of the firm. This is possible if an integrated view s
taken and all the ratios are considered together
Ratio analysis not only throws light on the financial position of a firm but also
serves as a stepping stone to remedial measures. This is made possible due
to inter firm comparison with industry average. A single figure of particular
ratio is meaningless unless it is related to some stander or norms. One of the
popular techniques is to compare the ratio of the firm with the industry
average. It should be reasonably expected that the performance of the firm
should be in broad conformity that of the industry to which it belongs. An
inter firm comparison would demonstrate the relative position vis-à-vis its
competitors. If the results are at variance either with the industry average or
with those of the competitors, the firm can seek to identify the probable
reasons and, in that light, take remedial measures.
6. Trend analysis-
Finally, ratio analysis enables the firm to take the time dimension into
account .in other words, it enables us to know whether the financial position
of a firm is improving or deteriorating over the years. This is made possible
by the use of trend analysis. The significance of trend analysis of the ratios
lies in the fact that the analysis can know the direction of movement, that is,
whether the movement is favorable or unfavorable. For example the ratio
can be low as compared to the norms/standard but the trend may be
upward. On the other hand, though the present level may be satisfactory but
the trend may be declining one. Thus, trend analysis is of great significance.
Classification of ratios:
Financial ratios have been classified in several ways. A number of
standpoints may be used as base for classifying the ratios. It is a matter of
great surprise that no uniformity has been achieved in this regard. Different
authors have classified the ratios in varying groups. To illustrate, the short-
term creditors main interest in the long-term solvency and profitability
analysis of the firm’s financial conditions; management is interested in
evaluating every activity of the firm because they have to protect the
interests of all parties. Thus accounting ratios may be classified on the
following bases leading to somewhat overlapping categories.
Classification by statements
• between companies
• between industries
• between different time periods for one company
• between a single company and its industry average
The ratios of firms in different industries, which face different risks, capital
requirements, and competition, are not usually comparable.
Profit and loss account ratio: profit earning is the main objective of each
business concern. A company should earn profits to survive and to grow over
long period. A measure of profitability is the overall measure of efficiency.
Profitability and profits are two different elements. Profit refers to the
absolute quantum of profit whereas profitability refers to the ability to earn
profits. It is a test of efficiency and a measure of control to the management.
It is a measure of the worth of owner’s investment. It is the margin of safety
to creditors. It is a source of fringe benefits to employees. Profit is a measure
of taxpaying capacity to the government. To customers, it is a hint to
demand for better quality and price cuts. Operation ratios and activity ratios
or efficiency ratios are calculated to measure the profitability of an
enterprise.
There are two types of profitability ratios. They are profit margin ratios and
rate of return ratios. Profit margin ratios show relationship between profit
and sales. Rate of return ratios reflect the relationship between profit and
investments.
12. Changing policies: Ratios are computed on the basis of past result.
Past is not an indicator of future. Ratios computed from historical data
are used for predicting and projecting the likely events in the future.
Such ratios may provide a glimpse of firm’s past performance. But
forecast for the future may not be correct as several other factors like
management policies, market conditions etc. may induce future
operations.
13. No exactness: Financial standard data are not exact, and have,
therefore, to be treated with great caution.
14. Ratios are likely to be misused. There are some situations in which
they may appear to be misleading.
15. V.V. Desai point out that the advancing artistry of the technique of
ratio analysis has miserably failed to accomplish the expected
impeccability or immaculacy. Moreover, it has made the technique
more complicated and complex far beyond the understanding of
ordinary businessmen.