Read this article to learn about the five methods of classification of ratios.
This classification is based on the nature of accounting statement on which the items used for compiling ratios appear.
Accordingly, the different subdivisions are:
These ratios are also called as financial ratios. The components or items for computation of these ratios are drawn from the Balance Sheet.
Current Ratio (items used for computation are current assets and current liabilities), Debt-Equity Ratio (items are long-term debts and shareholders’ funds).
These ratios are also called as operating ratios. The items used for the calculation of these ratios are usually taken out from the income statement i.e., trading and Profit and Loss Account. Examples are Gross Profit ratio, Net Profit Ratio, Operating Ratio, etc.
The information required for the computation of these ratios is normally drawn from both Balance Sheet and Trading and Profit and Loss Account. Examples are Debtors Turnover Ratio, (i.e., a debtor is balance sheet item and credit sales are trading account item). Stock Turnover Ratio, (stock is balance sheet item and cost of sales is trading account item.
This classification is based on the point of time in relation to which ratios are compiled. Accordingly, they may be classified as follows:
The data used for the computation of these ratios normally relate to the same point of time, e.g., ratios of a particular month, quarter or year. In this sense, the balance sheet ratios, and the income statement ratios of a particular year may be termed as structural ratios.
These ratios are computed between items over a period of time and used for the analysis. For example, current ratios for a period of 10 years may be calculated and the trend (long-term changes) observed from these ratios may be used for the analysis.
Some ratios when related to the main objective of the business for the purpose of analysis may be more important than others.
The British Institute of Management has recommended this basis of classification for inter-firm comparisons, and the Institute has suggested the following types:
The prime motive of any business undertaking is profit and therefore, ratios like Profit to Sales, Return on Capital employed may be termed as primary ratios for such undertaking.
These ratios are mainly used to explain the primary ratios. They are also known as subsidiary or supporting ratios.
Taking the ratio of Return on Capital employed as the primary ratio, the following ratios may be grouped as secondary ratios:
(a) Profit and earnings ratios;
(b) Cost or Expense ratios;
(c) Capital and related ratios and Turnover Ratios.
Robert N. Antony suggested that ratios may be grouped on the basis of certain tests, which satisfy the needs of the parties having financial interest in the business concern.
These tests are:
(i) Test of Liquidity
(ii) Test of Profitability and
(iii) Market tests
Under this classification, ratios are grouped as follows:
These ratios are used to measure the ability of the firm to meet its maturing obligations or current liabilities.
Current Ratio, Acid Test Ratio.
These ratios help to measure the financial contribution of the owners compared to that of creditors, as also the risk of debt financing. They are also known as Capital Structure Ratios.
Debt to Equity ratio, Fixed Assets to Net Worth, Interest Coverage Ratio.
These ratios enable measurement of the effectiveness of the usage of resources at the command of the concern.
Fixed Assets Turnover Ratio, Stock Turnover Ratio. These ratios would also indicate the profitability position of the business.
These ratios are intended to measure the end result of business operations.
Gross Profit Ratio, Return on Capital employed, and Operating Ratio.
From the above discussion, it may be observed that one basis of classification blends into another. Whatever classification is followed, the ratios should be computed carefully and presented to the management and other interested parties at regular intervals.