A ratio is a relationship between two quantities, attained by dividing one quantity by the other. Financial/accounting ratios help analysts make meaningful comparisons between one firm’s financial data at different points in time and that of other companies. An accounting ratio is simply one accounting figure expressed in terms of another. To calculate a ratio, therefore, one needs two figures. These two figures should be very carefully selected so that the resulting ratio, or the percentage, carries meaning and usefulness for decision-making purposes. A ratio may take any of the following forms: Financial statements such as income statements and balance sheets are of limited value as sources of information. This is because they only summarize what has happened in a business using certain accounting conventions. For example, a reported profit of $50,000 or a sales figure of $100,000 conveys very little about the performance of a company. However, if these figures are expressed as ratios, in the form of a percentage or a rate, then they have more meaning. Also, ratios have more meaning when compared to benchmarks. Benchmarks show the trend of a ratio over time, or they could be industry averages for firms of a similar size, background, or other characteristics. Hence, some important aspects to keep in mind when analyzing accounting ratios are: Accounting or financial ratios can be broadly classified into two groups: Performance-related ratios can be further classified into three groups: trading ratios, profitability ratios, and dividend ratios. These ratios relate to the trading aspect of the business. They are intended to help the management assess the effectiveness of the company’s pricing policy, stock carrying, and speed of stock turnover. The main trading ratios are: As the name implies, these ratios help management in assessing the company’s overall profitability. The important profitability ratios are: Dividend ratios disclose the company’s dividend policy (i.e., to what extent does it distribute or retain its profits?). The ratios include: Position-related ratios fall into two sub-groups: capital-related ratios and liquidity-related ratios. These ratios relate to the company’s capital structure. They show the relationship of each class of capital employed to the total capital employed. The important capital ratios are: These ratios reflect the company’s ability to meet its current liabilities out of current assets. The most commonly used liquidity ratios are:What Is a Financial/Accounting Ratio?
Analysis of Accounting Ratios
Classification of Accounting Ratios
Performance-related ratios
Trading ratios
Profitability ratios
Dividend ratios
Position-related ratios
Capital-related ratios
Liquidity-related ratios
Accounting Ratios and Their Classification FAQs
Accounting ratios are mathematical expressions that compare two or more company financial statements with the aim of gaining insight into its performance, liquidity, debt-paying ability and profitability.
Accounting ratios can be broadly classified as liquidity ratios, solvency ratios, profitability ratios, activity/efficiency ratios and coverage/leverage ratios.
Liquidity ratio measures a company’s ability to pay off short-term liabilities with current assets like cash and equivalents, accounts receivable and inventory. Examples include Current Ratio and Quick Ratio.
Solvency ratios measure a company’s ability to meet its long-term debt obligations. Examples include Debt Ratio, Debt to Equity Ratio and Interest Coverage Ratio.
Profitability ratios measure how successful the company has been in generating profits on its investments in assets or operations as compared to sales revenue. Examples include Gross Profit Margin, Operating Profit Margin and Net Profit Margin.
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.
To learn more about True, visit his personal website or view his author profiles on Amazon, Nasdaq and Forbes.
