Lear NEOnlne Types of Ratio 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: 1. Statement of Profit and Loss Ratios:Lear NEOnlne 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. XN 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. » . Composite Ratios: 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: 1. 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 ie. the firm's ability to meet its current obligations. The most common type of liquidity ratios are: + Current Ratio * Quick or Liquid RatioLear NEOnlne 2. 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 Equity Ratio + Debt to Capital Employed Ratio + Proprietary 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 tumover 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:Lear NEOnlne * Gross Profit Ratio * Operating Ratio + Operating Profit Ratio * Net Profit Ratio + Retum on Investment (RO!) 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: Liquidity Ratio Formulas Current Asset Current Ratio |} ————_— Current Liabilities Quick Ratio | Quick Asset __ Current Liabilities Liquid Asset Liquid Ratio ow a ee” a Current Liabilities Solvency Ratios Debt Equity | Long-Term Debts Ratio Shareholders FundsLear NEOnlne Debt to Capital Employed Ratio Capital Employed or Net Assets Proprietary ratio Shareholders Funds Capital Employed or Net Assets Total Asset to Total Assets Debt Ratio Long - Term Debts Halen Net Profit Before Interest And Tax Ratio Interest on Long - Term Debts Activity or Turnover Ratios iy Cost of Revenue From Business Operations Rao ‘Average Inventory Net Credit Revenue From Business Operations Trade Average Trade Receivables Receivable Turnover Here, Average Credit Receivables = Ratio Opening Debtors and Bill Receivables + Closing Debtors and Bills 2 Net Credit Purchase Trade Average Trade Payables Payable Ratio Here, Average Credit Payables = Turnover Ratio Opening Debtors and Bill Payables + Closing Debtors and Bills 2Lear NEOnlne Net Asset or Capital Employed - Turnover Capital Employed Ratio Tred Asset Net Revenue From Business Operations Ratio Net Fixed Assets Working Capital Net Revenue From Business Operations Turnover Working Capital Ratio Profitability Ratios Gross Profit Ratio Gross Profit ooo x «100 Net Revenue of Business Operations * Operating Cost of Revenue From Business Operations + Operating Expen: Ratio Net Revenue From Business Operations Operating Profit Sn GL DL Le 100: Operating | Revenue From Business Operations Profit Ratio Here, Operating Profit = Revenue From Business Operations Operating Cost Net Profit Net Profit x 100 Ratio Revenue From Business Operations Return on Investment (ROD or | Profit Before Interest And Tax ~~ 100 Capital Capital Employed Employed (ROCE)Lear NEOnlne Return on Net Worth (RONW) or Return on Shareholder's Fund Tore Aree Shareholders Fund * 1°° Earnings Per Profit Available For Equity Shareholders Share Number of Equity shares Book Value | Equity Shareholders Fund Per Share Number of Equity shares Dividend Dividend Per Share Payout Ratio | Earning Per Share Price Eaming | Market Price of Share Ratio Earning Per ShareVedaniti, Lear UNE Online Hi Surya, Best courses for you Full syllabus LIVE Crash course courses Starting from £86,000 Starting rom €6.249 Starting from £13,333 One-to-one LIVE classes Starting from €0tu Show more coursesLear NEOnlne Book your Free Demo session Get a flavour of LIVE classes here at Vedantu Vedantu Improvement Promise We promise improvement in marks or get your fees back. 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