2 methods in which ratios are categorised. Here is the traditional method, where ratios are divided on the source of the accounting statement from where they are received. The second is functional distribution, grounded on the merits of the financial ratios and the idea for which they are computed. Financial ratios can be classified into 2 types :
- Traditional classification
- The Functional classification
The traditional division has been on the grounds of financial statements to which the determinants of ratios belong. On this principle the ratios are categorised as follows :
- Profit and Loss Ratio: A ratio of 2 variables from the financial statement of P&L is referred to as a statement of P&L ratio. For instance, the proportion of gross profit to revenue from transactions is referred to as the gross profit ratio. It is computed utilising both figures from the statement of P&L.
- Composite Ratio: If a ratio is calculated with 1 variable from the record of P&L and another variable from the B/S, it is known as a composite ratio. Say, for instance, the ratio of credit revenue of transactions to trade receivables (also known as trade receivables turnover ratio) is computed utilising 1 figure from the statement of P&L (credit revenue from operations) and another figure (trade receivables) from the B/S.
- Balance Sheet Ratio: In case both the variables are from the balance sheet, it is called B/S ratios. For instance, the ratio of current assets to current liabilities is referred to as the current ratio. It is computed utilising both figures from the B/S.
The functional categorisation has been on the grounds of financial statements to which the determinants of ratios belong. On this principle the ratios are categorised as follows:
- Liquidity Ratios: An enterprise has to maintain some degree of liquidity, in order to pay the shareholders their share when they are outstanding. Assets of the enterprise cannot be firmed up, an enterprise must take care of its short-term liquidity. Such ratios assist manage such liquidity, so the enterprise may correct any issues. The 2 principal liquidity ratios are – Quick Ratio (or liquid ratio) and Current Ratio.
- Leverage Ratios: Leverage ratios ascertain the enterprise’s capability to pay its long-term deficit. So they determine the association between the owner’s capital and the liability of the organisation. They truly determine the long-term financial health of an enterprise, whether it has sufficient assets to repay all its shareholders, as well as all liability on the B/S. This is the reason they are known as Solvency ratios. Some instances are Debt-Equity Ratio, Debt Ratio, Capital Gearing ratio, etc.,
- Profitability Ratios: Profitability ratios examine the gains earned by an enterprise. They connect the profits to revenue or capitals applied or assets of an enterprise. These ratios mirror on the enterprise’s capability to obtain consistent returns with regard to the funds utilised. They even check the correctness of the financing strategies and choices. Instances will involve Gross Profit Ratio, Return on Equity Ratio Operating Profit ratio, etc.,
- Activity Ratios: Activity ratios assist to compute the performance of the business. They assist measure the efficiency of the employment of the resources that a firm has. They depict the association between assets and sales of the enterprise. Those types of ratios are preferably called turnover ratios or performance ratios. A few ratios like Stock to Working Capital ratio, Stock Turnover, Debtors turnover, etc., compute the production of a firm.
The above mentioned is the concept, that is elucidated in detail about the Types of Financial Ratios for the class 12 Commerce students. To know more, stay tuned to BYJU’S.