Ratio analysis and interpretation: Conventional and Functional classification

10/06/2020 1 By indiafreenotes

Traditional (Conventional) Classification

Traditional Classification has three types of ratios, namely

  • Balance Sheet Ratios
  • Profit and Loss Ratios
  • Composite Ratios

Profit and Loss Ratios

When both figures are derived from the statement of Profit and Loss A/c we will call it a Profit and Loss Ratio. It can also be known as Income Statement Ratio or Revenue Statement Ratio. One such example is the Gross Profit ratio, which is the ratio of Gross Profit to Sales or Revenue. As you will notice, both these amounts will be derived from the Profit and Loss A/c. Other examples include Operating ratio, Net Profit ratio, Stock Turnover Ratio etc.

Balance Sheet Ratios

Just as above, if both the variables are obtained from the balance sheets, it is known as a balance sheet ratio. When such a ratio expresses the relation between two accounts of the balance sheet, we also call them financial ratios (other than accounting ratios).

Take for example Current ratio that compares current assets to current liabilities, both derived from the balance sheet. Other examples include Quick Ratio, Capital Gearing Ratio, Debt-Equity ratio etc.

Composite Ratios

A composite ratio or combined ratio compares two variables from two different accounts. One is taken from the Profit and Loss A/c and the other from the Balance Sheet. For example the ratio of Return on Capital Employed. The profit (return) figure will be obtained from the Income Statement and the Capital Employed is seen in the Balance Sheet. A few other examples are Debtors Turnover Ratio, Creditors Turnover ratio, Earnings Per Share etc.

Functional Classification

Then we move onto the functional classification. These help us group the ratios according to the functions they perform in our understanding and analysis of financial statements. This is a more accurate and useful classification of ratios, and hence more commonly used as well. The types of ratios according to the functional classification are

  • Liquidity Ratio
  • Leverage Ratios
  • Activity Ratios
  • Profitability Ratios
  • Coverage Ratios

Liquidity Ratios

A firm needs to keep some level of liquidity, so stakeholders can be paid when they are due. All assets of the firm cannot be tied up, a firm must look after its short-term liquidity. These ratios help determine such liquidity, so the firm may rectify any problems. The two main liquidity ratios are Current ratio and Quick Ratio (or liquid ratio).

Leverage Ratios

These ratios determine the company’s ability to pay off its long-term debt. So they show the relationship between the owner’s fund and the debt of the company. They actually show the long-term solvency of a firm, whether it has enough assets to pay of all its stakeholders, as well as all debt on the Balance Sheet. This is why they are also called Solvency ratios. Some examples are Debt Ratio, Debt-Equity Ratio, Capital Gearing ratio etc.

Activity Ratios

Activity ratios help measure the efficiency of the organization. They help quantify the effectiveness of the utilization of the resources that a company has. They show the relationship between sales and assets of the company. These types of ratios are alternatively known as performance ratios or turnover ratios. Some ratios like Stock Turnover, Debtors turnover, Stock to Working Capital ratio etc measure the performance of a company.

Profitability Ratios

These ratios analyze the profits earned by an entity. They compare the profits to revenue or funds employed or assets of an entity. These ratios reflect on the entity’s ability to earn reasonable returns with respect to the capital employed. They even check the soundness of the investment policies and decisions. Examples will include Operating Profit ratio, Gross Profit Ratio, Return on Equity Ratio etc.

Coverage Ratios

Shows the equation between profit in hand and the claims of outside stakeholders. These are stakeholders that are required by the law to be paid, even in case of liquidation. So these types of ratios ensure that there is enough to cover these payments to such outsiders. Some examples of coverage ratios are Dividend Payout Ratio, Debt Service ratio etc.