Ratio: Meaning, Interpretation, Guidelines and Classification | Financial Analysis (2024)

Let us make an in-depth study of the meaning, interpretation, guidelines and classification of ratio.

Meaning of Ratio:

A ratio is a simple arithmetical expression of the relationship of one number to another. It may be defined as the indicated quotient of two mathematical expressions. According to Accountant’s Handbook by Wixon, Kell and Bedford, a ratio “is an expression of the quantitative relationship between two numbers'” According to Kohler, a ratio is the relation, of the amount, a, to another, b, expressed as the ratio of a to b; a: b (a is to b) ; or as a simple fraction, integer, decimal, fraction or percentage.”

In simple language ratio is one number expressed in terms of another and can be worked out by dividing one number into the other. For example, if the current assets of a firm on a given date are 5,00,000 and the current liabilities are Rs 2,50,000, then the ratio of current assets to current liabilities will work out to be 5,00,000/2,50 000 = 2.

Such type of ratios are called simple or pure ratios. A financial ratio is the relationship between two accounting figures expressed mathematically. A ratio can also be expressed as percentage by simply multiplying the ratio by 100. As in the above example, the ratio is 2 x 100 or 200% or say current assets are 200% of current liabilities.

It is also expressed as a proportion for example, ratio of current assets to current liabilities is, say, 5, 00,000 : 2,50,000 or 2 : 1. Some analysts also express ratio as a ‘ rate’ or ‘time’. For example, the ratio of stock turnover is, say 50,000/10,000 or 5 times which simply conveys that stock has been turned over 5 times. In the example given above (current assets Rs 5, 00,000 and current liabilities Rs. 2, 50,000 we can say that the ratio is 2 times.

Thus, the ratio of two figures 200 and 100 may be expressed in any of the following ways:

(a) 2:1

(b) 2

(c) 2/1

(d) 2 to 1

(e) 200%

In all these cases the inference is that the first figure is double, 200% or 2 times than that of the second. Ratios provide clues to the financial position of a concern. These are the pointers or indicators of financial strength, soundness, position or weakness of an enterprise. One can draw conclusions about the exact financial positions of a concern with the help of ratios.

Interpretation of Ratios:

The interpretation of ratios is an important factor. Though calculation of ratios is also important but it is only a clerical task whereas interpretation needs skill, intelligence and foresightedness. The inherent limitations of ratio analysis should be kept in mind while interpreting them. The impact of factors such as price level changes, change in accounting policies, window dressing etc., should also be kept in mind when -attempting to interpret ratios.

A single ratio in itself does not convey much of the sense. To make ratios useful, they have to be further interpreted. For example, say, the current ratio of 3 : 1 does not convey any sense unless it is interpreted and conclusion is drawn from it regarding the financial condition of the firm as to whether it is very strong, good, questionable or poor.

The interpretation of the ratios can be made in the following ways:

1. Single Absolute Ratio:

Generally speaking one cannot draw any meaningful conclusion when a single ratio is considered in isolation. But single ratios may be studied in relation to certain rules of thumb which are based upon well proven conventions as for example 2: 1 is considered to be a good ratio for current assets to current liabilities.

2. Group of Ratios:

Ratios may be interpreted by calculating a group of related ratios. A single ratio supported by other related additional ratios becomes more understandable and meaningful. For example, the ratio of current assets to current liabilities may be supported by the ratio of liquid assets to liquid liabilities to draw more dependable conclusions.

3. Historical Comparison:

One of the easiest and most popular ways of evaluating the performance of the firm is to compare its present ratios with the past ratios called comparison overtime. When financial ratios are compared over a period of time, it gives an indication of the direction of change and reflects whether the firm’s performance and financial position has improved, deteriorated or remained constant over a period of time. But while interpreting ratios from comparison over time, one has to be careful about the changes, if any, in the firm’s policies and accounting procedures.

4. Projected Ratios:

Ratios can also be calculated for future standards based upon the projected or proforma financial statements. These future ratios may be taken as standard for comparison and the ratios calculated on actual financial statements can be compared with the standard ratios to find out variances, if any. Such variances help in interpreting and taking corrective action for improvement in future.

5. Inter-Firm Comparison:

Ratios of one firm can also be compared with the ratios of some other selected firms in the same industry at the same point of time. This kind of comparison helps in evaluating relative financial position and performance of the firm. But while making use of such comparison one has to be very careful regarding the different accounting methods, policies and procedures adopted by different firms.

Guidelines or Precautions for the Use of Ratios:

1. Accuracy of Financial Statements:

The ratios are calculated from the data available in financial statements. The reliability of ratios is linked to the accuracy of information in these statements. Before calculating ratios one should see whether proper concepts and conventions have been used for preparing financial statements or not. These statements should also be properly audited by competent auditors. The precautions will establish the reliability of data given in financial statements.

2. Objective or Purpose of Analysis:

The type of ratios to be calculated will depend upon the purpose for which these are required. If the purpose is to study current financial position then ratios relating to current assets and current liabilities will be studied. The purpose of ‘user’ is also important for the analysis of ratios. A creditor, a banker, an investor, a shareholder, all has different objects for studying ratios. The purpose or object for which ratios are required to be studied should always be kept in mind for studying various ratios. Different objects may require the study of different ratios.

3. Selection of Ratios:

Another precaution in ratio analysis is the proper selection of appropriate ratios. The ratios should match the purpose for which these are required. Calculation of large number of ratios without determining their need in the present context may confuse the things instead of solving them. Only those ratios should be selected which can throw proper light on the matter to be discussed.

4. Use of Standards:

The ratios will give an indication of financial position only when discussed with reference to certain standards. Unless otherwise these ratios are compared with certain standards one will not be able to reach at conclusions. These standards may be rule of thumb as in case of current ratio (2:1) and acid-test ratio (1: 1), may be industry standards, may be budgeted or projected ratios, etc. The comparison of calculated ratios with the standards will help the analyst in forming his opinion about financial situation of the concern.

5. Calibre of the Analyst:

The ratios are only the tools of analysis and their interpretation will depend upon the calibre and competence of the analyst. He should be familiar with various financial statements and the significance of changes, etc. A wrong interpretation may create havoc for the concern since wrong conclusions may lead to wrong decisions. The utility of ratios is linked to the expertise of the analyst.

6. Ratios Provide Only a Base:

The ratios are only guidelines for the analyst, he should not base his decisions entirely on them. He should study any other relevant information, situation in the concern, general economic environment, etc. before reaching final conclusions. The study of ratios in isolation may not always prove useful. A businessman will not afford a single wrong decision because it may have far-reaching consequences. The interpreter should use the ratios as guide and may try to solicit any other relevant information which helps in reaching a correct decision.

Classification of Ratios:

The use of ratio analysis is not confined to financial manager only. There are different parties interested in the ratio analysis for knowing the financial position of a firm for different purposes. In view of various users of ratios, there are many types of ratios which can be calculated from the information given in the financial statements.

The particular purpose of the user determines the particular ratios that might be used for financial analysis. For example, a supplier of goods of a firm on credit or a banker advancing a short-term loan to a firm, is interested primarily in the short-term paying capacity of the firm, or say in its liquidity.

On the other hand, a financial institution advancing a long term credit to a firm will be primarily interested in the solvency or long- term financial position of the concern. Similarly, the interests of the owners (shareholders) and the management also differ. The shareholders are generally interested in the profitability or dividend position of a firm while management requires information on almost all the financial aspects of the firm to enable it to protect the interests of all the parties.

(A) Traditional Classification or Statement Ratios:

Traditional classification or classification according to the statement, from which these ratios are calculated, is as follows:

(a) Balance Sheet or Position Statement Ratios:

Balance Sheet ratios deal with the relationship between two balance sheet items, e.g. the ratio of current assets to current liabilities, or the ratio of proprietors’ funds to fixed-assets. Both the items must, however, pertain to the same balance sheet. The various balance sheet ratios have been named in the chart classifying statement ratios.

(b) Profit and Loss Account or Revenue/Income Statements Ratios:

These ratios deal with the relationship between two profit and loss account items, e.g., the ratio of gross profit to sales, or the ratio of net profit to sales. Both the items must, however, belong to the same profit and loss account. The various profit and loss account ratios, commonly used, are named in the chart classifying statement ratios.

(c) Composite/Mixed Ratios or Inter Statement Ratios:

These ratios exhibit the relation between a profit and loss account or income statement item and a balance sheet item, e.g., stock turnover ratio, or the ratio of total assets to sales. The most commonly used inter-statement ratios are given in the chart exhibiting traditional classification or statement ratios.

(B) Functional Classification or Classification According to Tests:

In view of the financial management or according to the tests satisfied, various ratios have been classified as below:

(a) Liquidity Ratios:

These are the ratios which measure the short-term solvency or financial position of a firm. These ratios are calculated to comment upon the short-term paying capacity of a concern or the firm’s ability to meet its current obligations. The various liquidity ratios are: current ratio, liquid ratio and absolute liquid ratio. Further to see the efficiency with which the liquid resources have been employed by a firm, debtors turnover and creditors turnover ratios are calculated.

(b) Long-term Solvency and Leverage Ratios:

Long-term solvency ratios convey a firm’s ability to meet the interest costs and repayments schedules of its long-term obligations e.g. Debt Equity Ratio and Interest Coverage Ratio. Leverage Ratios show the proportions of debt and equity in financing of the firm. These ratios measure the contribution of financing by owners as compared to financing by outsiders.

The leverage ratios can further be classified as:

(i) Financial Leverage,

(ii) Operating Leverage,

(iii) Composite Leverage.

(c) Activity Ratios:

Activity ratios are calculated to measure the efficiency with which the resources of a firm have been employed. These ratios are also called turnover ratios because they indicate the speed with which assets are being turned over into sales, e.g., debtors turnover ratio. The various activity or turnover ratios have been named in the chart classifying the ratios.

(d) Profitability Ratios:

These ratios measure the results of business operations or overall performance and effectiveness of the firm, e.g., gross profit ratio, operating ratio or return on capital employed. The various profitability ratios have been given in the chart exhibiting the classification of ratios according to test. Generally, two types of profitability ratios are calculated

(i) In relation to sales, and

(ii) In relation to investments.

(C) Classification According to Significance or Importance:

The ratios have also been classified according to their significance or importance. Some ratios are more important than others and the firm may classify them as primary and secondary ratios. The British Institute of Management has recommended the classification of ratios according to importance for inter-firm comparisons. For inter-firm comparisons, the ratios may be classified as Primary Ratios and Secondary Ratios.

The primary ratio is one which is of the prime importance to a concern; thus return on capital employed is named as primary ratio. The other ratios which support or explain the primary ratio are called secondary ratios, e.g., the relationship of operating profit to sales or the relationship of sales to total assets of the firm.