# Ratio Analysis – An Introduction

# What is Ratio?

** **The relationship between two variables expressed mathematically is called a ratio.

It refers to the systematic use of ratios to interpret the financial statements in terms of operating performance and financial position of a firm.

**Some important definitions:**

- “The relation of one amount, a to another b, expressed as the ratio of a to b”– Kohler
- “Ratio is the relationship or proportion that one amount bears to another, the first number being the numerator and the later denominator” – H.G.Guthmann

**Significance of ratio analysis:**

- It consolidates and simplifies the accounting information or data
- It is a clear indicator of an organisation’s efficiency
- It helps in the evaluation of a firm’s performance by comparing the past and present ratio
- It aids the management in formulating poilicies, preparing budgets etc.,
- It points out the liquidity position thereby assisting in assessing the short-term obligations and long-term solvency
- It facilitataes inter-firm and intra-firm comparison, the former to understand the position of firm in the market and latter to gauge the performance of different divisions of the firm.
- Since ratios have the power to speak, they are considered as effective means of communication

**A broad classification of ratios:**

**CLASSIFICATION BY FUNCTION **

1. **Solvency **

Short-term Long-term

Current ratio Proprietory ratio

Liquid ratio Debt-Equity ratio

2. **Profitability**

- Gross profit ratio
- Net profit ratio
- Operating profit ratio
- Return on Investment ratio

3. **Activity ratio**

- Fixed assets turnover ratio
- Debitors turnover ratio
- Creditors turnover ratio
- Stock turnover ratio

**4. Leverage **

- Financial leverage ratio
- Operating leverage ratio
- Capital gearing ratio

**CLASSIFICATION BY STATEMENTS**

1. **Balance sheet ratios**

- Current ratio
- Liquid ratio
- Proprietory ratio
- Debt-Equity ratio
- Capital Gearing ratio

2. **Profit and Loss Account ratios or Profitability ratios**

- Gross profit ratio
- Net profit ratio
- Operating profit ratio
- Return on Investment ratio

3. **Inter-Statement ratios or Turn-over ratios**

- Fixed assets turnover ratio
- Debitors turnover ratio
- Creditors turnover ratio
- Stock turnover ratio

Advantages and Limitations of Ratio Analysis – Management Guru

//cdn.embedly.com/widgets/platform.js