There are mainly 4 different types of accounting ratios to perform a financial statement analysis; Liquidity Ratios, Solvency Ratios, Activity Ratios and Profitability Ratios.
A financial ratio is a mathematical expression demonstrating a relationship between two independent or related accounting figures. Such ratios are calculated on the basis of accounting information gathered from financial statements.
Four different ways to show financial ratios are;
- Simple or Pure – A simple ratio is shown as a quotient, example – 3:1
- Percentage – This type of representation is done in form of a percentage, example 30%
- Turnover Rate or Times – Accounting ratio expressed in form of rate or times, example 3 times.
- Fraction – It is when a ratio is expressed in a fraction, example 2/3 or 0.67
Types of Accounting Ratios
Liquidity Ratios – First among types of financial ratios is liquidity ratio; it used to judge the paying capacity of a business towards its short-term liabilities. It helps with the evaluation of a company’s ability to satisfy its short-term commitments.
Higher the liquidity ratios better the company’s cash position. Main types of liquidity ratios are;
For Accounting Practice
Solvency Ratios – second among types of accounting ratios is solvency ratios; it helps to determine a company’s long-term solvency. It is often used to judge the long-term debt paying capacity of a business.
Solvency ratios look at a firm’s long-term financial strength to meet its obligations including both principal and interest repayments.
Main types of liquidity ratios are;
Activity Ratios – Activity ratios are also known as performance ratios, efficiency ratios & turnover ratios. They are an important subpart of financial ratios as they symbolise the speed at which the sales are being made.
Higher turnover ratio means better utilisation of assets which indicates
improved efficiency and profitability.
Main types of activity ratios are;
- Stock or Inventory Turnover Ratio
- Trade Receivables or Debtor’s Turnover Ratio
- Trade Payables or Creditor’s Turnover Ratio
- Working Capital Turnover Ratio
Profitability Ratios – Efficiency leads to profitability and profitability is the ultimate indicator of the overall success of a business. Profitability ratio shows earning capacity of the business with respect to the resources employed.
Main types of profitability ratios are;
- Gross Profit Ratio
- Net Profit Ratio
- Operating Profit Ratio
- Operating Ratio
- Return on Investment or Return on Capital Employed
- Price Earnings Ratio
All these types of accounting ratios are used by internal and external users for various different purposes such as management accounting, credit rating, loans and other credit, etc.