Question

in 200 words or more How does one distinguish between the different types of ratios and their purposes? Give an example

Answer 1

Financial ratios are used by all the stakeholders of a company to analyse the profitability and strength of any organisation.

There are 4 types of ratios namely:

1. Liquidity ratios or Short term solvency ratios
2. Leverage Ratios or Long term solvency ratios
3. Activity ratios
4. Profitability Ratios

All the above type of ratios are used to test a different aspect of financial amounts of the financial statements and are used for different purposes. The same has been discussed in detail below:

1. Liquidity ratios or Short term solvency ratios

These types of ratios are used to analyse whether the company is in the situation to meet its short term funds requirements. In other words it means ability to pay off short term Liabilities. It mainly relates to current assets and current liabilities.

• Current Ratio = Current Assets/ Current Liabilities

Current Ratio is a most common measure of short term liquidity. It is used to know whether the organisation has adequate current assets to meet its current liabilities. Higher the ratio, better is the liquidity.

• Quick Ratio = Quick Assets/ Current Liabilities

​​​​​​​ Quick Ratio is also known as acid test ratio. It is more conservative than current ratio and analyses whether the organisation is able to meet its current liabilities if its business shuts i.e. its unable to encash its stock.

quick assets= Current Assets less stock and prepaid expenses

• Cash Ratio​​​​​​​

Cash ratio is to measure absolute liquidity of any organisation. It is calculated by diving cash and cash equivalents with Current Liabilities. To explain, it means whether the cash currently available is sufficient to pay off current liabilities.

2. Leverage Ratios or Long term solvency ratios

Leverage ratios are of two types i.e. capital structure ratio and coverage ratios. The same has been discussed below:

CAPITAL STRUCTURE RATIO

Some of capital structure ratio are as under

• Equity ratio = Shareholders equity/ capital employed
• Debt Ratio = Total Debt/ (total debt + networth)
• Debt to Equity Ratio = Long Term debt/ Shareholders equity
• Debt to total assets Ratio= total debt/ total assets

Thus, it is clear from the above that capital structure ratio analyses the source of funding for Net Assets in any organisation and the ratio of equity and debt component. Generally, ideal debt to equity ratio is 2:1.

COVERAGE RATIOS

• Debt service coverage ratios= Net Profit + Depreciation + Non cash expense/ ( Interest +Loan instalment)
• Interest Coverage Ratios= Earning before interest and taxes/ Knterest

Thus, these ratios represent ability to pay off debt or interest out of current cash profits.

Apart from above, there is profitability ratio like net profit ratio, gross profit ratio which represents profitability of any organisation.