What a Ratio Is, and How Ratios Are Classified
Chapter Twenty-Five
Syllabus topic 1, "Ratio Analysis: Meaning, classification, Du Point Chart, advantages and limitations (Based on Vertical Form of Financial statements)"
Pages 67 to 69 of 162
In one line
A ratio is one figure divided by another, and it becomes information only when it is compared with something.
The meaning
A ratio expresses the relationship between two figures. It may be expressed three ways, and the question usually fixes which.
| Form | Example | Used for |
|---|---|---|
| A proportion, "x to 1" | Current ratio 2.11 to 1 | Balance sheet ratios where the two figures are of the same kind |
| A percentage | Gross profit ratio 30 per cent | Revenue statement ratios, and returns |
| A number of times | Stock turnover 5 times | Turnover ratios |
| A number of days or months | Debtors collection period 36.5 days | The same turnover ratios, inverted |
Give the unit. "The current ratio is 2.11" is incomplete; "2.11 to 1" is the answer. A ratio without its unit loses a mark every time.
MU's classification
Three classes, by where the two figures come from.
| Class | Both figures from | The nineteen, as MU lists them |
|---|---|---|
| Balance sheet ratios | The balance sheet | Current, liquid, stock working capital, proprietary, debt equity, capital gearing |
| Revenue statement ratios | The revenue statement | Gross profit, expenses, operating, net profit, net operating profit, stock turnover |
| Combined ratios | One from each statement | Return on capital employed, return on proprietor's fund, return on equity capital, dividend payout, debt service, debtors turnover, creditors turnover |
Six, six and seven. Learn the counts; a question that asks you to list the balance sheet ratios wants six and no more.
MU puts the stock turnover ratio in the revenue statement class. Strictly it takes cost of goods sold from the revenue statement and stock from the balance sheet, so it is a combined ratio. Answer as she classifies it, and if you have room, note the point in one line. It shows you understand the classification rather than having memorised the list.
The other classification, by purpose
A question sometimes asks for the classification by purpose instead, and it is the more useful one for interpretation.
| Class | Measures | Ratios in it |
|---|---|---|
| Liquidity ratios | Ability to pay within a year | Current, liquid, stock working capital |
| Solvency ratios | Ability to meet long-term obligations | Proprietary, debt equity, capital gearing, debt service |
| Profitability ratios | Earnings, against sales or against capital | Gross profit, net profit, operating, expenses, return on capital employed, return on proprietors' fund, return on equity |
| Activity or turnover ratios | How hard the assets are worked | Stock turnover, debtors turnover, creditors turnover |
| Market or ownership ratios | What the shareholder gets | Dividend payout, and earnings per share |
Say which classification you are using. Both are correct and the examiner marks against whichever you announce.
Why the vertical form
MU's topic line says the ratios are "Based on Vertical Form of Financial statements", and it is not decoration.
The rest of this chapter
Module one is free. The rest of this chapter comes with the B.Com. (Accountancy) Semester 3 notes.
You are reading a chapter from a later module. Everything in module one of every subject stays free, and so does the syllabus.
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Free either way: the syllabus, and module one of every subject.
The rest of this subject
These notes are cut from the University's printed syllabus. Open the syllabus itself, or the past papers, for the same subject.