Classification of ratios:
(1) Traditional classification, and (2) Functional classification.
1. Traditional classification (rarely used in practice).
This is on the basis of financial statements to which the determinants (components) of ratios belong. On this basis the ratios are classified as follows:
A. Income Statement Ratios:
A ratio of two variables from the income statement is known as Income Statement Ratio like gross profit ratio, stock turnover ratio.
B. Balance Sheet Ratios:
In case both variables are from balance sheet, it is classified as Balance Sheet Ratios like current ratio, debt equity ratio.
C. Composite Ratios:
If a ratio is computed with one variable from income statement and another variable from balance sheet, it is called Composite Ratio like working capital turnover ratio.
2. Functional classification (mostly used).
It is based on the purpose for which a ratio is computed. Following are the main types of such ratios:
A. Liquidity Ratios:
Liquidity is the capacity of the company to meet its short term liabilities and the ratios calculated to measure it are known as ‘Liquidity Ratios’. They are short-term in nature.
B. Solvency Ratios:
Solvency of business is determined by its ability to meet its contractual obligations towards external stakeholders, and the ratios calculated to measure solvency position are known as ‘Solvency Ratios’. They are long-term in nature.
C. Activity (or Turnover) Ratios:
This refers to the ratios that are calculated for measuring the efficiency of the business to make the effective utilization of resources. So, these are also known as ‘efficiency ratios’.
It refers to the analysis of profits in relation to sales or funds employed in the business. Ratios calculated for this purpose are known as profitability ratios.