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  Financial Ratio Classifications

Introduction to Financial Ratio Classifications

Ratios can be collected into categories, with each category relating to a specific aspect of financial performance or position.

The following broad categories give a helpful basis for describing the nature of the financial ratios to be dealt with. There are five of them are described as follow:

  • Profitability:

Businesses usually exist with the main purpose of creating wealth for their owners. Profitability ratios give insights relating to the degree of success in attaining this aim. They express the profit made (or figures bearing on profit, like sales revenue or overheads) in relation to other main figures in the financial statements or to a number of business resource.

  • Efficiency:

Ratios may be employed to measure the efficiency with which specific resources have been employed within the business. These ratios are also considered as activity ratios.

  • Liquidity:

It is very important to the survival of a business that there are enough liquid resources available to meet maturing obligations (i.e. amounts owing that must be paid in the near future). A number of liquidity ratios examine the relationship among liquid resources held and amounts that is due for payment in the near future.

  • Financial gearing:

This is the relationship among the contribution to financing the business made through the holders of the business and the amount contributed through others, in the form of loans. The level of gearing has a significant influence on the degree of risk related with a business, as we shall see. So, gearing is something that managers must refer when making financing decisions. Gearing ratios tend to emphasize the extent to which the business uses borrowings.

  • Investment:

Specific ratios are referred with assessing the returns and performance of shares in a specific business from the perspective of shareholders who are not included with the management of the business.

The analyst has to be clear who the target users are and why they require the information. Various users of financial information are likely to have dissimilar information needs that will in turn determine the ratios that they find helpful. For instance, shareholders are expected to be specifically interested in their returns in relation to the level of risk related with their investment. So, Profitability, investment and gearing ratios will be of specific interest. Long-term lenders are related with the long-term viability of the business and, to assist them to assess this, the profitability and gearing ratios of the business are also expected to be of specific interest. Short-term lenders, like suppliers of goods and services on credit, might be interested in the capability of the business to repay the amounts owing in the short term. The result, the liquidity ratios should be of interest.

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