Types of Ratios in Accounting with Practical Examples and Solutions
Financial ratio analysis is a fundamental tool in accounting and business studies. It involves comparing line items from a company’s financial statements to evaluate profitability, liquidity, efficiency, and solvency. By examining specific ratios, stakeholders gain clarity on a business’s financial health and can make informed decisions.
Ratio analysis is widely used not just to track a company’s performance over time, but also to compare it with similar businesses in the same industry. External parties, such as lenders, may require these analyses to ensure companies meet certain benchmarks or manage risk appropriately. However, ratio analysis is only one part of a broader evaluation and should be considered alongside other information for a full picture of a company's financial situation.
What Is Ratio Analysis?
Ratio analysis uses data from financial statements to create ratios—simple relationships between different accounts—that summarize key information. These ratios offer insights that raw financial numbers alone cannot. Some ratios, like the current ratio, focus on liquidity, while others—such as gross profit margin—illustrate profitability.
Ratio analysis helps answer questions like: Is the company earning enough profit? Can it pay its short-term and long-term debts? How efficiently is it managing its assets? Regular analysis helps businesses identify strengths and weaknesses, compare themselves with competitors, and plan for the future.
Key Ratio Analysis Formulas and Examples
| Ratio Name | Formula | Purpose / Example |
|---|---|---|
| Current Ratio | Current Assets / Current Liabilities | Measures ability to cover short-term debts. Example: If Current Assets = ₹1,80,000 and Current Liabilities = ₹90,000, Current Ratio = 2.0 |
| Quick Ratio | (Current Assets – Inventory) / Current Liabilities | Indicates immediate liquidity after removing inventory. |
| Debt-Equity Ratio | Total Debt / Shareholders' Equity | Shows the proportion of debt versus equity. |
| Net Profit Margin | Net Profit / Net Sales | Evaluates profitability from sales. |
| Inventory Turnover Ratio | Cost of Goods Sold / Average Inventory | Measures how quickly inventory is sold and replenished. If COGS = ₹4,00,000; Average Inventory = ₹80,000, Inventory Turnover = 5 times. |
Types of Ratios Used in Ratio Analysis
| Category | Common Ratios |
|---|---|
| Liquidity | Current Ratio, Quick Ratio, Working Capital Ratio |
| Solvency | Debt-Equity Ratio, Debt-Assets Ratio, Interest Coverage |
| Profitability | Gross Margin, Net Profit Margin, Return on Assets, Return on Equity, Return on Capital Employed |
| Efficiency / Turnover | Turnover Ratio, Inventory Turnover, Day’s Sales in Inventory |
| Coverage | Times Interest Earned, Debt Service Coverage Ratio |
| Market Prospects | P/E Ratio, Earnings Per Share, Dividend Yield, Dividend Payout Ratio |
Steps for Conducting Ratio Analysis
- Collect relevant data from the company’s financial statements (Balance Sheet and Income Statement).
- Apply the appropriate formulas to calculate required ratios.
- Compare calculated ratios to industry averages or past periods for meaningful insights.
- Interpret results—consider how ratios reflect the company's strengths, weaknesses, and trends.
- Combine ratio insights with other financial and non-financial information for informed decision-making.
How Ratio Analysis Works in Practice
Ratio analysis enables students and businesses to assess a company’s performance over time or compare it directly with others in the industry.
It is important to note that the same ratio may mean different things in different industries. For example, a higher debt-equity ratio might be acceptable in a utility business, but seen as risky in technology.
When analyzing ratios, take into account seasonality, variations in company size, and specific product lines, as these factors may impact results. Always compare similar businesses for the most meaningful outcomes.
Limitations of Ratio Analysis
- Does not consider qualitative factors like management quality or brand reputation.
- Comparisons may be difficult if companies use different accounting policies.
- Ratios based on past data may not predict future performance.
- Companies can sometimes influence ratios through short-term financial adjustments.
Practical Example: Inventory Turnover Ratio
Suppose a business wants to observe how efficiently it manages its inventory throughout the year. By calculating monthly inventory turnover, the company can identify months where inventory took longer to sell and investigate possible causes, such as seasonal demand or marketing issues.
This analysis may help the company make better inventory decisions and improve profitability in future periods.
Why Ratio Analysis Matters
Ratio analysis uncovers important trends that simple figures cannot—such as declining profit margins despite growing sales. It helps businesses plan strategies, manage risks, and communicate with investors or lenders.
By using ratio analysis together with other financial tools, companies and students can gain a deeper understanding of operational and financial health.
Next Steps for Mastery
- Tackle more practice questions and case studies for real-world application.
- Learn about related accounting concepts, such as Financial Statements and their preparation.
- For foundational Commerce revision, explore related sections and resources on Vedantu.
FAQs on Ratio Analysis Explained: Key Concepts, Formulas & Uses
1. What is ratio analysis?
Ratio analysis is a method used to evaluate various aspects of a company's financial performance by comparing key figures from financial statements. It helps assess profitability, liquidity, solvency, and efficiency using calculated ratios, supporting better decision-making for students, investors, and managers.
2. What are the main types of ratios used in ratio analysis?
The main types of ratios used in ratio analysis include:
- Liquidity Ratios: Current Ratio, Quick Ratio
- Solvency Ratios: Debt-Equity Ratio, Interest Coverage Ratio
- Profitability Ratios: Net Profit Ratio, Gross Profit Ratio, Return on Capital Employed
- Activity/Efficiency Ratios: Inventory Turnover Ratio, Debtors Turnover Ratio
3. What is the formula for current ratio?
Current Ratio is calculated as:
Current Ratio = Current Assets / Current Liabilities
This ratio measures short-term liquidity and the company's ability to pay its immediate obligations.
4. Why is ratio analysis important?
Ratio analysis is important because it:
- Helps assess a company's financial health and performance
- Assists in exam-based problem-solving for students
- Enables comparison with industry benchmarks and past performance
- Helps identify strengths, weaknesses, and decision-making areas
5. What are the advantages of ratio analysis?
The advantages of ratio analysis include:
- Simple and quick financial analysis tool
- Helps in trend analysis over years
- Enables cross-company and industry comparisons
- Supports planning, control, and strategic decisions
6. What are the limitations of ratio analysis?
Limitations of ratio analysis are:
- Relies on historical data which may not predict future conditions
- Influenced by different accounting policies
- Ignores qualitative and non-financial factors
- Results may be manipulated or lack comparability across industries
7. How is the Net Profit Ratio calculated?
Net Profit Ratio = (Net Profit / Net Sales) × 100
This ratio shows the percentage of profit earned to net sales, indicating overall profitability after all expenses.
8. Can you give an example of a solved ratio analysis problem?
Example: If Current Assets = ₹2,00,000 and Current Liabilities = ₹1,00,000,
Current Ratio = ₹2,00,000 / ₹1,00,000 = 2:1.
This means the company has twice the current assets for every unit of current liability.
9. Which ratios help in analyzing the liquidity of a business?
Liquidity ratios gauge a company's ability to meet short-term obligations. Key liquidity ratios are:
- Current Ratio
- Quick Ratio (Acid Test Ratio)
10. What practical tips help in preparing for ratio analysis questions in exams?
Practical exam tips for ratio analysis:
- Memorize standard formulas systematically
- Classify ratios based on their category (liquidity, solvency, etc.)
- Solve step-wise using proper sequencing
- Practice with examples and previous year papers
- Double-check calculations to avoid errors
11. How does ratio analysis assist in decision making?
Ratio analysis assists in decision-making by:
- Highlighting financial strengths and weaknesses
- Providing data for investment, lending, and management decisions
- Enabling accurate comparisons with benchmarks and competitors
12. What should be considered when comparing ratios across companies?
When comparing ratios:
- Only compare companies within the same industry
- Ensure similar accounting policies and time periods
- Adjust for any seasonal or size-related differences
- Consider qualitative factors along with numerical values
