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Classification of Ratios: Liquidity, Solvency & Profitability

Study material and explanations for Unit 2

Classification of Financial Ratios: Liquidity, Solvency, Turnover & Profitability

Financial ratios are broadly classified into four major functional categories based on the financial dimension they evaluate. In university examinations, this classification forms the core of practical numerical questions.

1. Classification Overview

                      ┌─────────────────────────────────┐
                      │    CLASSIFICATION OF RATIOS     │
                      └────────────────┬────────────────┘
                                       │
     ┌──────────────────┬──────────────┴─────┬──────────────────┐
     ▼                  ▼                    ▼                  ▼
┌──────────────┐ ┌──────────────┐    ┌──────────────┐    ┌──────────────┐
│  LIQUIDITY   │ │   SOLVENCY   │    │   ACTIVITY   │    │PROFITABILITY │
│    RATIOS    │ │(LEVERAGE)    │    │  (TURNOVER)  │    │    RATIOS    │
└──────────────┘ └──────────────┘    └──────────────┘    └──────────────┘

2. Liquidity Ratios (Short-Term Solvency)

Liquidity ratios measure the firm’s ability to meet its immediate and short-term obligations as they fall due.

A. Current Ratio (Working Capital Ratio)

Measures the margin of safety provided by current assets over current liabilities.

Current Ratio = Current Assets / Current Liabilities

  • Current Assets: Cash, Bank Balance, Marketable Securities, Debtors, Bills Receivable, Inventories, Prepaid Expenses.
  • Current Liabilities: Creditors, Bills Payable, Outstanding Expenses, Short-term Bank Loans, Provision for Tax.
  • Ideal Benchmark: 2 : 1

B. Quick Ratio (Acid-Test / Liquid Ratio)

Measures immediate liquidity by excluding assets that cannot be converted into cash instantly without loss of value (Inventories and Prepaid Expenses).

Quick Ratio = Quick Assets / Current Liabilities Quick Assets = Current Assets - (Inventories + Prepaid Expenses)

  • Ideal Benchmark: 1 : 1

3. Solvency / Leverage Ratios (Long-Term Health)

Solvency ratios measure the firm’s ability to service its long-term debts and interest payments over the multi-year horizon.

A. Debt-Equity Ratio

Measures the relative proportion of outsider debt compared to shareholder funds.

Debt-Equity Ratio = Total Long-Term Debt / Shareholders’ Funds (Net Worth)

  • Long-Term Debt: Debentures, Long-term Bank Loans, Bonds.
  • Shareholders’ Funds: Equity Share Capital + Preference Share Capital + Reserves & Surplus - Accumulated Losses.
  • Norm: 2 : 1 is generally acceptable, though lower ratios (0.5 : 1) indicate higher safety.

B. Interest Coverage Ratio (Debt Service Ratio)

Measures how many times operating profits cover annual interest charges on debt.

Interest Coverage Ratio = Earnings Before Interest and Tax (EBIT) / Fixed Interest Charges

  • A higher ratio (e.g., 6 to 8 times) assures lenders that interest payments are completely safe even during economic downturns.

4. Activity / Turnover Ratios (Operating Efficiency)

Turnover ratios measure how rapidly and productively the firm turns its assets into sales revenue.

A. Inventory Turnover Ratio (Stock Turnover)

Measures how many times inventory is sold and replaced during an accounting period.

Inventory Turnover Ratio = Cost of Goods Sold (COGS) / Average Inventory Average Inventory = (Opening Stock + Closing Stock) / 2

  • Holding Period in Days = 365 / Inventory Turnover Ratio
  • A high turnover indicates brisk sales; a very low ratio indicates idle, unsold, or obsolete inventory.

B. Trade Receivables (Debtors) Turnover Ratio

Measures how efficiently the firm collects dues from credit customers.

Debtors Turnover Ratio = Net Credit Sales / Average Trade Receivables Average Debtors Collection Period = 365 / Debtors Turnover Ratio

C. Working Capital Turnover Ratio

Measures how effectively working capital is deployed to generate revenue.

Working Capital Turnover Ratio = Net Sales / Net Working Capital

5. Profitability Ratios (Operating & Investment Returns)

Profitability ratios measure the overall operating efficiency and earning power of the firm.

A. Margin Ratios (Sales-Based):

  1. Gross Profit Margin:

    Gross Profit Ratio = (Gross Profit / Net Sales) × 100

  2. Net Profit Margin:

    Net Profit Ratio = (Net Profit After Tax / Net Sales) × 100

  3. Operating Ratio:

    Operating Ratio = [(COGS + Operating Expenses) / Net Sales] × 100

B. Return Ratios (Investment-Based):

  1. Return on Capital Employed (ROCE / ROI): The supreme measure of overall managerial efficiency.

    ROCE = (EBIT / Total Capital Employed) × 100

    • Capital Employed = Share Capital + Reserves + Long-term Debt - Fictitious Assets
  2. Return on Equity (ROE):

    ROE = (Net Profit After Tax & Preference Dividend / Equity Shareholders’ Funds) × 100

  3. Earnings Per Share (EPS):

    EPS = (Net Profit After Tax - Preference Dividend) / Number of Equity Shares

6. Comprehensive Solved Practical Numerical Problem

Given Financial Data:

  • Sales: ₹20,00,000 (80% on credit)
  • Cost of Goods Sold: ₹14,00,000
  • Operating Expenses: ₹2,00,000
  • Fixed Interest: ₹40,000
  • Tax Rate: 30%
  • Current Assets: ₹6,00,000 (including Closing Inventory of ₹1,50,000 and Prepaid Expenses of ₹50,000)
  • Current Liabilities: ₹3,00,000
  • Long-Term Debt: ₹4,00,000
  • Shareholders’ Funds: ₹8,00,000
  • Number of Equity Shares: 50,000

Step-by-Step Solutions:

  1. Current Ratio:

    Current Ratio = ₹6,00,000 / ₹3,00,000 = 2 : 1 (Matches the ideal standard)

  2. Quick Ratio:

    • Quick Assets = ₹6,00,000 - (₹1,50,000 + ₹50,000) = ₹4,00,000

    Quick Ratio = ₹4,00,000 / ₹3,00,000 = 1.33 : 1 (Healthy liquidity)

  3. Debt-Equity Ratio:

    Debt-Equity Ratio = ₹4,00,000 / ₹8,00,000 = 0.5 : 1 (Very safe conservative capital structure)

  4. Gross Profit Ratio:

    • Gross Profit = ₹20,00,000 - ₹14,00,000 = ₹6,00,000

    Gross Profit Ratio = (₹6,00,000 / ₹20,00,000) × 100 = 30.0%

  5. Net Profit and EPS:

    • Operating Profit (EBIT) = Gross Profit (₹6,00,000) - Operating Expenses (₹2,00,000) = ₹4,00,000
    • EBT = ₹4,00,000 - Interest (₹40,000) = ₹3,60,000
    • Tax at 30% = ₹1,08,000
    • Net Profit After Tax = ₹3,60,000 - ₹1,08,000 = ₹2,52,000

    Net Profit Ratio = (₹2,52,000 / ₹20,00,000) × 100 = 12.6% EPS = ₹2,52,000 / 50,000 shares = ₹5.04 per share

  6. Interest Coverage Ratio:

    Interest Coverage Ratio = ₹4,00,000 / ₹40,000 = 10 Times (Outstanding safety for lenders)

7. Summary & Quick Revision Checklist

  • Liquidity Ratios: Current Ratio (2:1) and Quick Ratio (1:1).
  • Solvency Ratios: Debt-Equity Ratio and Interest Coverage Ratio.
  • Turnover Ratios: Inventory Turnover (COGS / Avg Stock) and Debtors Turnover.
  • Profitability Ratios: Gross Profit, Net Profit, ROCE, and EPS.
  • Exam Tip: Always calculate EBIT first when finding coverage or return ratios.