It identifies the relationship between two financial variables in order to derive meaningful conclusions about their behaviour.

These ratios are useful for both strategic and operational level.

Generally there are four groups of ratio available:

Liquidity ratio:

It indicates the management ability to pay its share term debts.

It is expressed in two forms:

  • Current ratio: it signifies the relationship between current assets and current liability.
  • Quick ratio: it indicates the relationship between liquid assets and current liabilities.

Liquidity ratio helps in signifying if the current assets are adequate to pay current liabilities.

Activity ratio:

  • It shows how funds in the organisation are being used. They are in the form of inventory turnover ratio, receivable turnover ratio and assets turnover ratio.
  • Inventory turnover ratio indicates the inventory is replaced during the year and shows how efficiently the inventory is being managed.
  • Receivable turnover ratio shows how promptly the organisation is able to collect the debtors.
  • It indicates how effectively assets have been used to generate sales.

Leverage ratio:

  • It indicates the relative amounts of funds in the business supplied by creditors, financers, shareholders, owners etc.
  • These ratios are in the form of debt equity ratio, debt capital ratio and interest coverage ratio.
  • It indicates the proportion of debt in relation to equity and signifies the financial strength of the organisation.
  • It shows the proportion amount of debt to total capital employed.
  • It shows the interest burden being born by the organisation in relation to the profit.

Profitability ratio:

  • It shows the ability of the organisation to earn profit in relation to sales and investment.
  • They are expressed in terms of profit margin as well as return on investment.
  • Profit margin can be either net profit or gross profit whereas return on investment is measured by relating profit to investment.
  • ROI is most comprehensive technique to controlling overall performance.

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