Meaning and definition of Ratio
Ratio can be defined as one value divided by another. The resultant value is an indicator of the value of one quantity in other quantity’s terms. In other words, ratio is a relative magnitude of two selected numerical values obtained from the financial statements of an enterprise. The ratios are generally expressed as a decimal value, like 0.10, or as a corresponding percent value, like 10%.
Some ratios, especially those which are below 1, like earnings yield, are generally quoted as percentages. However, other ratios which are more than 1 are generally quoted as decimal numbers.
Purpose and types of ratios
A ratio form an integral part of the financial statement analysis and is used to measure the various aspects of a business. Financial ratios can be categorized according to the business’ financial aspect which is being measured by the ratio. The different types of ratios include:
1. Liquid ratios
These ratios measure the availability of cash to pay off the obligations.
2. Activity ratios
These ratios measure how quickly a business transforms its non-cash assets into cash assets.
3. Debt ratios
These ratios evaluate the business firm’s capability of repaying long-term debts.
4. Profitability ratios
These ratios evaluate the business’ capability to use its assets and control of the expenses to produce an acceptable return rate.
5. Market ratios
These ratios measure the response of the investors to holding the stock of a company as well as the cost of issuing stock. These are related to the return on investment for shareholders, in addition to the relationship between return and the investment value in the shares of a company.
The main purposes served by ratios include allowing for comparisons:
- between industries
- between companies
- between various time periods for companies
- between one company and its industry average
It should be noted that usually ratios hold no meaning if they are not benchmarked against a standard, such as past performance or the performance of another company. Therefore, the ratios of firms in each industry, experiencing different risks, competitions, and capital requirements are generally difficult to be compared.