Importance of Accounting Ratios & their Functional Classification

Accounting ratios are very useful tool to provide information about the underlying conditions of an organization. They act as indicator of financial soundness, strength, position and status of an organization. Importance of ratio Analysis depends on its interpretation. In the ratio analysis, we compare various items which reveal the financial positions of an enterprise. It is useful for all the components of a company i.e.

  • Management: It helps the management in formulation of policies, evaluation of the trend & performance of the business, decision making and in various segments.
  • Shareholders: It helps the shareholders to measure the effectiveness of the management functions. It also helps them to understand the working & operating efficiency of the company.
  • Investors: Investors search the secure company and industry through ratio analysis.
  • Creditors: Creditors find the liquidity & solvency position of the business by using ratio analysis.
  • Analysts: Analysts use the financial statements of various companies to compare the progress and position of various firms and industry.
  • Governments: These ratio help in better understanding of cost-structures and may justify price controls by the government to save the consumers

Functional classification of ratios:

The classification of ratios according to the purpose of its computation is known as functional classification. On this basis ratios are classified as follows:

  • Profitability Ratios: Profitability ratios measure the profit in relative term with reference to sales, assets, or capital employed. These ratios highlight the end result of the business activities. The main objective is to judge the efficiency of the business.
  • Turnover Ratio or Activity Ratio: These ratios are used to measure the effectiveness of the use of capital and assets of the business.
  • Financial Ratio or Solvency Ratio: These ratios are calculated to find the financial position of the organization from short term as well as long term solvency point of view.
  • Market Test Ratios: These are some profitability ratio, having a bearing on the market value of the shares.