Corporate Accounting and Financial Management · Financial Statement Analysis

Ratio Analysis: Classification and Uses of Accounting Ratios

Updated 11 October 2026 · Fact-checked

Ratio analysis expresses the relationship between two figures from financial statements as a ratio, percentage or times, so you can judge performance. Ratios are grouped into liquidity, solvency, activity and profitability. To solve a question, pick the group, write the formula, take figures from the right statement, compute and interpret.

Understand Ratio Analysis: Classification and Uses

A ratio is one number divided by another. An accounting ratio takes both numbers from the balance sheet or the statement of profit and loss. A single figure such as profit of ₹5,00,000 says little. Profit as a share of sales or capital tells you much more.

Ratio analysis is the process of calculating these ratios and reading them against a standard. The standard can be the same firm's past ratios, a competitor's ratios, the industry average, or a target set by management.

Ratios are classified by the question they answer:

Liquidity ratios: can the firm pay short-term dues? Examples: current ratio, quick ratio.
Solvency (leverage) ratios: can the firm meet long-term obligations and how much does it rely on debt? Examples: debt-equity ratio, interest coverage ratio.
Activity (turnover) ratios: how efficiently are assets used? Examples: inventory turnover, debtors turnover.
Profitability ratios: how well does the firm earn? Examples: gross profit ratio, net profit ratio, return on capital employed.

Ratios can also be classified by the statement they come from: balance sheet ratios, statement of profit and loss ratios, and composite (mixed) ratios that use both. This is the traditional classification and is often asked.

Uses: ratios simplify large statements, help compare years and firms, reveal strengths and weaknesses, support planning and forecasting, and help lenders, investors and management take decisions.

Limitations: ratios depend on historical figures, so they ignore current values and inflation. Different accounting policies make firms hard to compare. Window dressing can distort year-end figures. Ratios ignore qualitative factors such as management quality. A ratio alone has no meaning without a suitable standard. Ratio analysis is also different from trend analysis: ratio analysis relates two items at one point or period, while trend analysis follows one item across several years, usually as index numbers with a base year of 100.

Key rules to remember

Current ratio: Current assets ÷ Current liabilities; Liquidity. A common rule of thumb is 2:1, but it varies by industry.
Quick (liquid) ratio: Quick assets ÷ Quick liabilities; Quick assets = current assets − inventories − prepaid expenses. Quick liabilities = current liabilities − bank overdraft (if overdraft is a permanent source). Rule of thumb 1:1.
Debt-equity ratio: Long-term debt ÷ Shareholders' funds; Solvency. Define the terms used in your answer, as books differ.
Interest coverage ratio: EBIT ÷ Interest on long-term debt; Shows how many times interest is covered by earnings.
Inventory turnover ratio: Cost of goods sold ÷ Average inventory; Average inventory = (Opening + Closing) ÷ 2.
Debtors turnover ratio: Credit sales ÷ Average trade receivables; Collection period = 365 ÷ ratio (or 12 months ÷ ratio).
Gross profit ratio: Gross profit ÷ Net sales × 100; Profitability on sales.
Net profit ratio: Net profit ÷ Net sales × 100; State whether profit is before or after tax.
Return on capital employed: EBIT ÷ Capital employed × 100; Capital employed = shareholders' funds + long-term borrowings (or total assets − current liabilities).

How to solve Ratio Analysis: Classification and Uses questions

Use this method for any question, whether it asks you to classify, calculate or comment.

1Read what is asked: classification, calculation, uses, limitations or interpretation.
2If calculating, identify the group (liquidity, solvency, activity or profitability) and write the formula first.
3List the figures from the balance sheet and the statement of profit and loss. Compute missing items such as gross profit, EBIT, average inventory or capital employed.
4Check that numerator and denominator match. Use credit sales with debtors and cost of goods sold with inventory.
5Calculate and state the answer in the correct form: ratio (x : 1), times, days or percentage.
6Compare with a standard such as the previous year, industry norm or rule of thumb.
7Write a one-line conclusion on what the ratio means for the firm.

Quickest way: Group, formula, figures, comment

When to use it: Use when time is short and the question asks for several ratios at once.

Write the group name and formula for each ratio in a row before touching numbers.
Prepare working notes first: gross profit, EBIT, capital employed, quick assets.
Calculate in order of dependence, so one working feeds several ratios.
Add a short comment line for each ratio, such as improved, weaker or above norm.
For theory, answer in a list: four groups with two examples each, then uses, then limitations.

Common mistakes in Ratio Analysis: Classification and Uses

Using total sales instead of credit sales in the debtors turnover ratio.
Students take the first sales figure given.
Fix: Use credit sales when given. If only total sales is given and no credit data, state the assumption that all sales are credit.
Including inventory in quick assets.
Quick ratio is confused with current ratio.
Fix: Remove inventories and prepaid expenses from current assets before dividing.
Using net profit in return on capital employed.
Profit ratios are all treated alike.
Fix: Use EBIT with capital employed unless the question defines return differently, and state your definition.
Using closing inventory when average is given or possible.
Haste in picking figures.
Fix: Compute average inventory whenever opening and closing figures are available.
Treating ratio analysis and trend analysis as the same.
Both compare figures and sound similar.
Fix: Remember: ratio analysis links two items; trend analysis tracks one item over years against a base year.
Giving a number with no comment.
Students stop once calculation ends.
Fix: Add one line comparing with a standard and stating what it means.

Worked examples

Example 1

A company has current assets of ₹6,00,000 (including inventories ₹2,00,000 and prepaid expenses ₹20,000) and current liabilities of ₹3,00,000. Calculate the current ratio and quick ratio and comment.

Show the solution

Current ratio = 6,00,000 ÷ 3,00,000 = 2 : 1.
Quick assets = 6,00,000 − 2,00,000 − 20,000 = ₹3,80,000.
Quick ratio = 3,80,000 ÷ 3,00,000 = 1.27 : 1 (approx.).
Compare with rules of thumb of 2 : 1 and 1 : 1.

Answer: Current ratio is 2 : 1 and quick ratio is about 1.27 : 1. Both meet the usual norms, so short-term liquidity looks satisfactory.

Example 2

Net credit sales are ₹12,00,000 and average trade receivables are ₹2,00,000. Cost of goods sold is ₹9,00,000 and average inventory is ₹1,50,000. Calculate the debtors turnover ratio, collection period (365 days) and inventory turnover ratio.

Show the solution

Debtors turnover = 12,00,000 ÷ 2,00,000 = 6 times.
Collection period = 365 ÷ 6 = 60.83 days, about 61 days.
Inventory turnover = 9,00,000 ÷ 1,50,000 = 6 times.

Answer: Debtors turnover is 6 times, collection period is about 61 days, and inventory turnover is 6 times. Receivables are collected in about two months, so the credit policy may be worth reviewing against the industry.

Exam tips

Learn the four-group classification with two examples each. It is a frequent theory question.
Prepare a crisp list of five uses and five limitations for a 5-mark answer.
Write the formula before calculating. Marks are often given for formula and working.
State assumptions, such as all sales being credit, when data is missing.
Be ready to explain how ratio analysis differs from trend analysis and common size analysis.

Practice questions from Financial Statement Analysis

Ratio Analysis: Classification and Uses in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Ratio Analysis: Classification and Uses: frequently asked questions

What are the main types of accounting ratios?

The functional classification has four groups: liquidity, solvency, activity and profitability. The traditional classification has balance sheet ratios, statement of profit and loss ratios and composite ratios.

What are the limitations of ratio analysis?

Ratios rely on historical figures and ignore inflation. Different accounting policies reduce comparability, and window dressing can distort them. They also ignore qualitative factors and need a standard to be meaningful.

What is the difference between ratio analysis and trend analysis?

Ratio analysis relates two items from the statements, such as current assets to current liabilities. Trend analysis follows the same item over several years, usually with index numbers based on a base year.

Is there a standard ideal ratio for every firm?

No. Rules of thumb such as 2:1 for current ratio are only guides. The right level depends on the industry and the firm's business model.