Skip to page content

Accounting Ratios — Part 1: Meaning, Classification, Liquidity and Solvency Ratios

Beta

Lesson

Accounting Ratios

Part 1 — what ratios are, how they are grouped, and the liquidity and solvency ratios of an imagined company.

In this lesson you will

Explain what accounting ratios are, how they are expressed and why they are used
Classify ratios into liquidity, solvency, activity and profitability ratios
Compute and interpret the current ratio and the quick ratio, and the effect of transactions on them
Compute and interpret the debt-equity, total assets to debt, proprietary and interest coverage ratios

Part 1 at a glance

Concept

What is an accounting ratio?

A ratio relates two figures from the financial statements.
Ratio analysis: computing, comparing and interpreting ratios.

Rounding rule in this chapter: two decimal places, rounded half up.
Form	Example	Used mainly for
Pure ratio (x : 1)	Current ratio 2 : 1	Liquidity and solvency ratios
Times	Inventory turnover 10 times	Activity (turnover) ratios, interest coverage
Percentage	Gross profit ratio 25%	Profitability ratios

Concept

Why analyse ratios?

Table of objectives and advantages of ratio analysis: judge liquidity, judge solvency, measure efficiency, measure profitability, compare and plan, and locate weak spots
Ratio analysis helps to…	Because…
Judge liquidity	it compares what can be turned into cash soon with what must be paid soon
Judge solvency	it compares long-term debt with owners’ funds and assets
Measure efficiency	it shows how many times resources are turned into revenue
Measure profitability	it relates profit to revenue and to capital employed
Compare and plan	ratios of different years and firms can be set side by side
Locate weak spots	an unusual ratio points to the figure that needs attention