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Q1. Describe the functional classification of Ratios. Explain the benefits of each ratio.


Answer:
Functional Classification of Ratios: All the ratios discussed previous can be classified on the basis of their functions as follows:
1. Liquidity Ratios:
a) Current ratio
b) Acid test ratio
2. Solvency Ratios:
a) Current ratio
b) Acid test ratio

c) Equity ratio
d) Debt ratio
e) Debt-equity ratio
f) Net income to debt service ratio
3. Profitability Ratios:
a) Gross profit ratio
b) Net profit ratio
c) Return on equity
d) Return on investment
e) Return on networth
4. Activity Ratios:
a) Inventory turnover
b) Debtors turnover
c) Fixed assets turnover
d) Working capital turnover
5. Leverage Ratios:
a) Debt ratio
b) Net income to debt service ratio
c) Debt equity ratio
d) Proprietary ratio
6. Financial ratios:
a) Fixed assets ratio
b) Capital gearing ratio
c) Debt-equity ratio
d) Current ratio
e) Liquidity ratio

The classification given above would help students to work out problems which do not specify the individual ratios to be worked out but the student is asked to calculate a particular group such as solvency ratios, leverage ratios, etc.
The table given below would also help students to calculate the required ratios in a given problem:


Objectives of Analysis
Ratios to be Computed
1. Short-term financial solvency
a) Current ratio

b) Liquidity ratio
2. Long-term financial solvency
a) Equity or proprietary ratio

b) Debt ratio

c) Debt-equity ratio

d) Shareholders equity to total equity ratio
3. Immediate solvency
a) Liquidity ratio
4. Overall efficiency
a) Return on investment

b) Operating ratio

c) Assets turnover and other turnover ratios

d) Return on proprietors equity

e) Earnings per share
5. Profitability in relation to sales
a) Gross profit ratio

b) Net profit ratio
6. Profitability in relation to investment
a) Return on investment

b) Return on proprietor’s equity

c) Earnings per share
7. Over-trading or under-trading
a) Proprietary ratio

b) Current ratio

c) Stock turnover ratio
8. Trading on equity
a) Capital gearing ratio
9. Over-capitalisation and under-capitalisation
a) Proprietary ratio

b) Current ratio

c) Return on equity capital
10. Operating efficiency
a) Operating ratio

b) Expense ratios







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