Ratios are used to perform financial analysis of a company. To comment on the financial position of a company, analysts calculate and interpret various ratios. Different stakeholders may require different information on a company’s financial status. Vendors supplying raw material to the company may be interested in knowing the short term liquidity position of the company.

Investors, on the other hand, may be interested in knowing the overall profitability of the company in order to ascertain earning per share. Depending on the type of information required, different ratios may be calculated. To calculate these ratios, information available in company’s financial statements is used.

While some of these ratios are calculated with the information available in profit and loss account (such as gross profit ratio, net profit ratio etc.), other ratios are calculated with the information contained in balance sheet (such as current ratio, debt equity ratio etc.). Liquidity ratios and profitability ratios are two broad categories of financial ratios.

Let Us Understand The Difference Between These Two Categories Of Ratios

Liquidity Ratios

As the name suggests, this category of ratios is used the judge the liquidity position of the company. Liquidity means availability of adequate amount of cash to meet short term liabilities of the company. Vendors and suppliers are generally interested in liquidity ratios in order to measure a company’s ability to pay its outstanding dues.

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Current ratio and quick ratio are the most commonly used liquidity ratios. These ratios are calculated with the help of information available in the company’s balance sheet. Current ratio of 2:1 and quick ratio of 1:1 is generally considered to be optimum for a company. Current assets, quick assets and current liabilities are used in the calculation of these two liquidity ratios.

Profitability Ratios

Profitability ratios are calculated to measure a company’s earning capacity. Profitability ratios are calculated in relation to sales and investments made by the company. Some of the profitability ratios which are calculated in relation to sales include gross profit margin and net profit margin. Profitability ratios calculated in relation to investments include return on equity, return on total assets and return on capital employed.

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Information to calculate these ratios is available in balance sheet and profit and loss account of the company. Investors are generally interested in the percentage of net profit ratio and return on equity ratio. However, there are no fixed parameters that may be used by investors while performing an evaluation of a company’s profitability position. Profitability ratios may indicate a company’s ability to generate adequate amount of profits on total investment or total sales made by the company.

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While net profit ratio may indicate a firm’s ability to convert its sales into net profits, return on equity may indicate the percentage of net income that is generated by a company in proportion to the money invested by company’s shareholders. Calculation of these ratios may not appear to a very difficult task for an accountant. However, interpretation of these ratios may require special accounting and analytical skills on the part of the analyst in order to derive meaningful conclusions.

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