Accounting Ratios- An Overview
Accounting ratios are a key subset of financial ratios. They are a collection of indicators used to analyse an organisation's performance and profitability through financial reports. The balance sheet, income assertion, and money flow announcement are the three crucial aspects that make up a company's economic and fiscal declarations. These ratios can be used to estimate a company's fundamentals and provide data on the operation's performance during the fiscal year's final quarter.
The quick ratio, debt-to-equity ratio, gross margin, dividend payout ratio, and operating margin are some of the fundamental accounting ratios. Accounting ratios are used by investors to select the best investment opportunity as well as by businesses themselves to obtain improvements or control progress.
Benefits of Ratio Analysis
When properly applied, ratio analysis sheds light on numerous issues faced by the business and also draws attention to some aspects that are working well. Ratios are frequently insiders who reveal management's awareness of issues that need to be addressed. Following are a few advantages of accounting ratios:
- Ratio analysis will help to support or refute the company's investment, finance, and operational decisions. They break down the financial report into comparable numbers, which helps management better analyse and evaluate the company's financial situation and the results of its decisions
- It breaks down intricate financial data and accounting records into digestible ratios of operational performance, financial performance, solvency, long-term conditions, etc
- Ratio analysis helps identify problem conditions and draws management's attention to such actions. The ratios will help in analysing these issues when some data is lost during accounting
- Enables the management of intra-firm relationships, corporate standards, and comparisons with other companies. This will help the business comprehend its financial standing inside the economy.
Checklist for Accounting Ratio
Accounting ratios are used
- To determine which regions of the company needs additional focus
- To comprehend the prospective development regions that could be achieved with effort in the desired direction
- To provide clear insights of the company's ability, solvency levels, efficiency and liquidity
- Additionally, by assessing the performance with the highest possible business standards, it should generate data for cross-sectional research
- To provide useful information gleaned from financial reports for future estimates and planning.
Limitations of Accounting Ratios
These ratios are highly valuable tools when it comes to financial analysis. Despite being continuously used they do have some shortcomings:
- To build its ratios, the corporation can add some year-end information to its financial records
- Ratios ignore changes in price level brought on by inflation
- Numerous ratios are established when comparing expenses from the past, and they take into account variations in output over time. This is not relatively in line with the economic position
- Accounting ratios essentially overlook the firm's qualitative attributes. They take into account the economical factors (quantitative)
- Therefore, different ratio formulas may be used by different firms. One such example is the current ratio. While calibrating the current ratio some businesses tend to include the present obligations and ignore the bank overdrafts from present liabilities
- The financial restrictions and problems faced by a company cannot be resolved using accounting ratios.
Types of Accounting Ratios
Liquidity Ratio
This particular ratio is used to analyse the paying ability of a business in order to satisfy a short term liability. A firm holding a Liquidity ratio of 2 or additional is supposed ideal. Some accounting ratios are explained in the following table.
| Ratio Name | Usage | Formula |
|---|---|---|
| Current ratio | This ratio helps a business compare its current obligations to its current assets and is one that is most frequently used. The current ratio helps businesses determine whether they will be able to pay their outstanding debts in the upcoming year or not. | current assets ÷ current liabilities |
| Quick ratio | This is similar to that of the current ratio however it terminates immediate investments with current penalties. The asset test ratio is another indication of a quick ratio. | quick assets ÷ current liabilities |
| Cash ratio | This ratio incorporates current assets—assets that a corporation can immediately access to pay its debts—into the report. Any business that has a cash-to-assets ratio of one or higher is considered financially stable. | (cash + marketable securities) ÷ current liabilities |
Solvency Ratio
These ratios assist businesses in controlling their long-term solvency. These ratios are frequently used to assess a company's capacity for repaying its debts. The following is a list of the most popular solvency ratios:
| Ratio Name | Usage | Formula |
|---|---|---|
| Debt to equity ratio | A corporation is motivated to analyse the connection between total debt and shareholder budgets by analysing its debt to equity ratio. This ratio ties up the company's shareholders as well as its creditors. | Total debt ÷ total equity |
| Debt to asset ratio | A company can use the debt to asset ratio to calculate the percentage of its total assets that are backed by creditors. If the debt to asset ratio is less than one, and vice versa, assets may be further financed. | total debt ÷ total asset |
| Proprietary ratio | The proprietor's shareholder fund and the total assets of a company are connected by the proprietary ratio. This ratio aids in managing a company's financial health. | proprietor’s fund/shareholder’s funds ÷ total asset |
| Fixed asset ratio | A fixed asset ratio helps a business explain how its fixed assets and long-term debts relate to one another. This ratio demonstrates a company's capacity to meet its commitments and ensures long-term viability. | net fixed assets ÷ long-term debt |
| Interest coverage ratio | The relationship between revenue before interests and tariffs and the interest on long-term obligations is known as the interest range ratio. The hazard of financial insolvency is downward as interest range ratios increase. | income before interest and taxes (EBIT) ÷ interest on long-term debts |
Profitability Ratio
Profitability ratio assistance in evaluating the amount of profit a company earns from its procedures. In other words, a business's earning potential with its current resources is determined by its profitability ratio. Here is a an index of repeatedly operated profitability ratios:
| Ratio Name | Usage | Formula |
|---|---|---|
| Gross profit margin | Any business can compare its performance to that of its rivals or to its prior performance using the gross profit ratio. The gross profit ratio indicates the ratio of manufacturing costs to deals prices. A higher gross profit margin indicates that a business is operating more efficiently. | Gross profit ÷ revenue |
| Operating margin | One may quickly determine how much is collected through operational income by using the operating margin ratio. Operational margin ratio is also known as operating earnings margin. | Operating income ÷ net sales |
| Profit margin | With the help of the profit margin ratio any company can control the amount of interest received from the total generated value. A company can compare its overall profitability to that of its rivals quickly. | net income ÷ net sales |
| Earnings per share (EPS) | EPS is a criterion of a company's profitability that is divided in everything. The shareholder uses EPS to control their return on investment. | (net income – preferred dividend) ÷ common outstanding shares |
Activity Ratio / Efficiency Ratio
Activity ratio by balancing cost, business, sales, and asset data, demonstrates the revenue generated by a specific asset standard. This ratio enhances the ineffective management of the firm and the effective use of the resources. The list of widely used activity ratios is shown below:
| Ratio Name | Usage | Formula |
|---|---|---|
| StStock turnover ratio | The stock turnover ratio helps the company understand how inventory and COGS are related. It handles stock reordering and makes it easier for a company to understand its stock exchange rate. | COGS ÷ average stock/inventory |
| Debtor turnover ratio | Debtor turnover ratio is used to plan a properly between the credit sales and common debtors. This is also called bills receivable. A company with a higher debtor turnover percentage exhibits a sound credit policy. | Net credit sales ÷ average debtors or bills receivables |
| Creditors turnover ratio | This can be explained as the association between the net credit by and common creditors that is presented by the ratio. A greater ratio typically indicates efficient asset management and control on the part of the company. | Net credit purchase ÷ average creditors or bills payable |
| Working capital turnover ratio | This ratio is used to manage a relation between net selling and working capital that is supported by this ratio. A higher working capital turnover ratio directly implies adequate use of working money. | Sales or COGS ÷ working capital |
Why Vakilsearch?
Accounting ratios are merely numbers and are crucial to determine the company's future. Understanding these ratios is the first step in being able to tip the scales in your favour. Observing these ratios and first understanding the status of your organisation can help you grow faster and better before you start implementing your ideas. Now consult our in-house accountants to resolve all your doubts. Vakilsearch provides online accounting and bookkeeping services that can propel your business to the next level.
