Accounting Ratios

Measure the performance of your business accurately by applying the accounting ratio analysis method. Experience the difference it makes to your financial decisions!

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Accounting Ratios

Accounting ratios, a significant sub-set of financial ratios, are a combination of metrics applied to estimate the performance and profitability of a company or a business based on its financial reports. An accounting ratio matches two line items in a company’s financial and fiscal statements, specifically made up of its balance sheet, income statement, and cash flow statement. These ratios can be applied to estimate a company’s fundamentals and produce information about the performance of the business over the last quarter of the financial year.

Basic accounting ratios comprise the quick ratio, the debt-to-equity ratio, gross margin, the dividend payout ratio, and operating margin. Accounting ratios are practised by both the company itself to get improvements or control progress as well as by investors to decide the most suitable investment option.

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Benefits of Ratio Analysis

When employed perfectly, ratio analysis shines a light on many queries of the company and also highlights some positives. Ratios are typically whistleblowers and they represent the management’s consciousness towards problems requiring attention. Here are some benefits of accounting ratios:

  • Ratio analysis will assist to validate or disprove the investment, financing, and operating decisions of the company. They review the financial report into similar figures, thus improving the management to analyse and assess the financial condition of the company and the outcomes of their decisions.
  • It explains complex accounting records and financial data into manageable ratios of running performance, financial performance, solvency, long-term conditions, etc.
  • Ratio analysis assists with recognising problem states and brings the attention of the management to such measures. Some of the data is lost in the complex accounting statements, and ratios will improve pinpoint such difficulties.
  • Enables the company to manage comparisons with other firms, business standards, intra-firm connections, etc. This will serve the company better understand its financial position in the economy.

Checklist/requirements of Accounting Ratio

Here are some requirements to be known about the accounting ratios:

  • To identify the areas of the company which require more concentration.
  • To understand the potential areas which can be developed with the effort in the aspired direction.
  • Further, to provide a more extensive review of the profitability, liquidity, efficiency, and solvency levels in the business.
  • Additionally, it should provide information for obtaining cross-sectional study by examining the performance with the best business standards; and
  • To give information obtained from financial reports valuable for making projections and measures for the future.

Limitations of Accounting Ratios

While ratios are very valuable tools of financial analysis, they will also have some limitations, such as:

  • The company can make some year-end additions to its fiscal records, to develop their ratios.
  • Ratios neglect the price level variations due to inflation. Several ratios are determined relating historical costs, and they face the changes in output level between the times. This does not match the exact financial situation.
  • Accounting ratios effectively ignore the qualitative features of the firm. They get into consideration the financial aspects (quantitative).
  • So firms may be using different formulas for the ratios. One such instance is the current ratio, where some companies take into attention all current responsibilities but others ignore bank overdrafts from current liabilities while measuring the current ratio
  • And lastly, accounting ratios do not solve any financial difficulties of the company.

What are the types of Accounting Ratios?

Liquidity Ratio

The liquidity ratio defines the paying ability of a business to satisfy short-term liabilities. A company holding a liquid ratio of 2 or more is considered ideal. Here is the table for liquidity ratio:

Ratio NameUsageFormula
Current ratio

This is the most regularly used liquidity ratio that supports a business in examining their current assets with their current responsibilities

The current ratio supports business to examine whether they will be ready to pay their due debts in the subsequent twelve months or not

current assets ÷ current liabilities
Quick ratio

The quick ratio is like the current ratio without quick assets that are associated with current liabilities.

The other sign of quick ratio is also known as the acid test ratio

quick assets ÷ current liabilities
Cash ratio

This ratio uses those current assets into the report that is directly accessible to a company to meet its debts.

Any company owning a cash ratio of one or more is recognised as financially stable.

(cash + marketable securities) ÷ current liabilities

Solvency Ratio

The leverage ratio supports a business in managing its long term solvency. Usually, these ratios are applied to examine the debt-paying ability of the company. Here is a list of most commonly used solvency ratios:

Ratio NameUsageFormula
Debt to equity ratio

Debt to equity ratio promotes a company examining the relationship between total debt and shareholder’s fund.

This ratio commits both creditors of the business and the company’s shareholders.

total debt ÷ total equity
Debt to asset ratio

Debt to asset ratio supports a business in deciding how many entire assets are supported by the creditors.

Less than 1 debt to asset ratio means that assets can be additionally financed, and vice-versa.

total debt ÷ total asset
Proprietary ratio

The proprietary ratio gives a connection between the proprietor’s shareholder’s funds with the entire assets of a company.

This ratio assists in managing the financial strength of a company.

proprietor’s fund/shareholder’s funds ÷ total asset
Fixed asset ratio

A fixed asset ratio supports business to explain the relationship between fixed assets of the company with long-term debts.

This ratio shows a business’s ability to discharge its obligations and guarantees long-term durability.

net fixed assets ÷ long-term debt
Interest coverage ratio

Interest coverage ratio defines the link between the earnings before interests and taxes with interest on extended-term debts

The higher the interest coverage ratios lower the risk of financial default.

earnings before interest and taxes (EBIT) ÷ interest on long-term debts

Profitability Ratio

Profitability ratio assists in examining how much profit is obtained by a company from its operations. In other words, the profitability ratio defines the earning potential of a business using the means employed. Here is a list of profitability ratios that are commonly used:

Ratio NameUsageFormula
Gross profit margin

Through the gross profit ratio, any company can match its performance with its competitors or its previous performance

The gross profit ratio represents the percentage of factory cost about the sales price

A higher gross profit margin means that business is more effective in its performance.

gross profit ÷ revenue
Operating margin

Using the operating margin ratio can easily estimate how much is collected through the operating income

The other name of the operating margin ratio is operating profit margin

operating income ÷ net sales
Profit margin

Through the profit margin ratio, any company or business can manage the amount of interest received from its total generated revenue

A business can quickly evaluate its overall profitability to associate it with its competitors

net income ÷ net sales
Earnings per share (EPS)

EPS is a company profit portion given to every share showing its profitability

EPS serves the shareholder to manage their return on investment

(net income – preferred dividend) ÷ common outstanding shares

Activity Ratio / Efficiency Ratio

Activity ratio shows the revenue produced from a particular asset standard by balancing cost, businesses, sales, and asset data. This ratio improves the business inefficient control and efficient utilization of the assets. Here is the list of activity ratio that is used frequently:

Ratio NameUsageFormula
Stock turnover ratio

The stock turnover ratio supports the business to know the connection between inventory and COGS.

The stock turnover ratio performs the stock reordering task and simplifies the process for a business gets to know its stock exchange rate.

COGS ÷ average stock/inventory
Debtor turnover ratio

The debtor turnover ratio supports businesses to plan the relationship within net credit sales and common debtors or bills receivables.

An organisation holding a higher debtor turnover ratio shows an effective credit policy.

Net credit sales ÷ average debtors or bills receivables
Creditors turnover ratio

The creditors turnover ratio presents an opinion concerning the relation between net credit purchase and common creditors or bills payable.

Usually, a higher ratio means effective asset utilization and control by the business.

Net credit purchase ÷ average creditors or bills payable
Working capital turnover ratio

Working capital turnover ratio supports managing the relationship between net selling and working capital.

A higher ratio of working capital turnover means effective use of working capital.

Sales or COGS ÷ working capital

FAQs on Accounting Ratios

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