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.
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:
Here are some requirements to be known about the accounting ratios:
While ratios are very valuable tools of financial analysis, they will also have some limitations, such as:
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:
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|
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|
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|
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:
|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|
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 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:
|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|
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|
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:
|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|
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