What are Accounting Ratios?
Accounting ratios are the ratios which indicate the performance of the company by comparing various different figures from financial statements, compare results/performance of the company over the last period, indicates the relationship between two accounting items where financial statement analyses are done by using liquidity, solvency, activity and profitability ratios.
There are 4 main types of accounting ratios –
- Liquidity Ratio
- Profitability RatioProfitability RatioProfitability ratios help in evaluating the ability of a company to generate income against the expenses. These ratios represent the financial viability of the company in various terms.
- Leverage RatioLeverage RatioDebt-to-equity, debt-to-capital, debt-to-assets, and debt-to-EBITDA are examples of leverage ratios that are used to determine how much debt a company has taken out against its assets or equity.
- Activity RatiosActivity RatiosActivity Ratios measure the organizational efficiency to utilize its various operating assets (as shown in the balance sheet) to generate sales or cash. It includes inventory turnover ratio, total assets turnover ratio, fixed asset turnover ratio and accounts receivable turnover ratio.
Let us discuss each of these in detail –
Types of Accounting Ratios with Formulas
There are four types of Accounting Ratios with formulas
#1 – Liquidity Ratios
This first type of accounting ratio formula is used for ascertaining the liquidity position of the company. It is used for determining the paying capacity of the company towards its short term liabilities. A high liquidity ratio indicates that the cash position of the company is good. The liquidity ratio of 2 or more is acceptable.
The Current RatioCurrent RatioThe current ratio is a liquidity ratio that measures how efficiently a company can repay it' short-term loans within a year. Current ratio = current assets/current liabilities is used to compare the current assetsCurrent AssetsCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc. to current liabilities of the businessCurrent Liabilities Of The BusinessCurrent Liabilities are the payables which are likely to settled within twelve months of reporting. They're usually salaries payable, expense payable, short term loans etc.. This ratio indicates whether the company can settle its short term liabilities.
Current Assets include Cash, Inventory, Trade receivablesTrade ReceivablesTrade receivable is the amount owed to the business or company by its customers. It is also known as account receivables and is represented as current liabilities in balance sheet., other current assets, etc. Current liabilities include Trade payables and other current liabilities.
ABC Corp. has the following assets and liabilities in its balance sheet.
Current Assets = Short Term capital + Debtors + Stock + Cash and bank = $10,000 + $95,000 + $50,000 + $15,000 =$170,000.
Current Liabilities = Debentures + Trade payables + Bank Overdraft = $50,000 + $40,000 +$40,000 = $130,000
Current Ratio = $170,000/ $130,000 = 1.3
Quick Ratio is the same as the current ratio except it considers only quick assets that are easy to liquidate. It is also called an acid test ratioAcid Test RatioAcid test ratio is a measure of short term liquidity of the firm and is calculated by dividing the summation of the most liquid assets like cash, cash equivalents, marketable securities or short-term investments, and current accounts receivables by the total current liabilities. The ratio is also known as a Quick Ratio.
Quick Assets exclude Inventory and prepaid expenses.
Cash RatioCash RatioCash Ratio is calculated by dividing the total cash and the cash equivalents of the company by total current liabilities. It indicates how quickly a business can pay off its short term liabilities using the non-current assets. considers only those current assets which are immediately available for liquidity. The cash ratio is considered ideal if it is 1 or more.
#2 – Profitability Ratios
This type of accounting ratio formulas indicates the company’s efficiency in generating profits. It indicates the earning capacity of the business in correspondence to capital employed.
Gross profit Ratio
Gross Profit Ratio compares the gross profitGross ProfitGross Profit shows the earnings of the business entity from its core business activity i.e. the profit of the company that is arrived after deducting all the direct expenses like raw material cost, labor cost, etc. from the direct income generated from the sale of its goods and services. to the net sales of the company. It indicates the margin earned by the business before its operational expenses. It is represented as % of sales. The higher the gross profit ratio more profitable the business is.
Net Revenue from operations = Net Sales (i.e.) Sales (-) Sales Returns
Gross profit = Net Sales – Cost of goods sold
The Cost of goods soldCost Of Goods SoldThe cost of goods sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company. includes raw materials, labor cost, and other direct expenses
Zinc Trading Corp. has gross sales of $100,000, Sales return of $10,000, and the cost of goods sold of $80,000.
Net Sales = $100,000 – $10,000 = $90,000
Gross profit = $90,000 – $80,000 = $10,000
Gross profit ratio = $10,000/ $90,000 = 11.11%
The operating ratio expresses the relationship between operating costs and net salesNet SalesNet sales is the revenue earned by a company from the sale of its goods or services, and it is calculated by deducting returns, allowances, and other discounts from the company's gross sales.. It is used to check on the efficiency of the business and its profitability.
Operating expenses include Administrative expenses, Selling, and distribution expenses, salary costs, etc.
Net profit Ratio
Net Profit Ratio shows the overall profitability available for the owners as it considers both the operational and non-operational income and expenses. Higher the ratio, the more returns for the owners. It is an important ratio for investors and financiers.
Return on capital employed (ROCE)
ROCEROCEReturn on Capital Employed (ROCE) is a metric that analyses how effectively a company uses its capital and, as a result, indicates long-term profitability. ROCE=EBIT/Capital Employed. shows the company’s efficiency with respect to generating profits in comparison to the funds invested in the business. It indicates whether the funds are utilized efficiently.
R&M Inc. had PBIT of $10,000, total assets of $1,000,000 and liabilities of $600,000
Capital employed = $1,000,000 – $600,000 = $400,000
Return on capital employed = $10,000/ $400,000 = 2.5 %
Earnings per Share
Earnings Per shareEarnings Per ShareEarnings Per Share (EPS) is a key financial metric that investors use to assess a company's performance and profitability before investing. It is calculated by dividing total earnings or total net income by the total number of outstanding shares. The higher the earnings per share (EPS), the more profitable the company is. shows the earnings of a company with respect to one share. It is helpful to investors for decision making in relation to the purchasing/ sale of shares as it determines the return on investment. It also acts as an indicator of dividend declaration or bonus issuesBonus IssuesBonus shares refer to the stocks issued by the companies for free of cost to their existing shareholders in the proportion of their stock holdings. Companies issue such shares to compensate the shareholders with a higher dividend payout in the form of stocks. shares. If EPS is high, the stock price of the company will be high.
#3 – Leverage Ratios
These types of accounting ratios are known as solvency ratiosSolvency RatiosSolvency Ratios are the ratios which are calculated to judge the financial position of the organization from a long-term solvency point of view. These ratios measure the firm’s ability to satisfy its long-term obligations and are closely tracked by investors to understand and appreciate the ability of the business to meet its long-term liabilities and help them in decision making for long-term investment of their funds in the business.. It determines the company’s ability to pay for its debts. Investors are interested in this ratio as it helps to know how solvent the company is to meet its dues.
Debt to Equity ratio
It shows the relationship between total debts and the total equity of the company. It is useful to measure the leverage of the company. A low ratio indicates that the company is financially secure; a high ratio indicates that the business is at risk as it is more dependent on debts for its operations. It is also known as the gearing ratio. The ratio should be a maximum of 2:1.
INC Corp. has total debts of $10,000, and its total equity is $7,000.
Debt to Equity ratio = $10,000/ $7,000 = 1.4:1
The Debt RatioDebt RatioThe debt ratio is the division of total debt liabilities to the company's total assets. It represents a company's ability to hold and be in a position to repay the debt if necessary on an urgent basis. Formula = total liabilities/total assets measures the liabilities in comparison to the assets of the company. A high ratio indicates that the company may face solvencySolvencySolvency of a company means its ability to meet the long term financial commitments, continue its operation in the foreseeable future and achieve long term growth. It indicates that the entity will conduct its business with ease. issues.
It shows the relationship between total assets and shareholders’ funds. It indicates how much of shareholders’ funds are invested in the assets.
Interest Coverage ratio
Interest Coverage Ratio measures the company’s ability to meet its interest payment obligation. A higher ratio indicates that the company earns enough to cover its interest expense.
Duo Inc. has EBIT of $1,000 and it has issued debentures worth $10,000 @ 6%
Interest expense = $10,000*6% = $600
Interest coverage ratio = EBIT / Interest expense = $1,000/$600 = 1.7:1
So the current EBIT can cover the interest expense for 1.7 times.
#4 – Activity/Efficiency Ratios
Working Capital Turnover ratio
It establishes the relationship of sales to Net Working capitalNet Working CapitalThe Net Working Capital (NWC) is the difference between the total current assets and total current liabilities. A positive net working capital indicates that a company has a large number of assets, while a negative one indicates that the company has a large number of liabilities.. A higher ratio indicates that the company’s funds are efficiently used.
Inventory Turnover ratio
The Inventory Turnover RatioInventory Turnover RatioInventory Turnover Ratio is a measure to determine the efficiency of a Company concerning its overall inventory management. To calculate the ratio, divide the cost of goods sold by the gross inventory. indicates the pace at which the stock is converted into sales. It is useful for inventory reordering and to understand the conversion cycle.
Asset Turnover ratio
Asset Turnover RatioAsset Turnover RatioThe asset turnover ratio is the ratio of a company's net sales to total average assets, and it helps determine whether the company generates enough revenue to justify holding a large amount of assets under the company’s balance sheet. indicates the revenue as a % of the investment. A high ratio indicates that the company’s assets are managed better, and it yields good revenue.
Debtors turnover ratio
Debtors Turnover Ratio indicates how efficiently the credit salesCredit SalesCredit Sales is a transaction type in which the customers/buyers are allowed to pay up for the bought item later on instead of paying at the exact time of purchase. It gives them the required time to collect money & make the payment. value is collected from debtors. It shows the relationship between credit sales and the corresponding receivables.
X Corp makes a total sales of $6,000 in the current year, out of which 20% is cash sales. Debtors at the beginning are $800 and at the year-end is $1,600.
Credit sales = 80% of the total sales = $6,000 * 80% = $4,800
Average debtors = ($800+$1,600)/2 = $1,200
Debtors Turnover Ratio = Credit Sales/Average debtors = $4,800 / $1,200 = 4 times
Accounting ratios are useful in analyzing the company’s performance and financial position. It acts as a benchmark, and it is used for comparing between industries and companies. They are more than just numbers as they help to understand the company’s stability. It helps investors in relation to stock valuation. For macro-level analysis, ratios can be used, but to have a proper understanding of the business an in-depth analysis needs to be done.
This article has been a guide to what are Accounting Ratios and its Definition. Here we discuss 4 types of Accounting ratios along with Formula and Examples. You can learn more about Accounting from the following articles –