What Are Accounting Ratios?
Accounting ratios indicate the company’s performance by comparing various figures from financial statements and the results/performance of the company over the last period, suggesting the relationship between two accounting items where financial statement analysis performs using liquidity, solvency, activity, and profitability ratios.
They are useful in analyzing the company’s performance and financial position. It acts as a benchmark and is used to compare industries and companies. However, they are more than just numbers to help understand their stability. In addition, it allows investors with stock valuation. Ratios can be used for macro-level analysis, but in-depth research needs to understand the business properly.
Table of contents
- Accounting ratios show the company’s conduct by comparing different figures from financial statements and the company results/performance over the preceding years, indicating the relationship between two accounting items where financial statement analysis functions utilizing liquidity, solvency, activity, and profitability ratios.
- Liquidity ratios, profitability ratios, leverage ratios, and activity/efficiency ratios are accounting ratios.
- It also allows investors with stock valuation. One can use them for macro-level analysis, but in-depth research must determine the business appropriately.
Accounting Ratios Explained
Accounting ratios are an integral part of the various sets of ratios used in financial analysis to evaluate the profitability and level of efficiency with which a business operates in the competitive market. It helps companies communicate their performance and analysts and investors asses the overall financial health of an organization which facilitates investment related decisions.
In the concept of financial accounting ratios two items taken from the financial statements of the organization’s balance sheet is compared with each other in the form of ratio analysis. The result is expressed as a number or a percentage and compared with simiral ratios of the past data to evaluate the company performance. Similarly, is comparison can be done to get an idea about which way the performance is trending and make a numerical estimate about the future potential of growth.
These important accounting ratios proves to be extremely beneficial for the business because the projections can be used for planning related to production, pricing, revenue generation and expected sales figures, budgeting or investments. The management and stakeholders can assess the position of the business among its competitors in the market.
There are four 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 Ratios Activity 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.
These ratios also help in identify problem areas and design strategies for improvement depending of the urgency of the problems. The management can also determine how much effective the newly implemented policies and procedures proved to be considering one or more accounting periods so that they can be strictly followed and modified as per result. Let us discuss each of these in detail.
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There are four types of accounting ratios analysis with formulas: –
#1 – Liquidity Ratios
This first accounting ratio formula is used to ascertain the company’s liquidity position. It is used to determine its paying capacity towards its short-term liabilities. A high liquidity ratio indicates that the company’s cash position is good. A liquidity ratio of two 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 compares 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 the 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 Ratio = Current Assets / Current 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.
The quick ratioQuick RatioThe quick ratio, also known as the acid test ratio, measures the ability of the company to repay the short-term debts with the help of the most liquid assets. It is calculated by adding total cash and equivalents, accounts receivable, and the marketable investments of the company, then dividing it by its total current liabilities. 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 Ratio = Quick Assets / Current Liabilities
Quick assets exclude inventory and prepaid expensesPrepaid ExpensesPrepaid expenses refer to advance payments made by a firm whose benefits are acquired in the future. Payment for the goods is made in the current accounting period, but the delivery is received in the upcoming accounting period..
The 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 immediately available for liquidity. Therefore, the cash ratio is ideal if it is one or more.
Cash Ratio = (Cash + Marketable SecuritiesMarketable SecuritiesMarketable securities are liquid assets that can be converted into cash quickly and are classified as current assets on a company's balance sheet. Commercial Paper, Treasury notes, and other money market instruments are included in it.) / Current Liabilities
#2 – Profitability Ratios
This accounting ratio formula indicates the company’s efficiency in generating profits. It shows the earning capacity of the business in correspondence to the capital employed.
Gross Profit Ratio
The 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 company’s net sales. It indicates the margin earned by the business before its operational expenses. It is represented as a percentage of sales. The higher the gross profit ratio, the more profitable the company is.
Gross Profit Ratio = (Gross Profits/ Net revenueNet RevenueNet revenue refers to a company's sales realization acquired after deducting all the directly related selling expenses such as discount, return and other such costs from the gross sales revenue it generated. from Operations) X 100
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.
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 the efficiency of the business and its profitability.
Operating Ratio = ((Cost of Goods Sold + Operating Expenses)/ Net Revenue from Operations) X 100
Operating expenses include administrative expenses, selling, and distribution expenses, salary costs, etc.
Net Profit Ratio
The net profit ratio in accounting ratios analysis shows the overall profitability available for the owners as it considers both the operating and non-operating income and expenses. Higher the ratio, the more returns for the owners. It is an important ratio for investors and financiers.
Net Profit Ratio = (Net Profits After Tax / Net Revenue) X 100
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 concerning generating profits compared to the funds invested in the business. It indicates whether the funds are utilized efficiently.
Return on capital employedCapital EmployedCapital employed indicates the company's investment in the business, i.e., the total amount of funds used for expansion or acquisition and the entire value of assets engaged in business operations. "Capital Employed = Total Assets - Current Liabilities" or "Capital Employed = Non-Current Assets + Working Capital." = (Profits Before Interest and Taxes / Capital Employed) X 100
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. show the company’s revenues concerning one share. It is helpful to investors for decision-making about 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 earnings per share are high, the company’s stock price will be increased.
Earnings Per Share = Profit Available to Equity Shareholders / Weighted Average Outstanding Shares
#3 – Leverage Ratios
These 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.. That is because it determines its ability to pay for its debts. Investors are interested in this ratio as it helps determine how solvent the company is to meet its dues.
It shows the relationship between total debts and the company’s total equity. It is useful to measure the leverage of the company. A low ratio indicates that the company is financially secure; a high ratio suggests it 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.
Debt-to-Equity Ratio = Total Debts / Total Equity
The Debt Ratio Debt 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.
Debt Ratio = Total Liabilities/ Total Assets
Proprietary Ratio = Shareholders Funds / Total Assets
Interest Coverage Ratio
The Interest Coverage RatioInterest Coverage RatioThe interest coverage ratio indicates how many times a company's current earnings before interest and taxes can be used to pay interest on its outstanding debt. It can be used to determine a company's liquidity position by evaluating how easily it can pay interest on its outstanding debt. measures its ability to meet its interest payment obligation. A higher ratio indicates that the company earns enough to cover its interest expense.
Interest Coverage Ratio = Earnings Before Interest and Taxes / Interest Expense
#4 – Activity/Efficiency Ratios
Working Capital Turnover Ratio
It establishes the relationship of sales to net working capital Net 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.
Working Capital Turnover Ratio = Net Sales/ Net Working Capital
Inventory Turnover Ratio
The Inventory Turnover RatioInventory Turnover RatioInventory Turnover Ratio measures how fast the company replaces a current batch of inventories and transforms them into sales. Higher ratio indicates that the company’s product is in high demand and sells quickly, resulting in lower inventory management costs and more earnings. indicates the pace at which the stock is converted into sales. Therefore, it is useful for inventory reordering and understanding the conversion cycle.
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
Asset Turnover Ratio
The 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 percentage of the investment. A high ratio suggests that its assets are managed better, yielding good income.
Asset Turnover Ratio = Net Revenue / Assets
Debtors Turnover Ratio
The debtors’ turnover ratio indicates how efficiently debtors’ 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. In addition, it shows the relationship between credit sales and the corresponding receivables.
Debtors Turnover Ratio = Credit Sales / Average Debtors
Let us understand the concept of key accounting ratios with the help of some suitable examples:
X Corp. makes a total sale of $6,000 in the current year, of which 20% is cash sales. Debtors at the beginning are $800 and at the year-end are $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.
Duo Inc. has earnings before interest and taxes of $1,000, and it has issued debentures worth $10,000 @ 6%.
Interest expense = $10,000*6% = $600
Interest Coverage Ratio = Earnings Before Interest and Taxes / Interest Expense = $1,000/$600 = 1.7:1.
So, the current earnings before interest and taxes can cover the interest expense 1.7 times.
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
R&M Inc. had profits before interest and taxes 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%.
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 = $90,00
Gross Profit = $90,000 – $80,000 = $10,000
Gross Profit Ratio = $10,000/ $90,000 = 11.11%
ABC Corp. has the following assets and liabilities on 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
Every financial concept has both positive and negative effects. Let us analyse the same in case of key accounting ratios in details.
- Assessment of performance – The main aim of calculating these ratios is to make assessment of the performance of the business over the years and how it has been able to deliver the result that was expected from it on a year-on-year or quarter-on-quarter basis.
- Assessment of liquidity levels – The ratios also help in evaluating a very important metric, that is the liquidity levels. Any business should essentially have strong levels of liquid assets that is beneficial to meet the daily expenses as well as any unforseen contingency that might arise. Liquidity ensures sustainability and ability to absorb shocks in times of emergency.
- Efficiency of operation– They are useful in evaluation of operational efficiency and effectiveness of the implementation of policies and procedures related to production, sales, revenue budgeting, pricing, management operations, etc. If the results of the ratios prove to be positive, it can be assumed that the organization is in the right track.
- Investor decision – The investors widely use these ratios to make investment decisions. Lenders assess the creditworthiness of the company before lending money. Good ratios levels prove that the business is running smoothly and has future potential to rise and grow. This creates a good image in the market, raising stock prices and investors get the opportunity to earn good returns.
- Management decision – The management continuously depends on these important accounting ratios for decision making related to the future plans of investment, expansion and growth because the accounting ratios act as a guide or a benchmark to identify areas of the business that are showing high performance and areas that need attention. This helps in maintaining a balanced approach to the entire operational process and deal with the problems and design effective solutions for the same.
Some limitations or disadvantages of the concept are as given below:
- Based on past data – An important disadvantage of the concept is that it is based on the past performance and data to a huge extent. It is not necessary that the past performance will work in the current and future in that same manner, especially in the ever changing economic, social and political landscape.
- Subjective – The interpretation of the ratios is sometimes quite subjective in the sense that the data used may not always be accurate of authentic and mislead the users in many ways.
- Sometimes misleading – Misrepresentation is a huge problem in this concept because the data can be manipulated and presented in such a way so as to make the company operations appear very strong and in an upward trend over the years. The investors may take incorrect decisions based on these figures which has a hugely negative long term effect on both company and stakeholders.
- Industry variation – The interpretation of the raios will not be the same across all industries. It will depend on the sector or industry type, its performance, market demand, supply, price, and many other internal and external factors across industries. Therefore, it becomes difficult to compare them across companies if they belong to different industry.
- Changes in accounting rules – Any change in accounting rules and laws will change the interpretation of the accounting ratios, resulting in a different final decision under same circumstance as before. Therefore, stakeholders and management aways need to be up to date about and change in rules and laws related to accounting.
- Inflation – Inflation has an important effect in the sense that due to inflation the current value of assets will go down and it becomes difficult to compare the historical data with the current one due to differences in valuation.
Frequently Asked Questions (FAQs)
The accounting ratios or ratios in management accounting have four ratios: liquidity ratios, activity ratios, solvency ratios, and profitability ratios.
One can divide financial ratios into six critical areas of analysis: liquidity, profitability, debt, operating performance, cash flow, and investment valuation. The financial ratios representation needs the income statements and balance sheets knowledge.
Accounting ratios are an essential financial ratios subdivision. It is a group of metrics utilized to determine the company’s capability and profit based on the financial reports. Moreover, they offer a way of denoting the relationship between one accounting data point to another. In addition, they are also the basis of ratio analysis.
Companies use accounting ratios to know particular trends over time. In addition, one measure for analyzing your business’s financial state. These ratios can guide lenders and investors on if the business performance is worth giving or investing them.
This article is a guide to what are Accounting Ratios. We explain their types along with examples and their limitation and benefits. You can learn more about accounting from the following articles: –