Accounting Ratios
Updated on: Jun 14th, 2024
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3 min read
Accounting ratio is the comparison of two or more financial data which are used for analyzing the financial statements of companies. It is an effective tool used by the shareholders, creditors and all kinds of stakeholders to understand the profitability, strength and financial status of companies. This is also widely known as financial ratios based on which business performance can be monitored and important business decisions are made.
All these types of ratios are used for monitoring the business performance and comparing the business results with competitors. Let’s discuss each of the ratios in detail below-
Liquidity Ratio
Liquidity ratio helps in measuring the cash sufficiency of an enterprise to pay off its short-term liabilities. A High liquidity ratio ensures the company is in a good position to pay its creditors. The liquid ratio of 2 or more is considered acceptable. Listed below are some of the commonly used liquidity ratios:
| Sl.No | Ratio Name | Formula | Used for | Detail |
|---|---|---|---|---|
| 1 | Current Ratio | {(Current Assets)/(Current Liabilities)} | 1. One of the commonly used liquidity ratios is the current ratio which compares the current assets to current liabilities held by the business | Current assets include cash, inventory, accounts receivable etc |
| 2. This ratio is used to check if the company will be able to pay its debts which are due in next 12 months | Current liabilities include accounts payable, income tax payable and any other current liabilities | |||
| 2 | Quick Ratio | {(Quick Assets)/(Current Liabilities)} | 1. It is similar to current ratio except that this uses only quick assets which are easy to liquidate. | To calculate the Quick assets, inventory and prepaid expenses which are difficult to liquidate are to be removed from the current assets. |
| 2. This is also known as Acid test | ||||
| 3 | Cash Ratio | {(Cash + Marketable securities )/(Current Liabilities)} | 1. This ratio considers only those current assets which are immediately available to the company to pay its debts. | Only cash and marketable securities are considered for current assets. |
| 2. Business is considered as financially sound if it has a cash ratio of 1 or more. |
Profitability Ratio
Profitability ratio is generally used to determine how well the business is generating profits from its operations. Profit is the balance of income earned after deducting all related expenses. Given below are some of the commonly used profitability ratios:
| Sl.No | Particular | Formula | Used for | Detail |
|---|---|---|---|---|
| 1 | Gross Profit Margin | {(Revenue – Cost of Goods Sold (COGS))/(Revenue)} | 1. Higher the gross profit margin, more efficient is the business operation. | Revenue is the sales income and COGS includes raw material, labour, and other production expenses |
| 2. Gross Profit ratio is used to compare the business performance with its previous period or even with its competitors | ||||
| 2 | Operating Margin | {(Gross Profits- Operating Expense)/(Revenue)} | 1. Unlike Gross profit ratio, this includes more expenses and hence it is used to ascertain companies profitability more efficiently | From the gross profits, operating expenses such as selling and distribution cost, administration cost etc are deducted to arrive at operating margin |
| 3 | Profit Margin | {(Revenue – Operating expense + non-operating income-Interest Expense- Income taxes)/(Revenue)} | 1. This ratio helps an investor to know how much profit is generated from the total revenue of the business | As the formula itself explains, the profit margin is arrived from the revenue after adjusting all operating and non-operating expense and income |
| 2. The overall functional efficiency of an enterprise can be ascertained apart from its core business | ||||
| 4 | Earnings per Share (EPS) | {(Net Income – Preferred Dividend)/(Weighted Average Outstanding Shares)} | EPS is more important to shareholders since it helps in determining the return on investment | Generally weighted average Outstanding shares are used since outstanding shares can change over time |
| Higher the EPS, higher is the stock price of the company | Sometime Diluted EPS are used which includes options, convertible securities and warrants outstanding which affects outstanding shares |
Leverage Ratio
Leverage ratio measures the utilization of borrowed money by the business. It helps to identify the financial stability of the business by analyzing the total debt of the company.
| Sl.No | Particular | Formula | Used for | Example |
|---|---|---|---|---|
| 1 | Debt to Equity Ratio | {(Total Debt)/(Total Equity)} | 1. Business with high debt Equity ratio indicates that it is more dependent on debts for operation | Total Debt includes both long term and short term debts held by the company. |
| 2. This is also known as Gearing ratio which is used by Investors and Creditors to analyze the company’s financial leverage | ||||
| 2 | Debt to Asset Ratio | {(Total Debt)/(Total Asset)} | 1. Debt to Asset ratio can be used to determine if the business will be able to pay all of its debts if the business is closed immediately | It includes all the debt and assets of the company but there are different variations of this formula where only certain assets or specific liabilities are included |
| 2. A company having a debt to asset ratio of less than 1 is considered as good for investment. If the ratio is greater than 1, the company is considered as highly leveraged | ||||
| 3 | Debt Ratio | {(Total Liabilities)/(Total Asset)} | 1. The liabilities to assets ratio is also known as solvency ratio indicates how much of a company's assets are made of liabilities | Total long-term debt and total assets (tangible and intangible) are reported on the balance sheet are considered |
| 2. A high liability to assets ratio indicates the business might face potential solvency issues | ||||
| 4 | Interest Coverage Ratio | {(Earnings before interest and taxes (EBIT))/(Interest Expense)} | 1. This ratio is used to measure the company’s ability to meet its interest –payment obligation | Net Income before deducting interest and taxes by the company's interest expense and taxes are considered as a percentage on interest expense |
| 2. A higher ratio indicates a better financial position of the business |
Activity Ratio / Efficiency Ratio
Activity ratio indicates the return generated from a particular type of asset using the sales, cost and asset data. This ratio helps the business to identify effective utilization of the assets and thereby facilitates efficient management:
| Sl.No | Particular | Formula | Used for | Example |
|---|---|---|---|---|
| 1 | Receivable Ratio | {(Annual Sales Credit)/(Accounts Receivable)} | 1. Receivables Turnover ratio measures how soon the firms collect its receivables | For the ratio calculation, monthly average receivables and sales on credit terms are used generally |
| 2. A high receivable ratio indicates that the business sales collection process is working well | Average collection period can be determined using this ratio | |||
| 2 | Inventory Turnover Ratio | {(Cost of Goods Sold)/(Average Inventory)} | 1. It is used to ascertain the rate at which the company’s inventory is converted to cash | It is generally measured using inventory period which is the average inventory divided by average cost of goods is sold |
| 2. A company with higher inventory ratio is considered to have an effective sales strategy | ||||
| 3 | Asset Turnover Ratio | {(Net Revenue)/(Assets)} | 1. This ratio indicates the value of revenue as a percentage of the value of investment | This can have different variants depending upon the asset category used for the calculation |
| 2. A higher ratio indicates better asset management and utilization by the business |
Conclusion
Accounting ratios are very helpful in analyzing any company’s performance but on the flip side, these ratios calculated using balance sheet on a specific date. As such, may not reflect the financial position of the company during other periods of the year. Hence, it is always better for the analyst to do the in-depth analysis of the company’s performance rather to only rely on ratios.
Quick Summary
Accounting ratios compare financial data for analyzing companies' financial statements. They help stakeholders understand profitability, strength, and financial status. Ratios like liquidity, profitability, leverage and activity are used in business decision-making. Ratios like current, quick, cash, gross profit margin, operating margin, profit margin, EPS, debt to equity, debt to asset, debt ratio, interest coverage, receivable turnover, inventory turnover, asset turnover are commonly used.
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