An Introduction to Accounting Ratios and Formulas

What Are Accounting Ratios?

Definition: Accounting ratios are defined as the group of metrics used to gauge the efficiency and profitability on several parameters by making use of its financial data. Accountants and financial experts use these ratios to check the business’s financial condition and whether any significant red flags need to be addressed. These ratios are generally calculated yearly or sometimes quarterly. The importance and weightage of each of the ratios may differ from firm to firm and industry to industry.

Accounting ratios are a wide variety of ratios that measure efficiency and profitability in various ways using financial data. It includes a group of metrics used for measuring profitability alongside liquidity and potential financial distress in the financials of a company.

These ratios can be challenging to calculate and quantify when prominent and leading companies of the world are to be accounted for, and it may get incredibly befuddling for laypeople. Analysis of these ratios is crucial to determine the health of a business. Furthermore, any changes to accounting policies, management, and production plans can affect the business, and any improvements (or lack thereof) can be gauged with the help of accounting ratios.

Commonly Used Accounting Financial Ratios

Financial experts and accountants commonly employ many accounting ratios, which may be categorized into the following categories: profitability ratios, debt ratios, liquidity ratios, turnover ratios, market value ratios, and some others. Let us have a look at all those ratios here and now-

1. Profitability Ratios

It is used to measure a business’s earnings versus its expenses. Profitability ratios can include net profit ratio, net income ratio, gross profit margin, operating margin, profit margin, earnings per share, and return on owner’s funds. These ratios are generally used to determine the profitability of the business from its various operations. Profit is defined as the net revenue obtained by deducting all expenses incurred from the gross income earned by a firm. Some of the common profitability ratios are-

• Return on Assets = Net Income/Average Total Assets
• Return on Equity = Net Income/Average Stockholder Equity
• Profit Margin = Net Income/Sales
• Earnings Per Share = Net Income/Number of Common Shares Outstanding

2. Liquidity Ratios

These ratios help accountants in gauging how capable a company is of paying its debts. Generally, they check this by measuring current liabilities and liquid assets. Liquidity ratios generally involve the current ratio, liquid ratio, and quick ratio.

Liquidity ratios calculate the capacity of a company about its ability to pay off its debts and are generally measured with the aid of liquid liabilities and assets. A higher liquid assets to liquid liabilities ratio indicates it is considered favorable, and a minimum liquid ratio of two or more is considered acceptable. Profitability ratios, on the other hand, measure a business’s income relative to its expenditure. Some of the common liquidity ratios are-

• Current Ratio = Current Assets/Current Liabilities
• Quick Ratio = Quick Assets/Current Liabilities
• Net Working Capital Ratio = (Current Assets – Current Liabilities)/Total Assets:
• Cash Ratio = Cash/Current Liabilities
• Cash Coverage Ratio = (Earnings Before Interest and Taxes + Depreciation)/Interest
• Operating Cash Flow Ratio = Operating Cash Flow /Current Liabilities

3. Leverage Ratios

These ratios are used to check how much of a company’s capital comes from debt. They also suggest how likely it is for a company to meet its financial obligations. Leverage ratios or debt ratios gauge how much a firm’s capital is derived from its debt and how capable the firm is when settling its debts. They are conceptually similar to liquidity ratios but focus on total debts instead of current liabilities and assets. These ratios measure how the borrowed funds are used within the firm and help identify any financial instability by analyzing the firm’s total debt. These ratios include debt-to-equity ratio, debt ratio, debt-to-asset ratio, and interest coverage ratio.

• Current Ratio = Current Assets/Current Liabilities
• Quick Ratio = Quick Assets/Current Liabilities
• Net Working Capital Ratio = (Current Assets – Current Liabilities)/Total Assets
• Cash Ratio = Cash/Current Liabilities
• Cash Coverage Ratio = (Earnings Before Interest and Taxes + Depreciation)/Interest
• Operating Cash Flow Ratio = Operating Cash Flow /Current Liabilities

4. Turnover Ratios

Turnover ratios are considered effective in measuring the income of a company against its assets. Turnover ratios work by measuring a company’s earnings relative to its asset holdings. A higher ratio is generally regarded as being favorable. These ratios help the business in identifying effective utilization of assets and thereby helps with efficient management. Turnover ratios (or Activity ratios) may include ratios like inventory turnover ratio, asset turnover ratio, and receivable ratio. Let us have a look at some of the turnover ratios formulae-

• Inventory Turnover Ratio = Costs of Goods Sold/Average Inventories
• Assets Turnover Ratio = Sales/Average Total Assets
• Accounts Receivable Turnover Ratio = Sales/Average Accounts Receivable
• Accounts Payable Turnover Ratio = Total Supplier Purchases/(Beginning Accounts Payable + Ending Accounts Payable)/2)

5. Market Value Ratios

Such ratios are used while dealing with stocks and shares. Market value ratios are concerned with evaluating whether a company’s stocks or shares are undervalued or overvalued. The dividend payout ratio is somewhat similar and is equally useful for shareholders. It works by using data from the cash flow statement. This ratio shows the percentage of the net income paid to investors in the form of dividends. Dividends and share repurchases are outlaid of cash and may be found on the cash flow statement of the company. Some of the common types of market value ratios are-

• Price-to-Earnings Ratio = Price Per Share/Earnings Per Share
• Market-to-Book Ratio = Market Value Per Share/Book Value Per Share

It is also important to remember that these ratios are calculated on a specific date using information from the balance sheet of the company and may not accurately represent the financial condition of the business during other times of the year. Due to these reasons, analysts prefer an in-depth study or analysis of the company’s performance to get a clearer picture of its nuances and its effects on the business.

6. Utility Of Accounting Ratios

Accounting ratios may seem like tedious and superfluous number-crunching, but they are capable of painting an accurate picture of a company’s situation, especially for those well-versed in finance.

A successful business requires learning from mistakes made in the past and making better decisions for the future. For these reasons, a basic understanding of accounting is crucial to analyze and decide for the future of the business.

Using accounting ratios can prove useful to gauge the efficiency and profitability of the business. The Operating Ratio, for instance, can indicate the operating costs and efficiency of the business. Liquidity ratios can indicate the liquidity of the firm. The asset turnover ratio indicates the value of the assets relative to the production of the firm.

As with all things, however, these ratios need to be taken concerning context. Some companies favor growth over profitability. Analyzing the past profitability ratios might misleadingly lead one to assume that such firms were financially weak when they were not. Firms like these tend to reinvest their incomes into growth and not reporting it as profit. This is why background knowledge of the firm or business is crucial to be accounted for when interpreting accounting ratios.

Managers need to understand the accounting ratios, as they prove useful when making decisions and can help increase the overall profitability and health of the division they are in charge of.

Wrap Up!

Learning about accounting ratios and their calculation can help individual gain clarity on the inner workings and nuances of a firm, and is what helps the individuals separate from the layman and take them a step further in becoming an effective financial expert/ consultant, a future business owner or simply an informed and calculating investor.

These accounting ratios can provide key insight about what needs to be done or avoided in a business and can protect it from unnecessary pitfalls in ideal scenarios.

What are your thoughts about the importance of accounting ratios in gauging the financial health of a company?