Accounting ratio is mathematical representations of two or more data either interrelated or independent to analyze the financial condition of any business. Accounting ratios are determined using accounting information collected from the financial statements.
Accounting Ratios are also known as Financial Ratios as these ratios help in determining the financial performance of the business.
Different ways to show Accounting Ratios
Four different ways to show financial ratios are;
- Simple or Pure form – A simple form are those that are represented in the quotient form for instance– 2:1
- Percentage – A Percentage form are those that are represented in the percentage form for instance– 50%
- Turnover Rate or Times – A Turnover Rate and Times form are those that are represented in the rate or times form for instance– 5 Times
- Fraction – A fraction form are those that are represented in the fraction or decimal form for instance– 1/3 or 1.33
Types of Accounting Ratios
- Liquidity Ratio
- Solvency Ratio
- Profitability Ratio
- Activity Ratio
1. Liquidity Ratio
Liquidity ratio determines the paying capacity of a business to meet short-term liabilities. A business having a liquid ratio of 2 or more is considered ideal. Here is the list of Liquidity Ratio:
Ratio Name |
Usage |
Formula |
Current Ratio |
|
Current Assets ÷ Current Liabilities |
Quick Ratio |
|
Quick Assets ÷ Current Liabilities |
Cash Ratio |
|
(Cash + Marketable securities ) ÷ Current Liabilities |
2. Solvency Ratio
Leverage ratio helps a business to determine its long term solvency. Generally, these ratios are used to analyze the debt paying capacity of the company. Here is a list of most commonly used solvency ratios:
Ratio Name |
Usage |
Formula |
Debt to Equity Ratio |
|
Total Debt ÷ Total Equity |
Debt to Asset Ratio |
|
Total Debt ÷ Total Asset |
Proprietary Ratio |
|
Proprietor’s fund/shareholder’s funds ÷ Total Asset |
Fixed Asset Ratio |
|
Net Fixed Assets ÷ Long term debt |
Interest Coverage Ratio |
|
Earnings before interest and taxes (EBIT) ÷ Interest on long term debts |
3. Profitability Ratio
Profitability ratio helps in analyzing how much profit is earned by a business from its operations. In other words, Profitability Ratio determines the earning capacity of a business using through the resources employed. Here is a list of profitability ratios that are normally used:
Ratio Name |
Usage |
Formula |
Gross Profit Margin |
|
Gross Profit ÷ Revenue |
Operating Margin |
|
Operating Income ÷ Net Sales |
Profit Margin |
|
Net Income ÷ Net Sales |
Earnings per Share (EPS) |
|
(Net Income – Preferred Dividend) ÷ Common Outstanding Shares |
4. Activity Ratio / Efficiency Ratio
Activity ratio shows the revenue generated from a particular asset type by comparing cost, sales and asset data. This ratio helps the business inefficient management and effective utilization of the assets. Here is the list of Activity ratio that is used normally:
Ratio Name |
Usage |
Formula |
Stock Turnover Ratio |
|
COGS ÷ Average Stock/Inventory |
Debtor Turnover Ratio
|
|
Net credit sales ÷ Average debtors or bills receivables |
Creditors Turnover Ratio |
|
Net credit purchase ÷ Average Creditors or Bills payable |
Working Capital Turnover Ratio |
|
Sales or COGS ÷ Working Capital |
The Bottom Line
Accounting ratios may help you to analyze the performance of business but on the contrary, they are calculated at a specific time and date. Hence, it is important to do an in-depth evaluation instead of completely relying on the accounting ratios.